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Jefferies China Year of the Horse 2013
Jefferies China Year of the Horse 2013
Jefferies China Year of the Horse 2013
Jefferies China Year of the Horse 2013
Jefferies China Year of the Horse 2013
Jefferies China Year of the Horse 2013
Jefferies China Year of the Horse 2013
Jefferies China Year of the Horse 2013
Jefferies China Year of the Horse 2013
Jefferies China Year of the Horse 2013
Jefferies China Year of the Horse 2013
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Jefferies China Year of the Horse 2013
Jefferies China Year of the Horse 2013
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Jefferies China Year of the Horse 2013

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  • 1. Jefferies Global Footprint Jefferies Hong Kong Limited 22nd Floor Cheung Kong Center 2 Queen’s Road Central Central, Hong Kong Jefferies.com Investment Banking Equities Fixed Income Commodities Wealth & Asset Management The Americas New York (Global Headquarters) +1 212.284.2300 Albany +1 518.447.7941 Atlanta +1 404.264.5000 Boston +1 617.342.7800 Charlotte +1 704.943.7400 Chicago +1 312.750.4700 Dallas +1 972.701.3000 Denver +1 303.524.1625 Houston +1 281.774.2000 Jersey City +1 212.284.2300 Los Angeles +1 310.914.6611 Nashville +1 615.963.8300 Orlando +1 407.583.0855 San Francisco +1 415.229.1400 São Paulo +55 (11) 3728 9323 Short Hills +1 973.912.2900 Silicon Valley +1 650.573.4800 Stamford +1 203.708.5980 Toronto +1 416.572.2440 Washington, DC +1 202.639.3980 Europe & The Middle East London1 (European Headquarters) +44 (0) 20 7029 8000 Dubai +971 4 376 3200 Frankfurt +49 69 719 187 0 Hamburg +49 40 341080 Milan +39 (0) 2 3601 1900 Paris +33 1 5343 6700 Zurich +41 4 4227 1600 Asia Hong Kong2 (Asian Headquarters) +852 3743 8000 Mumbai +91 22 4356 6000 Shanghai3 +86 21 5111 8700 Singapore +65 6551 3950 Tokyo +81 3 5251 6100 © 2013 Jefferies LLC 1. Jefferies International Limited and Jefferies Bache Limited are authorised and regulated by the Financial Conduct Authority. 2. Jefferies Hong Kong Limited, Licensed by the Securities and Futures Commission of Hong Kong with CE number ATS546. 3. A representative office of Jefferies LLC China The Year of the Horse: China Gallops into a Historic Bull Run China 2014 | Equity Strategy Asia Equity Research | November 2013 • Baidu (BIDU US) • Bank of China (3988 HK) • CITIC Securities (6030 HK) • China Resources Enterprise (291 HK) • CapitaMalls Asia (CMA SP) • Dongfeng (489 HK) • Fosun Pharma (2196 HK) • Huaneng Renewable (958 HK) • PetroChina (857 HK) • Ping An (2318 HK) • Shanghai Industrial (363 HK) • Sinopharm (1099 HK) Jefferies Hong Kong Ltd. Christie Ju, CFA Laban Yu Julian Bu Venant Chiang Sean Darby Jessie Guo, PhD Johnson Leung Jessica Li, PhD Rong Li Cynthia Meng Ming Tan, CFA Jefferies China 2014 Top Buys: JefferiesResearchNovember2013China2014
  • 2. China | Equity Strategy China 20 November 2013 China The Year of the Horse: China Gallops into a Historic Bull Run EQUITYRESEARCHCHINA Christie Ju, CFA * Equity Analyst +852 3743 8012 cju@jefferies.com Laban Yu * Equity Analyst +852 3743 8047 lyu@jefferies.com Julian Bu * Equity Analyst +852 3743 8058 jbu@jefferies.com Venant Chiang * Equity Analyst +852 3743 8013 venant.chiang@jefferies.com Sean Darby * Chief Global Equity Strategist +852 3743 8073 sdarby@jefferies.com Jessie Guo, PhD * Equity Analyst +852 3743 8036 jguo@jefferies.com Johnson Leung * Equity Analyst +852 3743 8055 jleung@jefferies.com Jessica Li, Ph.D. * Equity Analyst +852 3743 8010 jessica.li@jefferies.com Rong Li * Equity Analyst +852 3743 8014 rli@jefferies.com Cynthia Meng * Equity Analyst +852 3743 8033 cmeng@jefferies.com Ming Tan, CFA * Equity Analyst +852 3743 8752 ming.tan@jefferies.com * Jefferies Hong Kong Limited Key Takeaway The Year of the Horse will see China unleash its full potential, as President Xi ushers in a new era of profound change. A journey of a thousand miles begins with the first step. With a clear path to prosperity in sight, we believe China will gallop into a historic multi-year bull run. Reform has reached consensus. In our China 2025: A Clear Path to Prosperity report, we wrote that economic reforms are required, well understood and will develop organically with rising wealth. The Third Plenum has provided a set of specific, substantial, comprehensive and actionable reforms. We believe President Xi has consolidated power, removed obstacles and established the political mechanisms to push through reforms. Bold steps in political reform. We believe the political reforms highlighted by the Third Plenum are myriad, substantial, and likely to be dismissed by Western observers. Political progress in China (and for all nations) is better judged through the lens of effectiveness rather than on a contrived authoritarian-democratic scale. We believe China is recreating Singapore writ large. Government power is being centralized; priority will shift from economic participation to social administration; SOEs will act less as levers of economic planning and more to maximize value of the nation's assets. Central Committee to drive implementation. We believe economic reforms stalled during the Hu-Wen administration as power fragmented between ministries, SOEs and local governments. The NDRC, the government entity responsible for economic reform, has become sclerotic, unable to cut through vested interests. We believe the creation of a Central Reform Committee (likely to be chaired by Secretary Xi) under the Party (not the government) is critically important. We believe this committee will be able to cut through calcified bureaucracies and vested interests to get things done. China gallops into a historic bull run. We believe President Xi is a determined reformer. After consolidating power, he now has the political capital to rapidly implement bold and myriad policies, in our view. We expect capital markets to gradually gain confidence in China’s ability to drive fundamental reforms and expect Chinese stocks to enter a historic multi-year bull run. Jefferies 2014 Sector Allocation. As the market comes to terms with China’s new growth trajectory, we expect the HSI and HSCEI to close 2013 on a high note. We believe the indices will test new highs in 2014 with increasing policy and implementation clarity. We recommend investors buy airlines, autos, banks, brokers, consumer staples, healthcare, insurance, Internet, clean energy and retail property, and sell industrials, metals & mining, residential property, shipping, tech and telecoms. Jefferies 2014 Top Picks. We believe investors should focus on domestic reform plays in 2014. Our Top Buys are Baidu, BOC, CITIC Securities, CRE, CMA, Dongfeng, Fosun Pharma, Huaneng Renewable, Sinopharm, PetroChina, Ping An and Shanghai Industrial. Our Top Sells are Agile, Belle, China Cosco, China Coal, CNBM, Digital China, Longfor, Zhaojin, Zijin and Yanzhou Coal. Jefferies does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Jefferies may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see analyst certifications, important disclosure information, and information regarding the status of non-US analysts on pages 221 to 226 of this report.
  • 3. Table of Contents The Year of the Horse: China Gallops into a Historic Bull Run Clearing the Path to Prosperity 3 Getting from here to there 9 China 2014: Sector Allocation & Top Picks 2013 Top Picks Performance Review 12 China 2014: Sector Allocation 14 China 2014: Top Buys and Top Sells 16 Our Journey Starts with China 2025 A review of Jefferies’ key China Strategy reports 43 Jefferies China 2014 Sector View China Macro 80 Agriculture 92 Conglomerate 101 Consumer 107 Energy 112 Financials (Bank, Insurance and Broker) 124 Gaming 141 Healthcare 148 Industrials 154 Metals & Mining 163 Property 179 TMT (Internet, Telecom and Tech) 187 Transportation 208 Utilities 215 Equity Strategy China 20 November 2013 page 2 of 228 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFA Please see important disclosure information on pages 221 - 226 of this report.
  • 4. Clearing the Path to Prosperity We believe President Xi will usher in a new era of profound change in China, rivaling that of Deng Xiaoping's opening of China in 1978. The Third Plenum has provided a set of specific, substantial, comprehensive and unprecedented reforms, in our view. We believe President Xi has consolidated power, removed obstacles and established the political mechanisms to push through reforms. We believe markets will gain strength in 2014 with confident implementation. Reform is consensus In China 2025: A Clear Path to Prosperity, we wrote that economic reforms in China are required, well understood and will develop organically with rising wealth. Reforms such as economic rebalancing, reducing inequality, financial liberalization, environmental protection, liberalizing rural land transfers etc. have become boilerplate, discussed by various government entities in many different forums. We believe the necessity of reform has won the argument at many levels of China's government to avoid the "middle-income trap". The challenge has been overcoming inertia and vested interests. We believe China's old growth model has run its course, revealing vulnerabilities in an unbalanced economy. As expected, policy uncertainty has made 2013 challenging for equities. In our China 2013: Transformation and Volatility in the Year of the Snake published February 2013, we wrote: We see 2013 as a year of transformation and a new beginning for China. This will be the year that Secretary (and soon to be President) Xi Jinping puts his policies on track. We believe China’s new leaders have the will, the power and the strong support from the 1.3 billion people to embark on its critical transformation. On the other hand, we expect 2013 to be a volatile year for China equities, as the market comes to terms with the developing policy trajectory. We would not be surprised if China stocks ended the year not far from where they began. 2014 will be different, in our view. We believe policy consensus has been reached and markets will gain strength with reform clarity and confident implementation. Consumption – an inequality problem It is almost universally acknowledged that China’s export/investment driven economic growth model is not sustainable. The central government has repeatedly tried to jump- start domestic consumption in hopes of transforming the growth model, but with limited success. Many blame China’s high savings rate for low consumption, and policies have been set up to discourage savings. We believe the real reason for low consumption is China’s alarming income and wealth inequality, of which a high savings rate is merely a natural consequence. With first-hand data provided by the China Household Finance Survey (CHFS), we believe the key to boosting domestic consumption is to reduce income/wealth inequality. We believe markets will gain strength in 2014 with confident implementation The real culprit for low consumption is inequality Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 3 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 5. Exhibit 1: China’s household income 2010 (Rmb) Source: CHFS, Jefferies Gini Coefficient unusually high We diagnosed that economic inequality, rather than a cultural propensity to save, is the root cause of persistent weakness in China’s consumption growth. We concluded that the key to addressing this unbalanced economy is income redistribution through transfer payments, a process that happens organically as societies become wealthier. Based on the CHFS, China’s Gini Coefficient was 0.61 in 2010, one of the highest in the world. The high Gini reflects disparity in labor income, business income and investment income. It is consistent with the vast income and wealth disparity among Chinese households and reflects a lack of state-mandated transfer payments. Given poorer households’ higher propensity to consume, we believe significant transfer payments are necessary to reduce the high Gini, narrow the wealth gap and boost domestic consumption. Exhibit 2: GINI coefficient, select countries Source: World Bank, OECD, Jefferies The Kuznets curve, development self-corrects In the 1930s, Simon Kuznets, a Russian American economist, developed a theory regarding wealth disparity which has later been applied to other undesirable outcomes of economic development. The Kuznets curve is an optimistic hypothesis which stipulates that there is a natural trend of economic inequality, determined by market forces, driving up inequality during early periods of industrialization and urbanization, which, in time, will be corrected as economies mature and human capital accrues. 17.5 28.0 10.6 559 664 275 0 100 200 300 400 500 600 700 Nationwide Urban RuralThousands Median Household income Top 1% Household income 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 Norway,late2000's Finland,late2000's Hungary,late2000's Germany,late2000's S.Korea,2000's Poland,late2000's Greece,late2000's OECD,late2000's Spain,late2000's Canada,late2000's Japan,late2000's N.Zealand,late2000's Italy,late2000's UK,late2000's US,late2000's Thailand,2009 Russia,2009 Philippines,2009 Uganda,2009 Argentina,2009 Malaysia,2009 DominicanRep,2010 Mexico,late2000's Nigeria,2009 Peru,2009 Ecuador,2010 Chile,late2000's Swaziland,2009 Panama,2009 Paraguay,2009 Brazil,2009 Colombia,2010 Honduras,2009 China,2012 SouthAfrica,2009 GINI China’s Gini Coefficient was 0.61 in 2010 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 4 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 6. The Kuznets curve hypothesis has been stretched beyond its original emphasis on economic inequality and applied to all sorts of undesirable by-products of economic growth. It is often used to analyse the relationship between economic development and environmental protection. In the China context, we believe it can also be applied to corruption, an unbalanced economy and personal freedoms. Exhibit 3: Theoretical Kuznets curve Source: Simon Kuznets, Jefferies Transfer payments and the modern economy Simon Kuznets developed his curve in the 1930s, based on the experience of US and European nations during industrialization. The Kuznets curve, where market forces push back against undesirable externalities of economic development, is not a concept new to China. Every developed nation, in fact, has travelled the same path. Empirically, every developed economy has established sophisticated transfer payment systems, redistributing a significant portion of societal income. Overall, taxes and transfer payments within the OECD economies lower total Gini coefficient from 0.46 to 0.32. Exhibit 4: GINI coefficient before and after taxes and transfers, OECD countries Source: OECD, Jefferies Ideology plays a role, wealth level plays a bigger role Using taxes and transfer payments, the Scandinavian cradle-to-grave welfare states have lowered their Gini coefficient to ~0.25 from ~0.43. Turkey, Mexico and Chile, lower income members of the OECD, have the least developed transfer payment systems. The US, the world’s leading champion of free-market principles, has still managed to lower 0.00 1.00 2.00 3.00 4.00 5.00 6.00 1930 1940 1950 1960 1970 1980 1990 2000 2010 Income per capita Undesireableexternality 0.24 0.25 0.25 0.26 0.26 0.26 0.26 0.26 0.26 0.27 0.29 0.29 0.29 0.30 0.30 0.30 0.31 0.31 0.31 0.31 0.32 0.32 0.32 0.33 0.33 0.34 0.34 0.34 0.35 0.37 0.38 0.41 0.48 0.49 0.42 0.42 0.41 0.44 0.42 0.47 0.47 0.43 0.47 0.47 0.48 0.48 0.43 0.50 0.38 0.41 0.47 0.44 0.34 0.46 0.46 0.46 0.44 0.46 0.46 0.47 0.53 0.51 0.52 0.50 0.49 0.47 0.49 0.53 0 0.1 0.2 0.3 0.4 0.5 0.6 Slovenia Denmark Norway CzechRep SlovakRep Belgium Finland Sweden Austria Hungary Luxemb… France Netherla… Germany Iceland Switzerl… Poland Greece Korea OECD… Estonia Spain Canada Japan N.Zealand Australia Italy UK Portugal Israel US Turkey Mexico Chile GINI After taxes and transfers Before taxes and transfer Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 5 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 7. its Gini coefficient from 0.49 to 0.38 through progressive taxation and transfer payments. More wealth = more redistribution Empirically, the extent of a nation’s income redistribution appears to be a function of its income level at least as much as its stated or perceived ideological disposition. The comparison between the US and China is especially stark. In recent years, Communist China’s “capitalism with Chinese characteristics” has taken on the distinct historical flavor of the “robber baron” capitalism experienced by the US at the turn of the last century. The free market champion of the US, while certainly no Scandinavia, has adopted an extensive social welfare system (now including universal healthcare) far more extensive than communist China’s. Exhibit 5: Government spending and tax burden as a percentage of GDP, 2011 Source: Heritage Foundation, Jefferies Among 46 major representative economies we tracked, there is a clear positive correlation between per capita GDP and government spending as a percentage of GDP. Government spending in under-developed nations is often below 20% of GDP while topping 50% among European welfare states. As seen in the OECD data, much of this spending is transfer payments used to redistribute income. The fact that China’s government spending constitutes only 21% of GDP (vs. 39% for the US), despite having a declared communist ideology, is largely understandable given its comparably low per capita GDP. Social welfare spending constitutes only 21.2% of China’s government budget compared to 46.7% in the US. As a percentage of GDP, social welfare spending constitutes 4.4% compared to 18.2% in the US. 0% 10% 20% 30% 40% 50% 60% France Sweden Denmark Belgium Belarus Finland Hungary Austria Italy Ukraine UK Greece Portugal Netherlands Germany Poland CzechRep Spain Brazil Norway Canada US Japan Australia Russia Egypt Venezuela Kenya Nigeria SouthKorea SaudiArabia Vietnam Iran SouthAfrica India Malaysia Argentina Mexico Turkey Chile China Pakistan Indonesia Thailand Philippines Bangladesh Government spending as percent of GDP Tax burden as percent of GDP There is a clear positive correlation between per capita GDP and government spending as a percentage of GDP Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 6 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 8. Exhibit 6: Gov’t spending as % of GDP vs. per capita GDP Source: World Bank, Heritage Foundation, Jefferies Exhibit 7: Contribution to GDP by spending Source: Heritage Foundation, CHFS, Jefferies Stronger and more comprehensive than our prescription In our report, we had identified eight basic policies that China would adopt to reduce inequality. All eight are covered by the Third Plenum report. By design, our prescription was academic in nature, focusing on development paths more than the nitty-gritty mechanics of specific policies and targets. The Third Plenum report is much more comprehensive, giving specific targets, policy prescriptions and administrative changes required to achieve reforms. Exhibit 8: Reform policies Jefferies China 2025 Third Plenum Economic Increase SOE dividend pay-out Increase SOE dividend pay-out to 30% Progressive taxation Impose property tax, luxury tax, close loopholes Market to play “decisive” resource allocation Accelerate Rmb convertibility Promote “mixed ownership” of SOEs Transfer some state assets to social security fund Lower entry barriers for private/foreign investors Accelerate Rmb convertibility Strengthen protection of intellectual property Support the Free Trade Zones Establish unified rural/urban land market Social Relax one child policy Relax one child policy Strengthen pension system Strengthen pension system Strengthen social healthcare system Strengthen social healthcare system Strengthen education and vocational training Strengthen education and vocational training Increase supply of social housing Increase supply of social housing Promote and ease urbanization Promote and ease urbanization Deficit spending Increase spending on welfare Political Strengthen judicial system Abolish reeducation through labor Strengthen anti-corruption efforts Strengthen environment regulations Source: China Communist Party, Jefferies France Sweden Denmark Belgium Belarus Finland Hungary Austria Italy Ukraine UK Greece Portugal Netherlands Germany Poland CzechRep Spain Brazil Norway Canada US Japan Australia Russia Egypt Venezuela Kenya Nigeria SouthKorea SaudiArabia Vietnam SouthAfrica India Malaysia Argentina Mexico Turkey Chile China Pakistan Indonesia Thailand Philippines Bangladesh R² = 0.4374 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000 50,000 Per capita GDP, US$2005 PPP 4.4% 18.2% 16.4% 20.7% 79.2% 61.1% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% China US Non government spending Other government spending Social welfare spending Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 7 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 9. Unprecedented economic reforms Pessimism over the Third Plenum's vague initial communiqué was premature, in our view. We find the 60-point follow-up document to be specific, substantial, comprehensive and unprecedented. The detailed paper is not a boiler-plate reiteration of required reforms but an internally consistent document that recognizes the complexity of China's problems and matches them with holistic solutions, in our view. Key economic reforms include: Market pricing. The initial Third Plenum communiqué stated that the markets will play a "decisive" role in allocating resources. The previous language was that markets would play a "basic" role. We believe this formulation has profound implications for China's energy industry, where regulated prices have been the norm. Details in the 60- point follow-up document specifically called for market pricing of petroleum, natural gas, water, electricity, transportation and telecommunications. SOE restructuring. The initial Third Plenum communiqué reiterated the central role of SOEs in China's economy, giving fodder to the reform pessimists. The 60-point follow- up document, however, has changed the mandate of SOEs from being levers of central planning to value maximizers of state assets, a profound change, in our view. Financial reform. The initial Third Plenum communiqué did not mention financial reform. This, we believe, more than anything else led to the initial pessimism and the market sell-off. Financial reform, however, is a major theme of the 60-point follow-up document. Among them, allowing private capital to enter banks, accelerate full convertibility of RMB and market pricing of FX/interest rates. Free trade zones. The 60-point follow-up document specifically mentioned support for the Shanghai Free Trade Zone as well as to accelerate the formation of other free trade zones. The Shanghai Free Trade Zone captured the excitement of China watchers this Fall which has, to some degree, waned as details and high-level political support appeared unforthcoming. We believe Free Trade Zones will be used as spring boards of economic reform and should be closely watched. Environmental regulations. The key environmental regulatory concept contained in Third Plenum reforms is that negative externalities of resource consumption must be priced and borne by consumers. Resource taxes, emission trading and stricter emissions standards are mechanisms that can reduce environmental damage. Invigorated environmental regulations will negatively affect the economics of highly polluting resources, with limited scope for emissions reduction and significant substitution potential by alternatives. A political transformation The political reforms mentioned in the document are myriad, substantial and we believe very likely to be dismissed by Western observers. Political progress in China (perhaps for all nations) is better judged through the lens of effectiveness rather than on a contrived authoritarian-democratic scale, in our view. Singapore writ large We believe China is recreating Singapore writ large. Government power is being centralized; priority will shift from economic participation to social administration; SOEs will act less as levers of economic planning and more to maximize the value of the nation's assets. The foreign media will highlight their hobby horses – relaxation of the one-child policy, abolishing the reeducation through labor system and overhauling the judicial system to enhance the independence of courts. We do not disagree that these are important political and social reforms but getting less press but perhaps more significant are administrative changes and a reprioritizing of government goals. China will change the way it evaluates local officials by focusing less on GDP growth and more on debt management, innovation, the environment, public health and social welfare. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 8 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 10. Growth-at-all-costs to growth-for-employment Two years in a row, China targeted 7.5% GDP growth, abandoning the double-digit growth rates of years past. Maintaining employment has forced the government to rely on substantial FAI in 2013. Premier Li Keqiang stated that China needs GDP to be ~7.2% to keep unemployment in check. This "growth-for-employment" is a significant departure from "growth-at-all-costs." We believe economic reforms will help drive organic job creation alleviating required FAI stimulus. Getting from here to there The 60-point Third Plenum document looks very good on paper, removing initial market doubt that President Xi and Premier Li are serious about reform. We believe confident implementation of myriad policies throughout 2014 will further strengthen markets. Quick consolidation of power With some credit to his predecessor, Xi Jinping successfully consolidated power in a short period of time. Xi Jinping assumed the offices of the General Secretary of the Party, the Presidency and Chairman of the Military within six months. In a break from tradition, outgoing President Hu Jintao gracefully relinquished all official posts on retirement. This auspicious start allowed President Xi to hit the ground running. Anti-corruption campaign clearing obstacles China's anti-corruption campaign has surprised us in intensity and duration. Party cadres at all levels have been called to the carpet to account for past deeds (or misdeeds). Investigations have brought down the top management of PetroChina, the head of SASAC, the director of the NEA and have reportedly reached into the Standing Committee of the Politburo. Anti-corruption drives are nothing new but Secretary Xi has conducted this one with an energy and style that wholly eluded his predecessors. We believe this anti-corruption campaign has sufficiently rattled the Party's rank-and-file, priming them to accept significant reforms. Xi Jinping gives anti-corruption efforts a shot in the arm China’s anti-corruption efforts appear to have been given a shot in the arm since Xi Jinping took over as Party Secretary. To be fair, exiting President Hu Jintao warned the Communist Party in his valedictory address that failing to rein in corruption “could prove fatal to the party and even cause the collapse of the state”. Anti-corruption efforts started the New Year strongly with a series of developments both large and small. Banning elaborate red carpet ceremonies, banquets and pompous speeches in routine government business Removal of Li Chuncheng, deputy Party secretary Sichuan, for breach of party discipline Removal of Liu Tienan, Director of the National Energy Administration, for accepting bribes, misrepresenting academic qualifications and transgressions in his personal life Conviction and life imprisonment of Bo Xilai for corruption and abuse of power. Investigation of and dismissal of five top PetroChina executives for serious violations of discipline Investigation of and dismissal of Jiang Jiemin, Director of SASAC and former Chairman of CNPC/PetroChina, for serious violations of discipline Tacit approval for online muckrakers who have exposed a parade of officials for illicit and inappropriate behaviour Xi Jinping publicly stated that the Party should welcome “sharp criticism” “Corruption could prove fatal to the party and even cause the collapse of the state” – President Hu Jintao Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 9 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 11. Party organ to push reform We believe economic reforms stalled during the Hu-Wen administration as power became fragmented among ministries, SOEs and local governments. The NDRC, the government entity responsible for economic reform, has become sclerotic, unable to cut through vested interests, in our view. We believe the establishment of a Central Reform Committee (likely to be chaired by Secretary Xi) under the Party (not the government) is critically important. We believe this committee will be able to cut through calcified bureaucracies and vested interests. Economic reform has calcified under the NDRC Before 2003 (when reforms start to stall) the State Council Office for Restructuring the Economic System (SCORES) was the government department dedicated to driving economic reforms. This department was independent of the State Planning Commission (SPC) which was responsible for the nuts and bolts of China’s planned economy. In 2003, these two government departments were merged to form the National Development and Reform Commission (NDRC). At the time, the idea was that the reformers from SCORES could be more effective working closely with the central planners at SPC. In actuality, it appears that the reformist vitality of SCORES was diluted by the conservatism of the SPC. The dual mandate of the NDRC, economic planning and economic reform, were in conflict, stalling economic reforms for a decade. Breaking the gridlock We believe the Central Reform Committee, with support from the highest levels of the Party, will recapture the reformist vitality of SCORES. The team will be in charge of designing reform on an overall basis, arranging and coordinating reform, pushing forward reform as a whole, and supervising the implementation of reform plans. Expect confident implementation in 2014 Within days of the release of the Third Plenum’s 60 point document, government agencies in China have floated coming policy changes through the press. We believe we will see rapid implementation of policies giving credence to the reformist agenda of the Xi-Li administration. So far, the media has given us a taste: President Xi declared through the press that implementation will be priority and must be conducted with courage. NDRC official commented that the next phase is to open up fuel prices to the market. PBOC governor Zhou Xiaochuan affirms that Rmb trading band will be widened and the PBOC will gradually exit FX intervention. In a media interview, NDRC chairman Xu Shaoshi declared the commission is drafting a paper to lead reforms by the nose. These include initiatives to reduce administrative approvals for investment, accelerate price reform and initiate investment projects in finance, oil and gas, power, railways, resources and utilities which are open to private investors. We believe government entities in China are now on the same page and are lined up to implement Third Plenum reforms. We expect bold, myriad and confident policies to be announced in 2014. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 10 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 12. Table of Contents The Year of the Horse: China Gallops into a Historic Bull Run Clearing the Path to Prosperity 3 Getting from here to there 9 China 2014: Sector Allocation & Top Picks 2013 Top Picks Performance Review 12 China 2014: Sector Allocation 14 China 2014: Top Buys and Top Sells 16 Our Journey Starts with China 2025 A review of Jefferies’ key China Strategy reports 43 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 11 of 228 Please see important disclosure information on pages 221 - 226 of this report. Jefferies China 2014 Sector View China Macro 80 Agriculture 92 Conglomerate 101 Consumer 107 Energy 112 Financials (Bank, Insurance and Broker) 124 Gaming 141 Healthcare 148 Industrials 154 Metals & Mining 163 Property 179 TMT (Internet, Telecom and Tech) 187 Transportation 208 Utilities 215
  • 13. JEF 2013 Top Picks Performance Review Since we introduced Jefferies China 2013 Top Picks on Feb 24, 2013, our investment portfolio, combining Top Buys and Top Sells, has generated a total return of 12.6% as of Nov 19, beating HSI and HSCEI by 8.8ppt and 12.2ppt, respectively. Exhibit 9: Jefferies Top Picks Performance (Top Buy & Sell combined) Source: Jefferies, Bloomberg, priced as of Nov 19, 2013 In our China 2013: Transformation & Volatility in the Year of Snake (February 24), we introduced 10 Top Buy stocks. These picks reflected our positive view on the growth outlook for banks, consumer, natural gas, retail property, internet and IPP. Exhibit 10: JEF Top Buys initiated on February 22 Price on Feb 22 Price on April 24 % change AIA 31.95 33.25 4.1% CapitaMalls Asia 2.09 1.97 -5.7% CCB 6.29 6.27 -0.3% CR Enterprises 25.4 25.8 1.6% CR Land 22.15 23 3.8% COLI 22.3 23.2 4.0% Guangdong Investment 6.58 7.61 15.7% PetroChina 10.7 9.56 -10.7% Intime 9.5 9.05 -4.7% Tencent 264.4 254.4 -3.8% Average 0.4% Source: Jefferies, Bloomberg, prices in trading currencies In April (China 2013 (II): Tough Tasks Call for Brave Leaders), we replaced Guangdong Investment and Intime with China Unicom and Shanghai Industrial as Top Buys, and also introduced a list of six stocks as Top Sell ideas. Exhibit 11: Rebalancing of JEF Top Buy portfolio on April 24 Addition Price on Feb 22 Price on April 24 % change China Unicom 10.82 Shanghai Industrial 24.25 Deletion Guangdong Investment 6.58 7.61 15.7% Intime 9.5 9.05 -4.7% Source: Jefferies, Bloomberg, prices in trading currencies 75 80 85 90 95 100 105 110 115 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 HSI HSCEI JEF TOP BUY & SELL Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 12 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 14. Exhibit 12: JEF Top Sell portfolio initiated on April 24 Stock Price China Cosco 3.38 China Shipping Dev. 3.45 CNBM 9.81 PICC Group 3.95 Yanzhou Coal 8.72 Zoomlion 8.26 Source: Jefferies, Bloomberg, prices in trading currencies as of April 24 Sticking to our theme of defensiveness with visible growth and low valuation, we adjusted our Top Buys in July (China 2013 Mid-Year Review: “Xi-Li New Deal” Building Momentum), replaced COLI and CCB with Dongfeng and ENN. We also removed PICC Group and Zoomlion from our Top Sell portfolio and added Agile, Daphne and Lonking. Exhibit 13: Rebalancing of Jefferies Top Buy/Sell portfolio on July 16 Top Buy portfolio Price on Feb 22 Price on July 16 % change Addition Dongfeng Motor 9.65 ENN 44.35 Deletion COLI 22.30 21.35 -4.3% CCB 6.29 5.47 -13.0% Top Sell portfolio Price on April 24 Price on July 16 % change Addition Agile 7.9 Daphne 5.26 Lonking 1.55 Deletion PICC Group 3.95 3.51 11.1% Zoomlion 8.26 5.11 38.1% Source: Jefferies, Bloomberg, prices in trading currencies As of Nov. 19, 2013, our Top Buy portfolio (equal-weighted) generated an absolute return of 12.7% since Feb. 24, beat HSI and HSCEI by 8.9ppt and 12.3ppt, respectively. Our Top Sell portfolio (equal-weighted) provided an absolute return of 9.2%, outperforming HSI and HSCEI by 5.4ppt and 8.8ppt since introduction on April 24. Exhibit 14: Jefferies Top Buy Portfolio Performance Source: Jefferies, Bloomberg, priced as of Nov 19, 2013 Exhibit 15: Jefferies Top Sell Portfolio Performance Source: Jefferies, Bloomberg, priced as of Nov19, 2013 75 80 85 90 95 100 105 110 115 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 HSI HSCEI JEF TOP BUY 80 90 100 110 120 130 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 HSI HSCEI JEF TOP SELL Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 13 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 15. Jefferies China 2014: Sector Allocation We like auto, energy, financial, healthcare, retail property, and staples In 2014, we are Overweight on secular growth sectors including healthcare, passenger auto, consumer staples, and Internet and commercial property. We prefer energy as we believe energy price reform will drive its profitability. Pending financial reforms should benefit insurers and brokers the most. We continue to prefer banks as reform will address the critical issue of local government debt and improve transparency. We also prefer airlines and ports in the transport sector; airlines are leveraged to consumption growth while ports will benefit from recovery in the developed world. Lastly, we like renewable energy as China moves to cleaner energy. Negative on industrials, metals & mining, residential property, shipping & tech On the flipside, we are Underweight on FAI beneficiaries, including coal, metals & mining, and industrials. We believe a unified rural/urban land market and property tax legislation will hurt residential demand. We are bearish on container shipping due to rapid capacity growth. We are cautious on tech as smartphone demand growth is decelerating and PC hardware demand recovery will be slow. Exhibit 16: JEF China 2014: Sector Allocation Source: Jefferies Agriculture (Fundamental Neutral; asset allocation Equal-weight) We are neutral on the sector and expect farmland transfer to increase, as China begins to embrace large-scale farming to raise food production. This will benefit agricultural machinery/high-tech farming. We are cautious on fertilizer on limited volume growth. Auto (Fundamental Positive; asset allocation Over-weight) We are bullish on Passenger Vehicles but cautious on Heavy Duty Trucks. We expect rising income to drive passenger vehicle penetration in China, especially in the lower tier cities. We prefer Compact to Luxury. We expect HDT names to continue to face headwinds as China moves away from investment. Consumer (Fundamental Positive; asset allocation Over-weight) We are positive on consumer staples on potential margin improvement. We are neutral on department stores as over-expansion and market share erosion by e-commerce are balanced by low valuation. We are bearish on footwear & apparel due to over- expansion and threats from e-commerce, while valuation is yet to become attractive. Conglomerates (Fundamental Neutral; asset allocation Equal-weight) We are neutral on the sector, and expect SOE reform to generate ample opportunities for consolidation of state-owned assets. On the other hand, reforms will lead to rising competition and gradually take away certain privileges enjoyed by SOEs. Over-weight Equal-weight Under-weight Airlines Agriculture Footwear & Apparel Autos Conglomerates Industrials Banks Department Stores Metals & Mining Brokers Gaming Residential Property Consumer Staples IPP Shipping Healthcare Jewellery Tech Insurance Natural Gas Distribution Telecom Internet Oil/Gas Ports Retail Property Wind Farm / Solar Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 14 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 16. Oil/Gas (Fundamental Positive; asset allocation Over-weight) We expect three themes to drive energy stocks: 1) market pricing, 2) SOE reform, and 3) environmental regulations. We believe market pricing will improve sector profitability while SOE reform can clear out a lot of the undesirables and improve efficiency. Financials (Fundamental Positive; asset allocation Over-weight) We are most positive on insurance and brokers. We like insurance given growing agency business, broadening of investment channels and policy support. We expect brokers to benefit from capital market reforms (a register-based IPO). For banks, we believe reforms will lead to stronger local gov’t finances, greater transparency, and better-quality growth. Gaming (Fundamental Positive; asset allocation Equal-weight) We are fundamentally positive on Macau Gaming and expect a 15% GGR growth in 2014, driven by rising demand from both the fast expanding high-net-worth-individual class in China and mass visitations. For asset allocation we commend equal-weight due to rich valuation and limited catalysts in 2014. Healthcare (Fundamental Positive; asset allocation Over-weight) We are positive on Chinese pharmaceuticals given the sustainable mid-teens growth, defensive characteristics, and undemanding valuation. We prefer the leading pharma companies to distributors. Industrials (Fundamental Negative; asset allocation Under-weight) We remain cautious on the Industrials space. In the rail sector, we prefer contractors to equipment makers on a relative basis, and diversified contractors over their rail peers. In machinery, we are structurally cautious on construction and coal machinery. Metals & Mining (Fundamental Negative; asset allocation Under-weight) We are cautious on coal, gold and steel in 2014. As China moves toward clean energy, coal will face increasing headwinds. We are bearish on gold price and believe gold stock’s valuation is expensive. On steel, we believe its margin will be squeezed. We are relatively positive on cement given limited capacity growth. For strategic allocation we recommend underweight the entire sector given multiple headwinds in 2014. Property (Fundamental Negative; asset allocation Under-weight) Residential property sector is facing tough headwinds, with softening demand and rising policy concerns. We expect increased affordable housing to curb demand, and expect property tax in Tier 1/2 in next 12 months. We continue to like retail property sector, as urbanization and domestic consumption will drive robust growth of this subsector. Transport (Fundamental Neutral; asset allocation Under-weight) Airlines have the least capacity issues and are set to rebound. Crude tankers could prove a contrarian investment for long-term investors. We are constructive on dry bulk shipping as freight rates could move higher, and are cautious on containers on surplus capacity. Internet, Telco & Tech (Fundamental Positive; asset allocation Over-weight) We are bullish on Internet, especially the four key segments: 1) E-Commerce, 2) Mobile games, 3) Search and performance-based ads, and 4) Online travel. We are fundamentally neutral on telecom, as earnings growth is likely to be slow or negative but 4G launch may provide some boost after 2014. We are cautious on tech, given the secular slowdown in consumer PC and deceleration in smartphone growth. Utilities (Fundamental Positive; asset allocation Over-weight) China will provide policy support and encourage investment in natural gas, wind, and solar infrastructure to address environmental issues. We are fundamentally positive on IPPs as coal prices could continue to slide. For asset allocation we recommend overweight wind over natural gas and IPPs, on valuation concerns and risk of potential tariff cut. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 15 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 17. Jefferies China 2014 Top Picks In 2014, we recommend investors to overweight autos, financials, healthcare, retail property, staples, and clean energy sectors. Our Top Buys are Baidu, BOC, CITIC Securities, CRE, CMA, Dongfeng, Fosun Pharma, Huaneng Renewable, Sinopharm, PetroChina, Ping An and Shanghai Industrial. We advise investors to avoid stocks with high FAI exposure. Our Top Sells are Agile, Belle, China Cosco, China Coal, CNBM, Digital China, Longfor, Zhaojin, Zijin and Yanzhou Coal. Our Top Buy portfolio is skewed towards financials (25%) and healthcare (16.7%) and has equal weighting (8.3%) on retail properties, utilities, Internet, energy, consumer staples and conglomerates. The Top Sell portfolio is concentrated in metals & mining (50%). Exhibit 17: Top Buy portfolio weighting by sector Source: Jefferies Exhibit 18: Top Sell portfolio weighting by sector Source: Jefferies Exhibit 19: Valuation metrics for top picks Mkt Cap Price PE PB Div Yield Company Ticker Rating US$ mn trading 2012 2013E 2014E 2012 2013E 2014E 2012 2013E 2014E Top Buy Baidu* BIDU US Buy 56,995 162.87 33.2 31.5 25.4 13.3 9.2 6.6 0.0% 0.0% 0.0% Bank of China 3988 HK Buy 130,403 3.70 5.8 5.5 4.9 1.0 0.9 0.8 6.0% 6.5% 7.6% Citic Securities 6030 HK Buy 23,457 18.88 39.0 33.0 20.6 1.9 1.9 1.7 2.0% 1.2% 2.0% CR Enterprises 291 HK Buy 8,307 26.80 38.0 35.3 29.5 1.6 1.5 1.5 1.1% 1.1% 1.1% CapitaMalls Asia CMA SP Buy 6,322 2.02 14.4 33.7 28.9 1.2 1.2 1.1 1.6% 1.6% 1.6% Dongfeng Motor 489 HK Buy 13,782 12.40 9.2 8.5 7.2 1.6 1.3 1.1 1.5% 1.7% 1.9% Fosun Pharma 2196 HK Buy 6,693 20.95 20.6 24.2 20.8 2.5 2.5 2.2 1.3% 1.3% 1.3% Huaneng Renewable 958 HK Buy 3,607 3.31 39.4 18.6 13.7 1.9 1.6 1.5 0.6% 1.0% 1.3% PetroChina 857 HK Buy 234,969 9.49 11.8 10.4 7.9 1.3 1.2 1.1 3.8% 4.2% 4.4% PingAn 2318 HK Buy 60,255 69.90 21.7 15.4 12.8 2.7 2.4 2.0 0.8% 1.3% 1.6% Shanghai Industrial 363 HK Buy 3,717 26.65 8.4 10.1 9.3 0.9 0.8 0.7 4.1% 4.1% 4.1% Sinopharm 1099 HK Buy 7,702 23.25 22.3 19.4 16.3 2.6 2.0 1.8 1.4% 1.5% 1.7% Average 22.0 20.5 16.4 2.7 2.2 1.9 2.0% 2.1% 2.4% Top Sell Agile 3383 HK UNPF 4,069 9.15 5.0 5.8 5.1 1.0 0.9 0.8 4.3% 4.2% 4.2% Belle 1880 HK UNPF 10,412 9.57 14.6 15.0 15.0 2.8 2.5 2.3 2.1% 2.1% 2.1% China Cosco 1919 HK UNPF 5,141 3.66 NM NM NM 1.2 1.6 2.5 0.0% 0.0% 0.0% China Coal 1898 HK UNPF 10,460 4.86 5.7 13.2 12.7 0.6 0.6 0.5 5.5% 3.1% 2.8% CNBM 3323 HK UNPF 5,641 8.10 6.2 6.9 6.6 1.1 1.0 0.9 2.4% 2.2% 2.5% Digital China 861 HK UNPF 1,450 10.28 8.0 8.0 8.7 1.4 1.3 1.1 3.8% 3.5% 3.9% Longfor 960 HK UNPF 8,521 12.14 8.0 8.3 6.6 1.7 1.5 1.2 2.1% 2.1% 2.4% Yanzhou Coal 1171 HK UNPF 6,744 7.85 4.9 14.7 23.7 0.7 0.7 0.7 4.6% 1.4% 2.1% Zhaojin 1818 HK UNPF 1,993 5.30 6.3 9.1 11.3 1.5 1.3 1.3 5.8% 4.1% 3.4% Zijin 2899 HK UNPF 7,763 1.85 6.1 12.1 13.2 1.1 1.0 1.0 6.9% 3.4% 3.4% Average 7.2 10.3 11.4 1.3 1.2 1.2 3.7% 2.6% 2.7% Source: Jefferies estimates, Bloomberg, priced as of Nov 19, 2013. *Priced as of Nov 18, 2013. Internet 8.3% Consumer staple 8.3% Auto 8.3% Energy 8.3% Utilities 8.3% Retail property 8.3% Conglomerate 8.3% Healthcare 16.7% Financials 25.0% Metals & mining 50% Residential property 20% Consumer discretionary 10% Transport 10% Tech 10% Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 16 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 18. TOP BUYS Baidu (BIDU US, BUY, TP US$222) Our positive outlook on Baidu is built upon its faster than expected mobile search ramp- up and monetization potential, driven by increasing mobile search demand and incremental mobile ad budget from Baidu’s customers. Newly launched “Zhixin” interim landing page may see more upside on both PC and mobile platforms. Bank of China (3988 HK, Buy, TP HK$4.9) We believe BOC will benefit from greater RMB internationalization, and is less susceptible to RMB interest rate (IR) deregulation as it has the highest proportion of non-interest income & overseas assets, which may also benefit from potentially stronger USD & higher Fed rates. In our view, valuation is compelling. CITIC Securities (6030 HK, Buy, TP HK$22) As the No.1 China broker with a strong investment banking (IB) franchise, CITICS is likely to deliver strong earnings growth after A-share IPOs resume and be the top beneficiary of disintermediation in China in the long term. CITICS’ strong capital position after aggressively leveraging up its balance sheet may better support the growth of its credit-related business, and the acquisition of China AMC and CLSA may improve its asset management and overseas businesses meaningfully. China Resources Enterprise (291 HK, Buy, TP HK$32.5) We believe CRE’s consolidation will bear fruit in the long term. Its retail business delivered industry leading SSS growth in the recent quarter; beer saw rising market share and margins. We think NT margin pressure from M&As with Kingway and Tesco will be offset by LT benefits. CapitaMalls Asia (CMA SP, Buy, TP SG$2.4) A mass-end mall operator, CapitaMalls Asia is a choice of defensiveness and resilient growth. Driven by urbanisation and consumption, CMA could continue to benefit from its first mover advantage on reversion from existing malls and new mall openings. Its financing advantage stemming from a strong background and a vertical capital recycle model will underpin further growth potential through future acquisitions. Dongfeng (489 HK, BUY, TP HK$15.3) Dongfeng is an obvious beneficiary of the set of reforms introduced after the 3rd plenum. Investors should remain positioned for further market share and margin recovery in 2H13 and 2014. With the lowest valuation in the space at 7.5x forward PER, Dongfeng remains a low-risk name, in our view. Fosun Pharma (2196 HK, BUY, TP HK$25) As a leading Chinese diversified healthcare company, Fosun Pharma has a strong presence in all key segments of the healthcare industry value chain. The company has the most impressive M&A track record among its peers. In a cost containment environment, we believe Fosun’s diversification and superb M&A capability should allow it to better mitigate pricing risk and deliver strong growth that outpaces the industry average. The company’s new incentive plan also sets commendable sales and profit targets with implied 2013-15 CAGR of at least 18% and 25%, respectively. Huaneng Renewable (958 HK, BUY, TP HK$4.3) We are in a structural growth story for wind farm operators, and Huaneng Renewable is our top pick among the wind farm operators. We are forecasting a 2013-15 EPS CAGR of 33% as earnings should continue to benefit from improving utilization hours and new installed capacity adds. The company’s historical discount to industry leaders should disappear as Huaneng Renewable continues to execute. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 17 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 19. PetroChina (857 HK, Buy, TP HK$12) PetroChina has the best oil & gas assets among the three oils. We believe 2014 energy policy will favor PetroChina from 1) market pricing, 2) SOE restructuring and 3) environmental regulations. We believe PetroChina will benefit from accelerating natural gas production growth and pricing reform. Ping An (2318 HK, BUY, TP HK$83) Ping An is our top pick in the China insurance sector. It is the only listed insurer that has limited exposure to bancassurance, with almost pure focus on agency distribution. We believe its life insurance NBV growth rate can be maintained at 7-12% for the next few years. In addition, we believe its strong P&C operation and improving banking business will also help with its re-rating going into 2014. Shanghai Industrial (363 HK, Buy, HK$30) We like SIHL’s balanced portfolio, stable earnings and attractive valuation. We believe the company is well-positioned to benefit from Shanghai’s robust outlook as the Free Trade Zone becomes a key growth driver. Thanks to strong government support, SIHL has ample opportunities to acquire quality state-owned assets in infrastructure utilities and real estate, therefore enhancing its potential. Sinopharm (1099 HK, BUY, TP HK$26.5) Sinopharm is our favourite Chinese pharma distributor, given its unsurpassed dominance in the space. While the company’s distribution business should sustain high- teens% organic growth in the next several years, significant opportunities lie in its retail pharmacy business longer term. Trading at 16x our 2014e EPS against our 3-year EPS CAGR of 18%, the stock’s valuation is attractive. TOP SELLS Agile (3383 HK, Underperform, TP HK$7.8) We maintain Underperform on Agile as we consider its aggressive land banking unjustified on lagging sales and rising inventories. Given the policy headwind, weakening market sentiment and tightening credit ahead, we believe the contribution from new cities remains highly uncertain. Compared to peers, Agile may be exposed to higher risk from stricter tax collection as its current tax liability is Rmb9.5bn. Belle (1880 HK, Underperform, TP HK$8.2) In 2014, we expect Belle to continue facing challenges from B2C e-commerce, while the sales from department store channel will demonstrate slow SSSG and operating deleverage. We expect the company to deliver flat YoY EPS growth in 14e, and reiterate Underperform on Belle. Cosco (1919 HK, Underperform, TP HK$1.9) A series of disposals this year including Cosco Logistics, CIMC, and some office buildings could save Cosco from a potential A-share suspension. However, challenges remain for container shipping, and valuation looks rich for an operationally challenged company. China Coal (1898 HK, Underperform, TP HK$2.8) We believe coal price will continue to fall next year due to China’s economy rebalancing and low cost coal capacity debottlenecking. Our 2014 earnings estimates for China Coal are 22% below consensus, which appears to believe coal prices will recover appreciably from present levels. Under our negative coal price forecast, we believe the company is in danger of ruining its pristine balance sheet with its intense capex program. CNBM (3323 HK, Underperform, TP HK$6) The 1H13 call was significant in that CNBM’s management confirmed it will focus on deleveraging its balance sheet in the next few years. This means CNBM has lost its most effective growth engine: acquisitions. We slash our 2013/14 earnings forecasts to 20%/30% below consensus which will slowly adjust downwards. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 18 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 20. Digital China (861 HK, UNDERPERFORM, TP HK$8) Despite management’s best efforts, we see ongoing structural challenges in Distribution and Systems, the two most profitable businesses at Digital China. We see the recent share price recovery, driven by the market value of Shenzhen Techo Telecom, as unwarranted. Longfor (960 HK, Underperform, TP HK$11) Aggressive expansion has not yet been proven to boost presales. Instead it undermines the balance sheet on rising capex pressure. Chongqing still contributes 1/4 of presales and a 15% down payment is provided to attract homebuyers. Weakening market demand, policy overhang and credit tightening raise our concerns about Longfor’s financial health. Yanzhou Coal (1171 HK, Underperform, TP HK$3.6) Yanzhou Coal’s previous success was achieved based on high coal prices. We believe coal prices will continue to fall in 2014 and our earnings estimate for Yanzhou Coal is 42% below consensus. We believe its cost saving in 3Q13 is unlikely to sustain as a significant contribution came from a one-off provision of obligation items on the balance sheet. Zhaojin (1818 HK, Underperform, TP HK$5) Between the two gold companies, we have a relative preference for Zhaojin over Zijin given its proven track record in volume growth and cost control. More importantly, it doesn’t have the resource depletion issue in its core mine that Zijin is facing. However, we believe valuation to be expensive based on our LT gold price assumption of US$1,250/oz. Even under a bull case assumption, the stock’s valuation seems demanding. Zijin (2899 HK, Underperform, TP HK$1.4) On top of the risk of falling gold price, we are concerned about Zijin’s stagnant mined gold production growth, steep rise in production costs and transition risks at its flagship Zijinshan mine, where it’s moving from mined gold to copper production. We see high executional risk as the company ramps up copper production to offset the decline in gold, which accounts for at least 30% of the company’s gross profits. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 19 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 21. Baidu (BIDU US, BUY, TP US$222) Key Takeaway Our positive outlook on Baidu is built upon its faster than expected mobile search ramp-up and monetization potential, driven by increasing mobile search demand and incremental mobile ad budget from Baidu’s customers. Newly launched “Zhixin” interim landing page may see more upside on both PC and mobile platforms. Increasing mobile search demand Our checks with search ad agents reveal that advertisers are increasingly allocating at least 10-15% incremental ad budget to mobile search. We estimate that mobile queries already account for 40% of total queries at Baidu, and the cost per click (CPC) gap between mobile and PC has narrowed over the past few months. Starting from Dec 1st , all Baidu mobile search customers are required to have a mobile landing page. New product helps drive monetization Baidu launched “Zhixin” search on four verticals including education, finance, travel and medical in July, presenting search results in an easy to use format on an interim landing page. Our channel checks indicate that Zhixin has improved click through rate (CTR) and conversion rate for Baidu’s search. According to management, iwan.baidu.com, Baidu’s PC-based online gaming portal, has delivered 50% increase in ROI since its integration with “Zhixin”. We hold the view that further upside exists if Zhixin is expanded successfully to other verticals, and onto mobile search. Laying out a mobile ecosystem with strong app distribution capability Baidu has enhanced its mobile apps distribution capability with the acquisition of 91Wireless, making it a close #2 with 20.5% in aggregate market share. Baidu is beefing up its LBS offering (over 140mn MAU, up from 120mn last quarter) with the integration of Nuomi and Baidu Map, an important mobile gateway of local search which enables transactions to be completed within Baidu ecosystem, such as hotel booking, movie ticket purchase, group buy and taxi booking. Valuation Maintain Buy with PT at USD222, based on 25x FY15 PE, 7% above peer average, with an implied 35x FY14 P/E. We believe investors will look through given mobile search upside and expected margin expansion in FY15. Risks include execution in the transition to and potential monetization of mobile, and stronger than expected competition. Exhibit 21: Mobile search traffic market share (3Q13) Source: Sootoo Research, Jefferies Exhibit 22: App distribution platform market share by number of times used in Sept 2013 Source: iResearch Oct 2013, Jefferies App Distripution Platfrom Market Share % 360 Mobile Assistant (Qihoo) 21.7% Wandoujia 15.3% Tao App Store (Alibaba) 10.6% 91 Mobile Assistant (Baidu) 9.2% HiMarket (Baidu) 6.5% Baidu Mobile Assistant (Baidu) 4.9% MIUI App Store (Xiaomi) 6.0% Anzhi Market 3.4% PP Mobile Assistant 4.7% Tencent Myapp 1.8% Others 15.9% Total 100.0% 20.5% Exhibit 20: Share price Source: Bloomberg, Jefferies 0 20 40 60 80 100 120 140 160 180 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Nov-13 Cynthia Meng +852 3743 8033 cmeng@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 20 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 22. Bank of China (3988 HK, Buy, TP HK$4.9) Key Takeaway We believe BOC will benefit from greater RMB internationalization, and is less susceptible to RMB interest rate (IR) deregulation as it has the highest proportion of non-interest income & overseas assets, which may also benefit from potentially stronger USD & higher Fed rates. In our view, valuation is compelling at 2014E P/B & P/E of 0.78x & 4.9x resp., with dividend yield of 7%. Core business BOC is the 4th largest commercial bank in China, with 3Q13 assets of Rmb13.6 trillion. It is China's most internationalized bank, with 19% of its assets overseas. BOC owns 66% of Hong Kong listed BOC Hong Kong (Holdings) Limited (2388 HK, NC). The bank currently has 10,786 domestic branch outlets and 623 overseas outlets. BOC was originally the state-designated specialized foreign exchange and foreign trade bank after the founding of the People’s Republic of China. BOC was listed on the Hong Kong Exchange and Shanghai Stock Exchange in June and July of 2006, respectively. Huijin and SSF are the two major shareholders of BOC. Most diversified business model with potential overseas tailwind With its business and geographical diversification, BOC is less dependent on RMB interest spread and thus less vulnerable to RMB-IR deregulation, in our view. The bank’s 9M13A non-interest income accounted for 32% of total income, highest among the H- share banks (avg 21%). Non-RMB loans & deposits at BOC accounted for 25% of total loans & 19% of total deposits, vs. H-share avg of 8% of loans & 5% of deposits. Furthermore, its overseas business, which is mainly in Hong Kong, may benefit from potentially stronger USD and rising US interest rate cycle next year, potentially narrowing its ROE gap vs. peers. Financials and Valuation Our HK$4.90 PT is the wt. avg. of our 3-stage DDM (50%) & fair P/B model (50%), based on profit growth of 9%/6%/3% in stage 1/2/3, 35% dividend payout, 16.7% sustainable ROE, and 13.0% COE. Our PT-implied avg. 2014E P/B is 1.02x. Exhibit 24: 9M13A non-int. income % revenue – BOC least dependent on interest spread income Source: Company data, Jefferies Exhibit 25: BOC least affected by RMB interest rates Source: Company data, Jefferies 0% 5% 10% 15% 20% 25% 30% 35% ICBC CCB ABC BOC BCOM CMB CNCB MSB CQRCB 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% ICBC CCB ABC BOC BCOM CMB CNCB MSB CQRCB RMB % Loans RMB % Deposits Exhibit 23: BOC’s share price Source: Bloomberg 0.0 1.0 2.0 3.0 4.0 5.0 6.0 Nov-09 Nov-10 Nov-11 Nov-12 Ming Tan, CFA +852 3743 8752 ming.tan@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 21 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 23. CITIC Securities (6030 HK, Buy, TP HK$22) Key Takeaway As the No.1 China broker with a strong investment banking (IB) franchise, CITICS is likely to deliver strong earnings growth after A-share IPOs resume and be the top beneficiary of disintermediation in China in the long term. CITICS’ strong capital position after aggressively leveraging up its balance sheet may better support the growth of its credit-related business, and the acquisition of China AMC and CLSA may improve its asset management and overseas businesses meaningfully. Core business CITIC Securities (CITICS) is the leading full-service investment bank in China. In 2012, CITICS ranked No. 1 in China in the investment banking business by total equity and debt underwritten, and No.1 in the brokerage business in terms of equity and fixed income trading turnover. It was also the largest investment bank in China in terms of total assets, equity and revenue in 2012. CITICS was established in 1995 and converted into a joint stock limited company in 1999. CITICS was listed on the Shanghai Stock Exchange on 6 Jan 2003 and the Hong Kong Stock Exchange on 6 Oct 2011. CITICS’ key shareholder is CITIC Group, which engages in a wide range of businesses with many subsidiaries. The No.1 China broker to ride the wave of disintermediation Since the trend of interest rate deregulation and disintermediation is unlikely to change, and the recent Third-Plenum report plans to promote a register-based IPO system, develop & standardize the bond market, and increase the proportion of direct financing, we believe investment banking will be a strong driver of brokers’ profit. Given its strong IB franchise, we expect CITICS to be the top beneficiary of disintermediation in China. CITICS aggressively increased its leverage (excluding customer cash) to 2.65x at end- Sep 2013 from 1.56x at end-2012 through bonds and commercial notes issuance, which will better support further development of its credit-related businesses (margin lending and stock repo). Also the acquisitions of CLSA and China AMC may help to improve its overseas and asset management businesses meaningfully, in our view. Financials and Valuation Our PT of HK$22.00 is the average of our 3-stage DDM model and Gordon Growth fair P/B model, based on profit growth of 35%/22%/6% in stage 1/ 2/ 3 (terminal), dividend pay-out of 40%, sustainable ROE of 16.9% and COE of 11.1% Our PT-implied 2014E P/B is 2.04x. Exhibit 27: CITICS' strong investment banking franchise Source: Wind, Jefferies Exhibit 28: Profitability improving Source: Company data, Jefferies estimates Market share Rank Market share Rank 2007 21% 2 10% 1 2008 20% 1 12% 1 2009 22% 2 8% 2 2010 14% 2 6% 1 2011 8% 2 6% 1 2012 12% 1 5% 1 Equity underwriting Debt underwriting 0% 2% 4% 6% 8% 10% 12% 14% 16% 0.00% 0.02% 0.04% 0.06% 0.08% 0.10% 0.12% 0.14% 0.16% 2008 2009 2010 2011 2012 2013E 2014E Net commission rate ROAE, adjusted Divestment of China AMC in 2011 Divestment of China Securities in 2010 Exhibit 26: CITICS’ share price Source: Bloomberg, Jefferies 0.0 5.0 10.0 15.0 20.0 25.0 Oct-11 May-12 Dec-12 Jul-13 Jaclyn Wang +852 3743 8746 Jaclyn.wang@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 22 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 24. China Resources Enterprise (291 HK, Buy, TP HK$32.5) Key Takeaway We believe CRE’s consolidation will bear fruit in the long term. Its retail business delivered industry leading SSS growth in the recent quarter; beer saw rising market share and margins. We think NT margin pressure from M&As with Kingway and Tesco will be offset by LT benefits. We have a Buy rating with PT of HKD32.5 on the stock. Core business CRE is a leading consumer company with a focus on retail, beer, beverage and food processing and distribution. It is the largest domestic brewer with 24% market share, while its supermarkets/hypermarkets ranked third in China with 11% market share. CRE has stepped up acquisition recently with two major M&As on Kingway Brewery and Tesco. These M&As will yield benefits in the long term. The company is set to reap the benefits of scale economy once consolidation is completed. CRE has an SOE background with 51.4% outstanding shares owned by China Resources Holding (CRH). A long-term winner CRE is likely to outshine peers in the long run due to the following features: 1) it will secure a strong presence and market share in both beer and retail through consolidation. 2) It is likely to catch up with industry average margins. 3) Its growth is likely to be faster during the process of market consolidation. 4) SOE background brings long-term stability to the company. Recent business update 1) Revenue rose 14.5% yoy to HKD112.4bn and core net profit rose 6.5% yoy to HKD1,916m in 9M13. Core net margin dropped 0.1ppt. to 1.7% in 9M. 2) Retail sales reached HKD71.8bn in 9M13 (+14% yoy), mainly driven by new stores, acquisition and 6.5% SSS growth in 3Q13 vs. 8.3% in 2Q and 2.9% in 1Q. Core net margin down 0.2ppt yoy to 1% in 9M13, mainly due to rising staff cost. 3) Beer sales reached HKD27.4bn in 9M13 (+15% yoy), driven by 8% volume growth and 6.2% ASP rise (incl. forex). Core net margin expanded to 4.0% in 9M (+0.3ppt. yoy) on mix upgrade and scale economy. 2014 outlook We expect CRE to deliver 14% top line growth to HKD163.5bn in 2013e. While operating leverage in the retail business and synergy with Kirin JV is likely to lift its margins, the consolidation of Kingway Brewery, which is expected to turn around in 2-3 years, brought margin pressure, thus we expect OP margin of 3.3% in 14e (+0.1ppt yoy). We forecast core net profit of HKD2.2bn in 2014e (+21% yoy, 1.3% net margin). Valuation We have a Buy rating on the stock with PT of HKD32.5, based on SOTP method. CRE trades at 30x 14e core PE, vs. median forward PE of 31x in the past one year. It has outperformed HSCEI by 7% in the past six months. Exhibit 30: CRE’s sales 2010-2015e Source: Company data, Jefferies Exhibit 31: CRE’s 1-yr forward PE Band Source: Bloomberg, Jefferies estimates Jessie Guo +852 3743 8036 jguo@jefferies.com Edwin Fan, CFA +852 3743 8037 efan@jefferies.com Kevin Chee +852 3743 8022 kchee@jefferies.com Exhibit 29: CRE’s share price Source: Bloomberg Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 23 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 25. CapitaMalls Asia (CMA SP, Buy, TP SG$2.4) Key Takeaway A mass-end mall operator, CapitaMalls Asia is a choice of defensiveness and resilient growth. Driven by urbanisation and consumption, CMA could continue to benefit from its first mover advantage on reversion from existing malls and new mall openings. Its financing advantage stemming from a strong background and a vertical capital recycle model will underpin further growth potential through future acquisitions. Company background CMA is one of the largest shopping mall developers, owners and managers in Asia with 103 malls across 52 cities in Singapore, China, Malaysia, Japan and India. CMA has an integrated shopping mall business model encompassing retail real estate investment, development mall operations, asset management and fund management capabilities. CMA is a subsidiary and the retail real estate platform of CapitaLand, a leading real estate conglomerate in Asia. Growth intact with robust pipeline ahead Driven by resilient necessity shopping, CMA’s tenant sales and shopper traffic still grow faster in the challenging China market, showcasing its capable management and proactive adjustment to withstand market slowdown and E-commerce competition. With a pipeline to open 2 malls each in China and in India, its earnings outlook remains intact and future expansion will continue. We regard CMA as a long-term winner in retail market restructuring, backed by its proven expertise, strong financing access and established income base. 2014 outlook We expect reversion from existing malls to continue to expand CMA’s rental base, and successful mall launches in China to contribute organic growth. Thanks to Singapore’s stable contribution and China’s extensive portfolio, CMA would enjoy visible recurrent rental income. Disposal of malls to underlying funds and further acquisitions are key catalysts for the counter. Valuation Our price target of SG$2.4/HK$15.1 is based on a 10% disc. to NAV of SG$2.6/HK$16.8. Key risks are 1) shortage of experienced local staff; 2) operational challenge in expansion in China. Exhibit 33: Core earnings growth (SGD mn) Source: Jefferies, company data Exhibit 34: NAV discount chart (CMA SP) Source: Bloomberg, Jefferies Exhibit 32: CMA share price Source: Bloomberg 0.0 0.5 1.0 1.5 2.0 2.5 3.0 Nov-09Aug-10May-11 Feb-12 Nov-12Aug-13 Christie Ju +852 3743 8012 cju@Jefferies.com Venant Chiang +852 3743 8013 Venant.chiang@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 24 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 26. Dongfeng (489 HK, BUY, TP HK$15.3) Key Takeaway Dongfeng is an obvious beneficiary of the set of reforms introduced after the 3rd plenum. Investors should remain positioned for further market share and margin recovery in 2H13 and 2014. With the lowest valuation in the space at 7.5x forward PER, Dongfeng remains a low-risk name, in our view. Read-through from 3rd plenum Pertaining to SOE reforms, the mandate is to increase dividend payout ratio to 30% by year 2020. We believe investors will benefit from this policy, as the company has an extremely healthy net cash pile of RMB19.8bn in 1H13 with just 14% payout ratio in FY12. In addition, Dongfeng has 57% exposure to the Compact segment in 1H13, which is a segment expected to benefit from rural land reform, and Hukou reform which encourages greater urbanization and income redistribution. Compact remains the best proxy to first-time car buyers’ demand. Recovery still underway Despite being affected by the anti-Japanese sentiment, PV volume growth of 3.4% in 1H13 represents a marked turnaround from the 8.3% fall seen in 2H12, during the peak of the crisis. In 2H13, volume growth is expected to see a big leg up, from the low base last year. Note the magnitude of the ASP fall has also narrowed, by 2ppt in 1H13 from 6.3% drop in 2H12. We continue to expect further recovery in margin in 2H13 and 2014, along with a better pricing environment. CV volume growth takes a U-turn For the first time in two years, the Commercial Vehicles (CV) segment showed positive growth in 1H13. And within the segment, heavy trucks showed striking recovery of 8.3% growth, reversing the trend from heavy declines seen in 2011-12. In 2H13, we expect y/y growth to improve further, given that Dongfeng HDT has grown 35% y/y in June – Oct 13. And recall, Dongfeng is due to introduce Volvo as a new partner in the CV business, which would allow access to top-notch technology in engines, transmission and alternative-energy vehicles. Partnering with the global leader in CV would enable the company to transcend in competitiveness over the longer term. New models pipeline exciting An intensive pipeline for 2014 will include new-generation Nissan X-trail, Infiniti, new gen Honda Spirior, Venucia SUV & sedan, Fengshen SUV, Peugeot 2008, new gen 408 and a Liuzhou MPV. There will be more new models in 2015 for each of the brands, including new gen Nissan Qashqai, new gen Murano, a new Honda compact SUV, second Infiniti model, new gen Citroen C4. For 2014 and beyond, the pipeline looks full and exciting, and this is also expected to raise profitability from current levels. Exhibit 36: Dongfeng PV market share recovery obvious Source: CAAM, Jefferies estimates Exhibit 37: 2012 Unit sales volume breakdown Source: PetroChina, Jefferies estimates 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0% Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Trucks 17% Buses 2% Basic passenger cars 58% MPVs 9% SUVs 14% Cross type 0% Exhibit 35: Share price Source: Bloomberg, Jefferies -4.0 4.0 12.0 20.0 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Zhi Aik, Yeo +852 3743 8075 zyeo@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 25 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 27. Fosun Pharma (2196 HK, BUY, TP HK$25) Key Takeaway As a leading Chinese diversified healthcare company, Fosun Pharma has a strong presence in all key segments of the healthcare industry value chain. The company has the most impressive M&A track record among its peers. In a cost containment environment, we believe Fosun’s diversification and superb M&A capability should allow it to better mitigate pricing risk and deliver strong growth that outpaces the industry average. The company’s new incentive plan also sets commendable sales and profit targets with implied 2013-15 CAGR of at least 18% and 25%, respectively. Leading Chinese pharmaceutical manufacturer with superior growth prospects We forecast that Fosun Pharma will deliver strong revenue and earning CAGR of 19% and 30% in 2013–16, above our estimate of industry average of ~15%. Key growth drivers include (1) Broad pharmaceutical product portfolio focusing on attractive therapeutic areas; (2) Demonstrated capability in strategic acquisitions and integration; and (3) Strong R&D and robust pipeline. First-mover in the attractive hospital segment We foresee strong growth for Fosun Pharma’s healthcare service segment and think that its strategy of focusing on premium medical services and specialty hospitals has the potential for good returns. The company has been rapidly growing its hospital franchise via acquisitions. Within the past two years, Fosun Pharma acquired three general hospitals and one cancer specialty hospital, operating a combined total of ~2,200 beds. The company plans to acquire 1-2 hospitals each year. By 2015, Fosun aims to own 10- 15 hospitals with combined sales reaching Rmb 1 billion. Leading Chinese pharmaceutical distributor a long-term winner By owning close to a third of Sinopharm, Fosun Pharma has established a significant presence in China’s pharmaceutical distribution industry with attractive growth prospects. We expect Sinopharm’s scale advantage to drive above-industry growth of ~20s over the next 3-5 years. Growth could accelerate with further industry consolidation and improving hospital financing. Attractive valuation We maintain our BUY rating, and 12-month TP of HK$25, based on 2014e PEG of 1.1, 3- year adjusted EPS CAGR of 28%, and 2014e adjusted EPS of HK$0.62. Our DCF analysis suggests that the current share price is attractive. Risks Key risks to our rating and price target include more severe pricing pressure for drugs and medical devices; less policy support for the development of private hospitals; slower M&A pace in pharmaceutical and medical services segments; failure to consolidate and integrate business operations post acquisition; and development setbacks on key drug candidates such as human insulin and insulin analogues. Exhibit 38: Fosun’s share price Source: Bloomberg 0 5 10 15 20 25 30 Oct-12 Feb-13 Jun-13 Oct-13 Jessica Li, Ph.D. +852 3743 8010 Jessica.li@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 26 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 28. Huaneng Renewable (958 HK, BUY, TP HK$4.3) Key Takeaway We are in a structural growth story for wind farm operators, and Huaneng Renewable is our top pick among the wind farm operators. We are forecasting a 2013-15 EPS CAGR of 33% as earnings should continue to benefit from improving utilization hours and new installed capacity adds. The company’s historical discount to industry leaders should disappear as Huaneng Renewable continues to execute. Utilization hours set to improve further in 2014 2013 has been a good year for wind farm operators as utilization hours recovered on the back of improving curtailment and better wind resources. The recovery in utilization hours has beat our expectations as Huaneng Renewable reported 9M13 YTD power generation of 8,213GWh, +50% YoY. We expect 2014 to see incrementally higher utilization hours as curtailment should continue to ease, offsetting a possible normalization in wind resources. New installed capacity should accelerate modestly in 2014 The industry will look to increase their new capacity additions to varying degrees, albeit a return to the levels seen in 2010 is unlikely. Huaneng Renewable is looking to increase its new capacity additions from 1GW in 2013 to 1.5GW to 2.0GW p.a. over the next few years. We believe the company will also look at new solar projects as well. Concerns over a tariff cut overdone One lingering question that has dogged wind farm operators is the risk of a potential cut in feed-in tariff, especially in light of the recent cut in on-grid thermal power tariffs. Although we believe there is long-term risk to wind FiT as WTG costs decline, we do NOT believe it is a near-term risk. With curtailment negatively impacting profitability, we believe revisions to the FiT would be a mistake. New announcements should help sentiment We believe there are more environmental policies to come out in the coming months and years that should help the sentiment for alternative energy names. The Renewable portfolio standard could be announced next year and the emissions trading scheme could be rolled out nationwide in time. Furthermore, we expect local government to announce new policies, emission and zoning requirements in order to alleviate local air pollution. Discount to Longyuan should disappear We believe Huaneng Renewable should benefit from a continued sector re-rating and we believe its discount to Longyuan should narrow; Huaneng Renewable is trading at a 10% discount to Longyuan on a P/E basis. Exhibit 40: Geographical Exposure Source: Company data, Jefferies Exhibit 41: Utilization hours to recover to ~2,200 hours Source: Company data, Jefferies estimates Inner Mongolia 31% Liaoning 20% Shandong 15% Yunnan 8% Shanxi 7% Guizhou 5% Guangdong 5% Other 9% 0 500 1,000 1,500 2,000 2,500 2007 2008 2009 2010 2011 2012 2013 2014 2015 Exhibit 39: Share price Source: Bloomberg, Jefferies 0.0 1.0 2.0 3.0 4.0 Jun-11 Feb-12 Oct-12 Jun-13 Joseph Fong +852 3743 8074 jfong@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 27 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 29. PetroChina (857 HK, Buy, TP HK$12) Key Takeaway PetroChina has the best oil & gas assets among the three oil and gas companies. We believe Petrochina will benefit from the 2014 energy policy in terms of 1) market pricing, 2) SOE restructuring and 3) environmental regulations. We believe PetroChina will benefit from accelerating natural gas production growth and pricing reform. Best oil & gas assets in China PetroChina’s oil assets are superb free cash-flow machines. Oil R/P ratio is 12.6 vs. 8.9 and 8.4 for Sinopec and CNOOC, respectively. We estimate PetroChina’s oil drilling is much more economical than CNOOC and Sinopec at the same prevailing oil prices. We believe PetroChina also has China’s best natural gas assets. The company controls ~70% of China’s natural gas reserves with double digit production growth expected for the next 5-10 years. 2014 policy to favor PetroChina We believe three themes will drive energy equities in 2014, 1) market pricing, 2) SOE restructuring and 3) environmental regulations. None of these themes are new, but Third Plenum reforms will provide the political cover and administrative structure to cut through inertia and vested interests, in our view. The poster boy of SOE reform We believe PetroChina will be the poster boy of SOE reform. The unprecedented corruption purge of senior management is not just an investigation into PetroChina, in our view, but a maneuver against entrenched SOE interests. We believe PetroChina may become a "pilot project" for SOE reform with experiments in "mixed ownership" structures and SOE-private sector partnerships — all geared towards optimizing efficiency, improving management, reducing corruption and maximizing value. With natural gas prices being reformed, we believe eliminating the inefficiencies and leakages plaguing the company will have a renewed urgency. Get free stuff According to the FAS69 disclosure, PetroChina's proved reserves were worth US$274B at YE12 (~HK$8.24/share less YE14 debt). Shareholders are getting probable/possible reserves, pipelines, gas price reform, refiners and chemical plants, more or less, for free. Natural gas story In China, we believe natural gas will be a substitute for fuel oil/LPG in the medium term and gasoline/diesel as vehicle fuel in the long term, forcing prices towards oil levels. A re-rating for PetroChina is warranted as the company controls the crown jewels of China’s upstream assets and as government intervention in upstream energy markets fade. Exhibit 43: PetroChina’s oil & gas production Source: PetroChina, Jefferies estimates Exhibit 44: China natural gas and refined product prices Source: PetroChina, Jefferies estimates Oil Gas 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 2000 2005 2010 2015E 2020E 2025E mboe/d 10.68 14.24 18.87 16.60 21.33 21.40 3.24 3.58 4.81 1.39 1.85 3.21 3.37 4.23 4.46 0 5 10 15 20 25 30 Pilot price (2010 subsitute prices) Implied pilot price @ current prices Current LPG import price Current fuel oil import price Current diesel price Current gasoline price US$/mmBtu VAT Consumption tax Price excl. tax 30.67 29.14 23.21 22.08 16.09 12.07 Exhibit 42: Share price Source: Bloomberg, Jefferies 0.0 4.0 8.0 12.0 16.0 20.0 Nov-07 Feb-09 May-10 Aug-11 Nov-12 Laban Yu +852 3743 8047 lyu@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 28 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 30. Ping An (2318 HK, BUY, TP HK$83) Key takeaway Ping An is our top pick in the China insurance sector. It is the only listed insurer that has limited exposure to bancassurance, with almost pure focus on agency distribution. We believe its life insurance NBV growth rate can be maintained at 7-12% for the next few years. In addition, we believe its strong P&C operation and improving banking business will also help with its re-rating going into 2014. Our TP of HK$83.0 implies 1.32x 14E P/EV. Life insurance recovered nicely in 2013: Ping An reported strong agency business growth momentum for 1-9M13, with agency new business up approximately 10%, translating to NBV expansion of 9-11% in our view (recall that Ping An Life delivered strong NBV growth of 14% in 1H13. As a result, we revised up our 2013 NBV growth assumption to 10% (from 7.5% previously). Strong product design leads the industry: On 16th Oct, Ping An launched its first post-deregulation product, called “Ping An Fu”, via its agency distribution. “Ping An Fu” is a protection driven whole-life policy, targeting critical illness/accident protections. The policy uses a guaranteed interest rate of 4.0%, higher than most other insurers’ common application of 3.5%. However, the policy is not cheap, and has comparable pricing vs. China Life’s “Kang Ning 2”, which uses 2.5% as guaranteed pricing. This gives us comfort that Ping An has not blindly started a pricing war; on the contrary, it has maintained good product margins and used 4% as a powerful marketing tool. The only one planning for e-commerce platform: Recently, Ping An has started preparing and launching various on-line platforms to prepare for the e-commerce era. Noticeable platforms include: Lufax (www.lufax.com); Wanlitong (www.wanlitong.com); Ping An Hao Che (www.pahaoche.com) and 24 money (www.24money.com). We understand that the probability of success is still unknown for some of these platforms, but we do not believe investors have assigned any meaningful valuations to such efforts. As a result, we see such e-commerce effort as an option on the company, which could help Ping An to achieve high quality sales of financial products in the future. Valuation and risks Ping An is currently trading at 1.1x 14E P/EV. Given its stronger agency growth momentum, limited exposure to bancassurance business, solid P&C operations, and recovery in banking business, we believe upside is attractive. Ping An remains our top pick in the sector. Our TP of HK$83.0 values Ping An at 1.32x 14E P/EV. Risks: 1) Negative A-share return; 2) Irrational pricing competition in life insurance products; 3) Deterioration in macro environment, which could cause concerns on Ping An Bank. Exhibit 46: Ping An has low bancassurance exposure (1H13) Source: Company data, Jefferies Exhibit 47: NBV growth returned to an uptrend Source: Jefferies estimates Agency NBV 92% Bancassurance NBV 5% Others NBV 3% 13% 40% 19% 38% 31% 8% -5% 14% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 2006 2007 2008 2009 2010 2011 2012 1H13 NBV growth Exhibit 45: Ping An’s share price Source: Bloomberg, Jefferies 0.0 20.0 40.0 60.0 80.0 100.0 Nov-09 Nov-10 Nov-11 Nov-12 Baron Nie, CFA, AIAA +852 3743 8747 Baron.nie@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 29 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 31. Shanghai Industrial (363 HK, Buy, HK$30) Key takeaways We like SIHL’s balanced portfolio, stable earnings and attractive valuation. We believe the company is well-positioned to benefit from Shanghai’s robust outlook as the Free Trade Zone becomes a key growth driver. Thanks to strong government support, SIHL has ample opportunities to acquire quality state-owned assets in infrastructure utilities and real estate, therefore enhancing its potential. Its valuation is attractive at 0.8x P/B and 25% discount to NAV, with a 4% dividend yield. Buy. The listed flagship of Shanghai government. As the only overseas listed window company of Shanghai Municipal Government, SIHL is a good proxy for Shanghai’s vibrant economic growth outlook, in our view. We like its quality assets and a balanced portfolio across infrastructure, consumer and property, which are well positioned to benefit from the long- term growth of the city. Well-positioned to benefit from Shanghai FTZ. We believe the launch of Shanghai Free Trade Zone (FTZ) is poised to boost Shanghai’s outlook. SIHL’s infrastructure business should benefit from growing transportation demand as FTZ becomes a major economic growth driver of the region, while its property business should benefit from appreciation land value. The preferred consolidator of state-owned assets. Given its solid track record and strong government support, we believe SIHL will have ample opportunities to consolidate quality state-owned assets as SOE reform accelerates and enhance its outlook. We feel sewage treatment is an area in which SIHL has high M&A potential as Shanghai begins to privatize them. Its parent will likely inject stakes in Hangzhou Bay Bridge in 2014. Also, we expect SIHL to acquire real estate assets from its parent or through local state-owned asset consolidations. Stable earnings, valuation attractive; Buy. The infrastructure and consumer units contribute ~2/3 of SIHL’s core net profit, making it one of the most defensive names in the conglomerate space. The stock is trading at 0.8x P/B and 25% discount to NAV, with a 4% dividend yield. We believe the valuation is attractive; Buy. Valuation/Risks Our HK$30 price target is based on a 15% discount to our NAV estimate. Key risks include: 1) tightening policies could curb property demand; 2) slower-than-expected M&A or asset injection; and 3) weak execution on property. Exhibit 49: NAV breakdown – 2013E Source: Jefferies, company data Exhibit 50: Net profit breakdown (HKD$mn) Source: Jefferies, company data Christie Ju, CFA Equity Analyst +852 3743 8012 cju@jefferies.com Exhibit 48: Share price Source: Bloomberg, Jefferies 0.0 10.0 20.0 30.0 40.0 50.0 Nov-07 Feb-09 May-10 Aug-11 Nov-12 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 30 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 32. Sinopharm (1099 HK, BUY, TP HK$26.5) Key Takeaway Sinopharm is our favourite Chinese pharma distributor, given its unsurpassed dominance in the space. While the company’s distribution business should sustain high-teens% organic growth in the next several years, significant opportunities lie in its retail pharmacy business longer term. Trading at 16x our 2014e EPS against our 3-year EPS CAGR of 18%, the stock’s valuation is attractive. Expect above-industry growth amidst reform uncertainties While the health reform uncertainties will continue, we believe that Sinopharm’s competitive advantage as an industry leader should become increasingly apparent and benefit from the industry consolidation trend. We remain confident that Sinopharm will continue to outgrow the industry by 3~5%, given its scale advantage, most comprehensive national distribution network, and better ability to fend off pressures from reforms. We forecast that the company is capable of delivering sales and earnings CAGR of 18% over the next three years. Maintain margins with business optimization Despite increasing pricing pressure, we believe Sinopharm can maintain its margins by: 1) potentially monopolizing the distribution of certain products; 2) focusing on high end services such as cold-chain management and hospital pharmacy outsourcing; and, 3) exploring new business opportunities in healthcare services and dialysis. Sinopharm could also help improve its margins via minority interest (accounts for ~37% of net income) buyback. Pressure on cash flow a structural risk As public hospital reform deepens, the hospital payment cycle will likely continue to lengthen; a structural risk that pressures the company’s cash flow and tempers its growth. Sinopharm should be able to alleviate such pressure through better working capital management, receivables factoring and securing lower rate borrowings. Sinopharm could also issue a second tranche of corporate bonds with principal not less than Rmb4bn and coupon rate of 4.54% by September 2014 to lower its borrowing costs. Potential in pharmacy business underappreciated Contributing ~3% to its total sales and profit, Sinopharm’s #1 retail pharmacy business is much less visible. We see strong potential in this business segment in the long run as the pace of acquisition accelerates further. Potential collaboration with leading domestic and international players could lead to a jump in this business. There is room for significant margin improvement in the segment, which should lift overall company margin and help alleviate pressure on cash flow. Valuation We derive a 12-month price target of HK$26.5 based on a combination of DCF and the relative valuation approach. Trading at 16x 2014e EPS against our 18% 3-year CAGR projection and 2014 PEG of 1.1, Sinopharm’s valuation is attractive. Risks Risk to our view and price target include slower economic growth in China, less favorable government policy on healthcare spending, stiffer competition, a slower pace of M&A, failure to achieve any post-merger integration synergy in later years, and higher-than-anticipated working capital requirements. Exhibit 51: Sinopharm’s share price Source: Bloomberg 0 5 10 15 20 25 30 35 40 Sep-09 Dec-10 Mar-12 Jun-13 Jessica Li, Ph.D. +852 3743 8010 Jessica.li@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 31 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 33. Agile (3383 HK, Underperform, TP HK$7.8) Key takeaway We maintain Underperform on Agile as we consider its aggressive land banking unjustified on lagging sales and rising inventories. Given the policy headwind, weakening market sentiment and tightening credit ahead, we believe the contribution from new cities remains highly uncertain. Compared to peers, Agile may be exposed to higher risk from stricter tax collection as its current tax liability is Rmb9.5bn. Disappointing sales performance continues Despite the booming property market, Agile reported sluggish presales with merely 70% locked-in ratio as of Oct (vs. 88% average for peers) mainly due to shortage of products with real demand, while inventory increased 42% to Rmb11.3bn in the interim. Although the company targets to launch 7 new projects in 4Q and reach Rmb5bn/6bn in Nov/Dec respectively, we are afraid its oversized units and aggressive pricing strategy may hinder sales contribution. Unjustified land banking on financial concern Despite sluggish sales, Agile accelerated expansion this year as it has allocated Rmb14bn (48% of its presales) to land acquisition, and entered into 9 new cities, including Yangzhou, Wuxi and Chuzhou. We are concerned about its management capacity during the expansion and expect its gearing to grow to 65% at the year-end vs. 58% at the interim. Moreover, Agile still has Rmb9.5bn current tax liabilities as of Jun-2013, equivalent to 63% of its cash on hand. Yunnan market uncertain Driven by the successful experience in Sanyan, the company entered into Yunnan aggressively to develop another tourism project. So far, its land reserves in Ruili, Tengchong and Xishuangbanna amount to 4.7mn sqm, accounting for 10% of its total land bank. As Agile targets to launch Tengchong project at Rmb6.4k-11k/sqm and Ruili project at Rmb4.8k/sqm at year end, we see sales performance as uncertain given the remote geographic region. Valuation Our price target of HK$7.8 is based on a 60% disc. to NAV of HK$19.4. Key risks are: 1) stronger-than-expected presales; and 2) substantial improvement in cash position. Exhibit 53: Core earnings growth(SGD mn) Source: Jefferies, company data Exhibit 54: NAV discount chart Source: Bloomberg, Jefferies 0 10,000 20,000 30,000 40,000 50,000 2009 2010 2011 2012 2013E -120% -95% -70% -45% -20% 5% 30% Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 -3.7% Peak -63.9% -1stdev -32.6% +1stdev -82.1% Trough -48.3% Avg Exhibit 52: Agile share price Source: Bloomberg 0.0 4.0 8.0 12.0 16.0 20.0 Nov-07 Feb-09 May-10 Aug-11 Nov-12 Venant Chiang +852 3743 8013 venant.chiang@Jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 32 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 34. Belle (1880 HK, Underperform, TP HK$8.2) Key Takeaway In 2014, we expect Belle to continue facing challenges from B2C e- commerce, while the sales from department store channel will demonstrate slow SSSG and operating deleverage. We expect the company to deliver flat YoY EPS growth in 14e, and reiterate Underperform on Belle with PT at HK$8.2, based on 13x 1-year forward PE. Core business Belle mainly focuses on footwear and international (mainly Nike and Adidas) sportswear retailing; footwear contributes more than 80% of EBIT and the remaining is generated from sportswear retailing. Medium term challenges Belle has no obvious advantages on B2C e-commerce: Belle obtained 5% market share on B2C channels, vs. 20-30% market share in department stores, with ASP at RMB320/pair vs. offline above RMB400/pair. In addition, mid-high end ladies footwear brands (Belle, Kisscat, Teenmix, CBanner etc) in department stores continue to offer more than 30% discount on new (winter) products and 50% on old products. We expect Belle’s ASP to decline by 2-3% in 14e. We also believe the inventory destocking process by Belle’s competitors may continue over the next 12 months as they face mounting competition from B2C online shops. Recent business update In 3Q13, Belle’s SSSG on footwear was at 1.3% (vs. 2Q13 0.5%; 1Q13 4.5%), sportswear was at 4.5% (vs. 2Q13 2.5%, 1Q13 11%). Management targets the group’s overall SSSG at 3-5% for 2013e. Number of footwear shops increased by 11% YoY in 3Q13 to 12,816, while sportswear shops increased by 12% YoY in 3Q13 to 5,780. 2014 outlook For 14e, we expect Belle to have revenue growth of 9% and reach RMB39.6bn, while GP is expected to increase by 7% to RMB22bn (GPM at 55.9% in 14e vs. 56.9% in 13e). Operating profit is expected to decline by 1% and reach RMB5.3bn (OPM at 13.3% in 14e vs. 14.7% of 13e); net profit is expected to remain flat at RMB4.2bn *(NPM at 10.7% in 14e vs. 11.7% in 13e) Valuation We reiterate Underperform on Belle with PT of HK$8.2, based on 13x 1-year forward PE; the stock is trading at 15x 1-year forward PE vs. 3-year average 22x. The stock has underperformed HSI index by 15% over the past 2 months. Exhibit 56: Belle’s SSSG forecast Source: Company, Jefferies Exhibit 57: Belle’s operating deleverage to continue Source: Company, Jefferies estimates - 5 10 15 20 2010A 2011A 2012A 2013E 2014E 2015E Footwear Sportswear 54.0% 55.0% 56.0% 57.0% 58.0% 59.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 2010 2011 2012 2013e 2014e 2015e EBITDA margin (LHS) Operating margin (LHS) Net margin (LHS) Gross margin (RHS) Exhibit 55: Share price Source: Bloomberg, Jefferies 0.0 4.0 8.0 12.0 16.0 20.0 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Nov-13 Edwin Fan, CFA +852 3743 8037 efan@jefferies.com Jessie Guo, PhD +852 3743 8036 jguo@jefferies.com Kevin Chee +852 3743 8022 kchee@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 33 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 35. Cosco (1919 HK, Underperform, TP HK$1.9) Key Takeaway A series of disposals this year including Cosco Logistics, CIMC, and some office buildings could save Cosco from a potential A-share suspension. However, challenges remain for container shipping, and valuation looks rich for an operationally challenged company. We maintain Underperform. 4Q13 results will determine A-shares suspension Cumulative 1Q-3Q13 net losses are at about Rmb2.0bn, including the gains from disposals of Cosco Logistics and its shares of CIMC. If we were to add the potential Rmb3.7bn gains from property disposal, Cosco could manage to turnaround at net profit level in 2013 and avoid the A shares suspension if 4Q13 losses were less than Rmb1.7bn. Container shipping still looks worrying While container shipping showed little improvement in 3Q, we expect more challenges to come in 4Q as freight rates on all major trade routes have reached YTD lows end of October while volumes are expected to weaken on seasonality. Looking forward into 2014, the situation may continue to deteriorate as the global contract freight rates currently under negotiation could be impacted by the weak spot market that has set a lower benchmark for the negotiations. We may see some improvements in Cosco’s dry bulk segment on better spot freight rates next year, but a turnaround from core operations could remain in doubt, in our view. Valuation looks rich for an operationally challenged company Despite the persistent dangers of a potential A-share suspension and the challenges faced by its operations in container shipping, Cosco’s valuation is far ahead of its weak fundamentals. The company is trading at much higher than book at 1.5x 13E PB, with 13E ROE at -28% (before property disposal gains). Previously, the stock traded at similar levels in 2010, when ROE was 15%. Valuation/Risks We maintain our Underperform rating and our 12-month target price of HK$1.90 based on 100% 13E EV/Fleet versus 2.4% 13E ROCE. The main upside risks are a strong and sustainable industry-wide turnaround for container and dry bulk shipping. Exhibit 59: CCFI – freight rates at YTD lows end of Oct. could set a low base for global contract freight rates negotiations Source: SSEFC Exhibit 60: PB vs. ROE – Cosco is trading ahead of its weak fundamentals Source: Jefferies estimates, Bloomberg 800 950 1,100 1,250 1,400 10 12 CCFI 26W MA 52W MA -45% -30% -15% 0% 15% 30% 45% 0.0 0.5 1.0 1.5 2.0 2.5 3.0 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 PB ROE historical average PB 1.95x Exhibit 58: Share price Source: Bloomberg, Jefferies 0.0 8.0 16.0 24.0 32.0 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Johnson Leung +852 3743 8055 jleung@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 34 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 36. China Coal (1898 HK, Underperform, TP HK$2.8) Key Takeaway We believe coal prices will continue to fall next year due to China’s economy rebalancing and low cost coal capacity debottlenecking. Our 2014 earnings estimates for China Coal are 22% below consensus, which appears to believe coal prices will recover appreciably from present levels. Under our negative coal price forecast, we believe the company is in danger of ruining its pristine balance sheet with its intense capex program. Plain Jane coal producer As a coal company, China Coal is a bit of a cipher. It does not have all the positives of Shenhua and it does not have Yanzhou Coal’s high grade products, spot price exposure and Australian adventures. What it does have is organic growth. The company has a portfolio of legacy and start-up coal mines, which we believe can drive growth for the next 5-10 years. This growth, however, would be capex-intensive. Capex-intense strategy… not good in falling coal price environment We have our qualms about China Coal’s capex program in a falling coal price environment. We believe the strategic plans were made in a high coal price environment with relatively high future coal price forecasts. On our forecasts, China Coal will lever up dramatically given the capex program and falling coal prices. Mining equipment business to suffer, chemicals strategy promising but early We believe the coal mining business will experience declining revenues in the coming years as coal production growth slows dramatically. The market has purchased significant quantities of machines, which we believe will be underutilized. The company’s coal-to-chemicals business may be promising in a falling coal price environment but for now, it embeds significant project risk. Valuations/risks Coal prices are trending very close to our full year 2013 estimate. We believe benchmark 2014 QHD coal prices will be 7% lower YoY. Our 2014 earnings estimate for China Coal is 22% below consensus, which appears to believe coal prices will recover appreciably from present levels. We assign 7.1x EV/EBITDA multiple to 2014E coal EBITDA, 7.50x P/E to equipment manufacturing earnings, and 0.15x P/A to coking and chemical assets. This derives a target price of HK$2.8. We believe the major risk to our estimates and price target is a substantial recovery in coal prices. Exhibit 62: Coal and total energy consumption in China Source: SXCoal, Jefferies Exhibit 63: China Coal EBIT Source: SXCoal, Jefferies 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015E 2020E 2025E mtoe Coal high Total high Coal base Total base Coal low Total low -3 -1 1 3 5 7 9 11 13 15 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E Others Coal equipment Coking&chemical Coal sales Rmb bn Exhibit 61: Share price Source: Bloomberg, Jefferies 0.0 5.0 10.0 15.0 20.0 25.0 30.0 Nov-07 Feb-09 May-10 Aug-11 Nov-12 Laban Yu +852 3743 8047 lyu@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 35 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 37. CNBM (3323 HK, Underperform, TP HK$6) Key Takeaway We believe CNBM’s growth model has reached a tipping point in that CNBM’s management confirmed it will focus on deleveraging its balance sheet in the next few years. This means CNBM has lost its most effective growth engine: acquisitions which accounted for 97% of sales volume growth in 2012. We expect the company’s sales volume growth to slowdown drastically to 3% in 2014 from over 20% in 2013 and our 2013/14 earnings forecasts are 20%/30% below consensus which will slowly adjust downwards. CNBM’s old business model depended heavily on acquisitions to drive the business and for CNBM to meet consensus expectations. In 2012, almost 100% of the company’s volume growth came from acquisition. Organic volume growth in its core East China market was actually negative in 2012 despite the massive acquisitions the company made. Given operating cash flows were insufficient to support capex, the acquisitions were funded by continuous debt and equity issuance. We have been arguing that the company has not been making reasonable returns to shareholder from such acquisitions. The new model: Going forward, the company is going to focus on (1) cost cutting; (2) price cooperation. The problem with this strategy is that costs won’t come down if CNBM is exercising “price cooperation”, which ultimately involves production suspension. In 1H13, costs went up in regions where the company exercised price cooperation despite the massive yoy drop in thermal coal prices. If CNBM sticks to the price cooperation strategy, it will only indirectly subsidize its biggest competitor Anhui Conch (Buy, TP HK$30), who will enjoy high prices without sacrificing on volume/cost. In this scenario, our Long Conch/Short CNBM strategy will continue to work well. Exhibit 65: In 2012, CNBM’s sales volume grew 37mt yoy, almost all of which comes from acquisition in the Southwest and North East Source: Company data; Jefferies Note: Binzhou cement also contributed to about 1.5mt of acquisition driven growth in 2012 184 220 35 1 2 3 140 150 160 170 180 190 200 210 220 230 2011 sales volume Increase in Southwest Cement Increase in China United Increase in North Cement Decline in South Cement 2012 sales volume milliontons Acquisition in the southwest accounts for 97% of 2012's volume growth Up 37mt yoy or 20% yoy Exhibit 64: Share price Source: Bloomberg, Jefferies 0.0 5.0 10.0 15.0 20.0 Jul-10 Jul-11 Jul-12 Jul-13 Po Wei +852 3743 8067 po.wei@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 36 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 38. Digital China (861 HK, UNDERPERFORM, TP HK$8) Key Takeaway Despite management’s best efforts, we see ongoing structural challenges in Distribution and Systems, the two most profitable businesses at Digital China. We see the recent share price recovery, driven by the market value of Shenzhen Techo Telecom, as unwarranted. Structural headwinds to Distribution We see a secular downtrend in consumer PC demand in China and increasing threats from e-commerce. PC stores are being closed in tier-one cities. While Digital China is providing e-commerce operators with logistics services, the growth opportunity is unable to offset the shortfall in the highly profitable Distribution business. Long-term threats to Systems Foreign vendors have been losing tenders to domestic competitors such as Huawei (NC), particularly in information-sensitive telcos and public sectors. We also expect persistent weakness in corporate IT demand in near term. While we expect the overall demand to improve in CY14 to partly offset the structural headwinds, it is unlikely to return to the level in CY12. Positive on spinning off Services, but smart city remains distant We are encouraged by the spinning off of Services into A-share Shenzhen Techo Telecom. However, with its current sub-optimal scale, Services requires capital investment in the near term. Contributions from smart city remain distant before a viable business model can be devised. Recent stock price recovery is not warranted The stock price recovered 27% from its bottom in Aug as some investors began to apply a sum-of-the-parts valuation based on the market value of Shenzhen Techo Telecom. We do not believe this valuation methodology is warranted. 69% of H-shares are trading below their A-share counterparts with discounts as large as 78%. Valuation/Risks Our HK$8 PT is based on 7x our estimated FY14 diluted EPS of HK$1.18, the low end of Digital China’s historical trading range over last three years. We note that Asian peers are trading at a wide range of 4-12x. The biggest near-term upside risk is faster-than- expected demand recovery. Exhibit 67: Online % of consumer electronics retail sales Source: Enfodesk Exhibit 68: Digital China’s vendor mix FY13 Source: Company Data 7.0% 15.5% 29.4% 0% 5% 10% 15% 20% 25% 30% 2009 2012 2017E HP 10% Cisco 10% IBM 9% Apple 8% Dell 8% Asustek 6% Lenovo 5%Acer 3% Intel 2% Oracle 2% Others 37% Exhibit 66: Share price HK$ Source: Bloomberg, Jefferies 0 5 10 15 20 Ken Hui +852 3743 8061 khui@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 37 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 39. Longfor (960 HK, Underperform, TP HK$11) Key takeaway Aggressive expansion has not yet been proven to boost presales. Instead it undermines the balance sheet on rising capex pressure. Chongqing still contributes 1/4 of presales and a 15% down payment is provided to attract homebuyers. Weakening market demand, policy overhang and credit tightening raise our concerns about Longfor’s financial health. Trading at 38% discount to NAV, valuation is demanding. Underperform with TP of HK$11.0. Expansion requires a longer time to translate into sales Longfor is striving to improve land bank quality and project structure, and has been accelerating expansion since early 2012. As one of the most aggressive developers, it has supplemented 12.8mn sqm land for Rmb21.5bn so far. It has a presence in 21 cities, including the 6 new cities it enters this year, almost completing the expansion target of 24 cities. However, we have not seen significant sales improvement given that its presales grew 26% yoy to Rmb40.2bn as of Oct, merely in line with industry average. Over-reliance on Chongqing, lower down payment a concern Despite its fast expansion, Chongqing, Chengdu, Beijing and Hangzhou, which are the cities established before 2009, still contribute over 60% of 2013 presales. Chongqing, as its home base, accounts for 1/4 of the total, fetching over Rmb10bn sales. Notably, Longfor rolled out a 15% down payment plan in Nov to attract Chongqing buyers, allowing them to pay the remaining down payment three months later, reflecting the company’s urgency to fulfill sales targets. But this will lead to a lower cash collection ratio. 2014 outlook not as promising Longfor’s balance sheet deteriorated in 2013 interim with net gearing surging 16ppts to 64% as cash decreased 30% in six months. We see no improvement in the short term given its endeavor to develop commercial properties that is highly capex intensive. Given the softening demand and policy overhang ahead, we are concerned about its 2014 presales and margin as well. Valuation demanding; maintain Underperform Longfor originally targets to complete product-mix enhancement by 2014. Based on the current market environment, we expect it will take a longer time to have the target done. Trading at 1.5x PB and 38% discount to NAV, valuation is demanding in our view. Maintain Underperform with PT of HK$11.0. Exhibit 70: Annual sales & single-city sales (Rmb mn) Source: Jefferies, company data Exhibit 71: NAV discount chart Source: Bloomberg, Jefferies 0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 0 500 1,000 1,500 2,000 2,500 3,000 2010 2011 2012 2013E Single-city sales (LHS) Sales (RHS) -70% -60% -50% -40% -30% -20% -10% 0% Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13 Aug-13 Nov-13 -9.1% Peak -39.7% -1stdev -24.2% +1stdev -63.7% Trough -31.9% Avg Exhibit 69: Longfor share price Source: Bloomberg 0 5 10 15 20 Nov-09 Feb-11 May-12 Aug-13 Venant Chiang +852 3743 8013 venant.chiang@Jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 38 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 40. Yanzhou Coal (1171 HK, Underperform, TP HK$3.6) Key Takeaway Yanzhou Coal’s previous success was achieved based on high coal prices, in our view. We believe coal prices will continue to fall in 2014 and our earnings estimate for Yanzhou Coal is 42% below consensus. We believe its cost saving in 3Q13 is unlikely to sustain as a significant contribution came from a one-off provision of obligation items on the balance sheet. The Rocky Balboa of coal companies Unlike the two large central government-owned coal companies, Yanzhou Coal is controlled by the Shandong provincial government. Yanzhou Coal is a local boy who made it big on the world stage. From six coal mines in Shandong province, Yanzhou Coal punched its way to national prominence with coal mines in Shanxi and Inner Mongolia and has since gone global, acquiring coal mines in Australia. Previous success based on high coal prices We believe Yanzhou Coal took full advantage (and more) of surging coal prices, punching its way out of Shandong Province and stretching its balance sheet. We believe the time has come for Yanzhou Coal to focus on cost control (especially capex) and manage its balance sheet. However, the significant cost reduction in 3Q13 mainly resulted from a one-off provision of obligation items on the balance sheet which is unlikely to sustain. Well below consensus in 2014 Coal prices are trending very close to our full year 2013 estimate. We believe benchmark 2014 QHD coal prices will be 7% lower YoY. Our 2014 earnings estimates for Yanzhou Coal are 42% below consensus, which appears to believe coal prices will recover appreciably from present levels. Valuations/risks We assign 6.75x EV/EBITDA multiple to our 2014E EBITDA, generating a target price of HK$3.6. We believe the major risk to our estimates and price target is a substantial recovery in coal prices. Exhibit 73: Coal and energy consumption in China Source: SXCoal, Jefferies Exhibit 74: Yanzhou Coal EBIT Source: SXCoal, Jefferies 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015E 2020E 2025E mtoe Coal high Total high Coal base Total base Coal low Total low (2) - 2 4 6 8 10 12 14 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014E 2015E Methanol, power and heat Railway transportation Coal sales Rmb bn Exhibit 72: Share price Source: Bloomberg, Jefferies 0.0 8.0 16.0 24.0 32.0 40.0 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Laban Yu +852 3743 8047 lyu@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 39 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 41. Zhaojin (1818 HK, Underperform, TP HK$5) Key Takeaway Between the two gold companies, we have a relative preference for Zhaojin over Zijin given its proven track record in volume growth and cost control. More importantly, it doesn’t have the resource depletion issue in its core mine that Zijin is facing. However, we believe valuation to be expensive based on our LT gold price assumption of US$1,250/oz. Even under a bull case assumption, the stock’s valuation seems demanding. Underperform. Decent mining volume growth and cost control. Zhaojin’s topline grew by a strong 37% CAGR from 2008 to 2012, mainly driven by the growth of its gold segment. Self-mined gold sales volume grew an impressive 15% CAGR with about half of the growth coming from new mines outside of Shandong Zhaoyuan area, which is Zhaojin’s headquarters. We like how well Zhaojin has kept its costs under control, despite the ramp-up of new mines in west and north east China. In 2012, Zhaojin’s cash cost was US$512/oz, one of the lowest among the top gold producers in the world. Multi-year earnings decline expected. We expect Zhaojin’s EPS to decline 18%/8% in 2014/15 due to muted topline growth as well as margin contraction resulting from falling gold prices, which we expect to decline by 12% in 2014E to US$1,250/oz, vs. current spot price of US$1,288/oz. High capex in the past has led to a stretched balance sheet. In the past three years, the company has invested RMB2-3bn on acquisitions and other capex, vs. operating cash flows of below RMB2bn per year. As a result, the gearing ratio has increased from just 30% in 2011 to 82% as of 1H13. Going forward, we expect capex of >RMB2bn, meaning gearing is likely to continue to increase. We don’t expect Zhaojin to turn FCF positive until 2015E. Valuation expensive even under a bullish gold price assumption. Zhaojin’s share price has rebounded by almost 50% (HSCEI was up 16%) since its trough of HK$4.60 in July 2013. The company is now trading at 10x/12x our 2013E/14E earnings, which are based on a LT gold price of US$1,250/oz. Even by assuming a bull case LT gold price of US$1,400/oz (an unlikely scenario in our view), the company would still be trading at roughly 11x 2013 and 2014 earnings, still a fairly expensive valuation. Exhibit 76: Zhaojin’s cash cost is the lowest vs. its larger Peers Source: PetroChina, Jefferies estimates Exhibit 77: Zhaojin’s net gearing ratio Source: PetroChina, Jefferies estimates 512 557 584 603 638 640 677 706 862 894 1,111 0 200 400 600 800 1,000 1,200 USD/oz 19.9% 27.3% 49.5% 64.3% 72.2% 74.7% 0% 10% 20% 30% 40% 50% 60% 70% 80% 2010 2011 2012 2013E 2014E 2015E Exhibit 75: Share price Source: Bloomberg, Jefferies 0.0 5.0 10.0 15.0 20.0 25.0 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Po Wei +852 3743 8067 po.wei@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 40 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 42. Zijin (2899 HK, Underperform, TP HK$1.4) Key Takeaway On top of the risk of falling gold price, we are concerned about Zijin’s stagnant mined gold production growth, steep rise in production costs and transition risks at its flagship Zijinshan mine, where it’s moving from mined gold to copper production. We see high executional risk as the company ramps up copper production to offset the decline in gold, which accounts for at least 30% of the company’s gross profits. Underperform. Quality refinery growth masked poor mining output: Similar to Zhaojin, Zijin’s topline grew strongly in the past 5 years (Zijin’s topline was up by 31% CAGR vs. Zhaojin’s 37%). However, the quality of Zijin’s growth, in our view, has been much lower than Zhaojin’s: gold and copper refinery business, which has razor-thin gross margin (or negative contribution to the bottom line) accounted for about 40% of the total growth in 2008-12. Excluding the refinery business, Zijin’s topline would have grown by a much slower 21% CAGR. Due to this sales mix shift, the company’s gross/operating margins were down >10pts from 36%/28% in 2008 to only 25%/18% in 2012 despite the strong bull run in gold prices. Going forward, we see three pressing issues caused by Zijinshan depletion: We believe the depletion of the company’s flagship Zijinshan gold mine will lead to: (1) Stagnant mined gold production: The company has guided a decline in mined gold production in 2013 with the ramp-up of the newly acquired mines not being able to offset the decline in Zijinshan’s decline in production; (2) Steep rise in mining cost: At only about RMB70/g in 2012, Zijinshan gold mine’s unit production cost is the lowest among all of Zijin’s gold mines (company average was RMB121/g in 2012). With the ramping down of Zijinshan production, the higher-cost mines will become larger contributors to the company’s mined output, causing a steep rise in mining cost (on top of the same mine cost inflation). We expect the company’s unit mined gold cost to grow at 12% CAGR till 2015E vs. the 4% growth we are expecting for Zhaojin. Zijin’s unit mined gold production cost should reach about US$835/oz in 2015E. (3) Transitional risk from gold to copper: While we expect copper production to ramp up in Zijinshan as gold production subsides, the ramp up of copper’s contribution to profits needs to be well executed in order for it to completely offset the decline in gold’s contribution to profitability. By our estimate, we believe Zijinshan contributed at least 30% of the company’s gross profits in 2012E. Exhibit 79: Average cost of Zijin’s production by mines: the depleting Zijinshan has the lowest costs (2012) Source: Company data, Jefferies estimates Exhibit 80: Average cost of Zijin’s production by mines: the depleting Zijinshan has the lowest costs (2012) Source: Company data, Jefferies estimates 69 120 338 0 50 100 150 200 250 300 350 400 Zijinshan Company average Norton (acquired in 2012) RMB/g 454 509 472 490 510 531 364 427 596 731 781 835 50 150 250 350 450 550 650 750 850 950 2010 2011 2012 2013E 2014E 2015E US$/oz Zhaojin Zijin Exhibit 78: Share price Source: Bloomberg, Jefferies 0.0 2.0 4.0 6.0 8.0 10.0 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Po Wei +852 3743 8067 po.wei@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 41 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 43. Table of Contents The Year of the Horse: China Gallops into a Historic Bull Run Clearing the Path to Prosperity 3 Getting from here to there 9 China 2014: Sector Allocation & Top Picks 2013 Top Picks Performance Review 12 China 2014: Sector Allocation 14 China 2014: Top Buys and Top Sells 16 Our Journey Starts with China 2025 A review of Jefferies’ key China Strategy reports 43 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 42 of 228 Please see important disclosure information on pages 221 - 226 of this report. Jefferies China 2014 Sector View China Macro 80 Agriculture 92 Conglomerate 101 Consumer 107 Energy 112 Financials (Bank, Insurance and Broker) 124 Gaming 141 Healthcare 148 Industrials 154 Metals & Mining 163 Property 179 TMT (Internet, Telecom and Tech) 187 Transportation 208 Utilities 215
  • 44. Review of Jefferies China Strategy – A Journey that Began With China 2025 We are confident that China will attain its greatness Based on the collective insights of Jefferies HK/China Research team, we took a long and hard look into China’s future till 2025, in order to gain a strategic understanding of how China’s economy will evolve, what industries will prosper more than others, and how investors should be positioned for the long haul. We realized that China has vast potential still untapped and acknowledge fundamental reform is a must for China to attain its greatness. Compared to others, we are much more confident on the new leader’s determination and execution ability to push hard reforms to navigate China through any hazards and finally fulfil the “Chinese Dream.” Our unequivocal confidence is based on a deep and thorough understanding of China, its history and present, our faith in the nation’s resilience, and the 1.3bn population’s call for prosperity that any leadership cannot afford to ignore. Xi-Li determined to accelerate fundamental reform Since taking power, the Xi-Li administration has demonstrated strong execution ability in tackling urgent issues, such as anti-corruption and sweeping changes in government work style. Not only have these developments strengthened people’s confidence, they are strong signs that after years of delay, reforms could re-accelerate. Throughout the year, we were positively surprised by reform progress highlighted below, and the Third Plenum was a high point. Of course, the Third Plenum is another starting point on our way to the “Chinese Dream.” In February 2013, China’s State Council published a policy guideline titled: Intensifying Reform of Income Distribution System. We were impressed with the scope, spirit and language of the document. In March, the Ministry of Rail was re-organized into China Railway Corporation, paving the way to break down monopoly and open it up to private capital. In June, State Council announced Hukou reform in order to promote urbanization. The timing was a positive surprise. In late June, China witnessed a liquidity squeeze, as new leaders stand tough against bank’s insatiable appetite for liquidity. It was made clear to the world that China will follow its old path to pump up the economy by stepping on the money printing press. In September, the nation launched China (Shanghai) Pilot Free Trade Zone. Aiming at full economic liberalization and further opening up, the free trade zone will explore ways to transform the government’s role and become the next growth engine of China. In November, as the Third Plenum has just concluded, China unveiled its blueprint for comprehensive and fundamental reform, and vowed to achieve decisive outcomes by 2020. China has clearly reached a consensus on reform. As reform accelerates, we believe China is on the cusp of a massive multi-year bull run Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 43 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 45. 2013 defining moments: Captured by Jefferies As we are heading into 2014 and presenting our best ideas on sector trends as well as stock calls, we want to highlight our China 2025 and China Strategy reports, which have captured 2013’s defining moments highlighted above. (Pages 45 to 78) China 2025: A Clear Path to Prosperity In this report, we hope to shine a light on China’s economic path to 2025. We hope to convincingly show that inequality, not excess savings, has suppressed consumption. We believe urbanization will be China’s growth engine, and transfer payments will be the ignition key. We believe the timing is ripe for reforms to occur organically. We highlight China’s defining trends till 2025 and suggest how to be positioned for the long haul. China 2013: Transformation & Volatility in the Year of the Snake The Year of the Snake will see China shedding its old skin and growing a new one – shifting from export and FAI driven growth to the new paradigm of domestic consumption. We believe 2013 could be a volatile year for Chinese equities, as the market comes to terms with the new growth trajectory. China 2013 (II): Tough Tasks Call for Brave Leaders While the bird flu, Sichuan earthquake and weak 1Q GDP have generated powerful headwinds, we see early signs of fundamental changes, and are optimistic on the XI-Li New Era. The new leaders have made a strong debut on the global stage, as the island dispute with Japan and the North Korea situation are largely under control. Now they face the real critical challenge to drive domestic consumption growth. A Historic Step in Hukou Reform While we expect the new leadership to promote fundamental reforms, the timing of Hukou reform, announced by State Council yesterday, was a positive surprise. Hukou reform is critical to China’s economic transition, and is consistent with our long-term bullish view. We see reform accelerating, and advise investors to fasten their seat belts ahead of a tough summer. China 2013 Mid-Year Review: “Xi-Li New Deal” Building Momentum China’s new leadership has surprised us with their resolve. Starting the year with an aggressive assault on corruption, they have since engineered a liquidity “crisis”, kick- started Hukou reform and announced aggressive natural gas price reform. With timely insights from our Expert Summit, we are confident that China is in the early stage of re- balancing, and the new leaders have the resolve to inflict more short-term pain. Shanghai Free Trade Zone: China’s New Engine for Growth? Originally a local initiative, Shanghai FTZ is now a focal point for financial and economic reforms, on strong backing of Premier Li Keqiang. Shanghai FTZ will be a critical pilot test to implement long-awaited reforms, including liberalization of interest rates and full RMB convertibility. In our view, Shanghai FTZ marks a fundamental shift toward a “service-oriented government” and may become China’s new engine to drive economic growth. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 44 of 228 Please see important disclosure information on pages 221 - 226 of this report. The Third Plenum: A Catalyst for Reform, or the Start of a New Bull Market? Endorsed by President Xi, the highly anticipated Third Plenum of the 18th Party Congress promises to tackle deep-rooted conflicts, to drive vital reforms in order to realize the Chinese Dream. Transforming government’s role, breaking up monopoly, improving the social safety net and financial reform are likely key priorities. We see it as a historic event to drive China’s growth to long-term prosperity, could it be the catalyst for a new bull market? China Has Reached a Consensus; Now Is the Time to Get It Done The communique from the Third Plenum was ahead of our expectations, as China unveils its blueprint for comprehensive, fundamental reform to drive future growth and prosperity. The confidence and determination of the new leaders is unmistakable; we see the consolidation of power as very positive. China has reached a consensus, now is the time to make it happen.
  • 46. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFA INDUSTRY NOTE China | Equity Strategy China 1 January 2013 China China 2025: A Clear Path to Prosperity EQUITYRESEARCHASIA 2025 TOP PICKS Company Ticker Implied PT* by 2025 ABC 1288 HK 23.3 Baidu BIDU US NA CMA CMA SP 7.4 CRE 291 HK 176.4 CRLand 1109 HK 105.0 Hang Lung 101 HK 117.0 Kunlun 135 HK 40.0 MSB 1988 HK 43.0 PetroChina 857 HK 41.0 Ping An 2318 HK 427.0 Sands China 1928 HK 90.0 Tencent 700 HK NA *In today's value, trading currency, based on 2025 market cap projections Christie Ju, CFA * Equity Analyst +852 3743 8012 cju@jefferies.com Laban Yu * Equity Analyst +852 3743 8047 lyu@jefferies.com Julian Bu * Equity Analyst +852 3743 8058 jbu@jefferies.com Venant Chiang * Equity Analyst +852 3743 8013 venant.chiang@jefferies.com Sean Darby * Chief Global Equity Strategist +852 3743 8073 sdarby@jefferies.com Jessie Guo, PhD * Equity Analyst +852 3743 8036 jguo@jefferies.com Johnson Leung * Equity Analyst +852 3743 8055 jleung@jefferies.com Rong Li * Equity Analyst +852 3743 8014 rli@jefferies.com Cynthia Meng * Equity Analyst +852 3743 8033 cmeng@jefferies.com Ming Tan, CFA * Equity Analyst +852 3743 8752 ming.tan@jefferies.com * Jefferies Hong Kong Limited Key Takeaway In this report, we hope to shine a light on China’s economic path to 2025. We hope to convincingly show that inequality, not excess savings, has suppressed consumption. We believe urbanization will be China’s growth engine, and transfer payments will be the ignition key. We believe the timing is ripe for reforms to occur organically. We will highlight China’s defining trends till 2025 and suggest how to be positioned for the long haul. A clear path to prosperity. We will marshal, in our opinion, compelling evidence that low consumption in China is caused by severe wealth inequality, not a socio-economic propensity to over-save. We will show that reducing inequality through transfer payments, from the state to the needy, can best stimulate consumption. We believe these reforms will occur as a natural phase of economic modernization with historical gravity on its side. Bold projections. We forecast China’s GDP to reach ~US$18trn (6.9% CAGR) by 2025, almost equal to the US at that time. Firmly in the upper middle income range, we expect GDP/capita to reach US$9,750 (~US$18,000 PPP). The economic mix will improve significantly: we project final consumption to reach 73% of GDP, up from 49% in 2012. We expect household consumption to become the dominant growth driver, with government consumption playing “catch up.” Traditional drivers, such as exports and FAI, will become ever less relevant as China rebalances. Seven megatrends. Based on this vision, we have laid out the seven mega-trends that will define China in the next 13 years – urbanization, consumerization, slowing trade, slowing FAI, financial reform, information mobility and service sector development. Comprehensive sector views. This report also includes deep dive analysis and projections across the breadth of our coverage universe – Agriculture, Consumer, Energy, Financials (Banks, Insurance and Brokers), Healthcare, Industrials (Machinery & Autos), Metals & Mining (Cement, Steel, Coal and Gold), Property, Telecom, Internet & Technology, Tourism & Gaming, Transportation, and Utilities. These sector views should provide a comprehensive and granular survey of China’s economic growth through 2025. Investment implications. We believe the growth outlook for consumer, property, healthcare, tourism, and Internet/IT is promising, as rising income and more even wealth distribution boost private and discretionary spending. Deepening reform and deregulations will bring uncertainties, but opportunities will outweigh the risks. While there will be pockets of strength, we are less optimistic (if not pessimistic) on industrials, materials and transportation. Jefferies’ 2025 Top Picks. We have scoured our coverage universe for twelve companies we believe to be best positioned to thrive in the China of 2025: Agricultural Bank of China (1288 HK), Baidu (BIDU US), CapitaMalls Asia (CMA SP), CRE (291 HK), CR Land (1109 HK), Hang Lung Properties (101 HK), Kunlun Energy (135 HK), Minsheng Bank (1988 HK), Ping An (2318 HK), PetroChina (857 HK), Sands China (1928 HK), Tencent (700 HK). These are our long-term winners that are most likely to succeed. Jefferies does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Jefferies may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see analyst certifications, important disclosure information, and information regarding the status of non-US analysts on pages 421 to 426 of this report. page 45 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 47. China 2025: A Clear Path to Prosperity We see a clear path China’s economy needs to be rebalanced by increasing the contribution of consumption to GDP. This is not new. There has been much market handwringing over how and whether this rebalancing will occur. The prevailing belief is that the government can easily turn the dials on investment but is at a loss when it comes to increasing consumption. Many in the market believe that China will revert to old habits, driving economic growth through investment spending, because they know little else. We do not believe this to be true. We see a clear path towards rebalancing by stimulating consumption. The key, as we will demonstrate, is to reduce inequality through transfer payments – pensions, healthcare, education, social housing etc. We believe depressed consumption in China has erroneously been attributed to excessive savings by households. The real culprit is inequality. We believe China has ample economic resources – from tax revenue, to SOE profits, to deficit spending – which can be pumped into the “soft infrastructure” of the social welfare system. We believe the transfer payments of a welfare state are integral parts of a modern economy which develops organically with increasing societal wealth. We will demonstrate that this path will largely be Pareto efficient (not robbing Peter to pay Paul) and will be palatable to China’s political economy. Exhibit 81: Real GDP by output, 1980-2025E Note: GDP in real 2010 Rmb terms Source: CEIC, China NBS, Jefferies estimates Exhibit 82: Real GDP by output, 1980-2025E Source: CEIC, China NBS, Jefferies estimates GDP by expenditure By 2025, we project final consumption in China to reach 73% of GDP, up from 49% in 2012. Of note, we forecast government consumption spending to reach 24% of GDP from 13% in 2012. Also of note, by 2025, we expect China to be a net importing country amounting to 1.7% of GDP. Gross Capital Formation Household Consumption Government consumption Net Exports - 20,000 40,000 60,000 80,000 100,000 120,000 1980 1985 1990 1995 2000 2005 2010 2015E 2020E 2025E Rmb B US Gross Capital Formation Household Consumption Government Consumption Net Exports 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1980 1985 1990 1995 2000 2005 2010 2015E 2020E 2025E The prevailing belief is that the government can easily turn the dials on investment but is at a loss when it comes to increasing consumption We do not believe this to be true. We see a clear path towards rebalancing by stimulating consumption We believe the transfer payments of a welfare state are integral parts of a modern economy Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 46 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 48. Exhibit 83: China GDP by expenditure Note: 1980 net exports accounted for -0.3% of GDP Note: 2025E net exports accounted for -2% of GDP Source: CEIC, China NBS, Jefferies estimates Exhibit 84: Real GDP by output, 1980-2025E Note: GDP in real 2010 Rmb terms Source: CEIC, China NBS, Jefferies estimates Exhibit 85: Real GDP by output, 1980-2025E Source: CEIC, China NBS, Jefferies estimates GDP by output By 2025, we project tertiary industries (services) in China will reach 67% of GDP, up from 44% in 2012. We forecast secondary industries (manufacturing and construction) to fall to 27% of GDP, from 47% in 2012. Exhibit 86: China and US GDP by output Source: CEIC, China NBS, Jefferies estimates Exchange rate GDP vs. purchasing power parity GDP We project China’s real GDP to surpass the US in 2026, one year outside the scope of this report. On purchasing power parity, however, we expected China’s GDP to surpass the US in 2017. We forecast China’s exchange rate per capita GDP to reach US$9,750/year in 2025, a level considered upper middle income by the World Bank. Countries at a comparable per capita GDP today include Mexico, Malaysia, Turkey and Venezuela. HH Cons 50% Gov Cons 15% Gross Cap Form 35% China 1980 HH Cons 35% Gov Cons 13% Gross Cap Form 48% Net Exports 4% China 2010 HH Cons 48% Gov Cons 24% Gross Cap Form 28% China 2025E Primary Secondary Tertiary 0 20,000 40,000 60,000 80,000 100,000 120,000 1980 1985 1990 1995 2000 2005 2010 2015E 2020E 2025E Rmb B US Primary Secondary Tertiary 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1980 1985 1990 1995 2000 2005 2010 2015E 2020E 2025E Primary 30% Secondary 48% Tertiary 22% China 1980 Primary 10% Secondary 47% Tertiary 43% China 2010 Primary 6% Secondary 27% Tertiary 67% China 2025E Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 47 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 49. On a purchasing power parity basis, we forecast China’s per capita GDP to reach US$18,000/year in 2025, which should make it a high income nation according to the World Bank. Greece has a comparable per capita purchasing power GDP today. Exhibit 87: Purchasing power parity GDP Note: PPP GDP in 2005 US$ terms Source: CEIC, China NBS, Jefferies estimates Exhibit 88: China per capita GDP, 1980-2025E Note: PPP GDP in 2005 US$ terms Source: CEIC, China NBS, Jefferies estimates Exhibit 89: Per capita GDP, 2011 Source: World Bank 0 5,000 10,000 15,000 20,000 25,000 1980 1985 1990 1995 2000 2005 2010 2015E 2020E 2025E US$B US China - 2,500 5,000 7,500 10,000 12,500 15,000 17,500 20,000 1980 1985 1990 1995 2000 2005 2010 2015E 2020E 2025E US$/head PPP, 2005 US$ Real, 2005 US$ 0 10,000 20,000 30,000 40,000 50,000 60,000 0 10,000 20,000 30,000 40,000 50,000 60,000 Ethiopia Leastdeveloped Lesotho Kenya Bangladesh Vietnam India Iraq Philippines Indonesia Bolivia Bhutan Armenia Egypt Middleincomeavg China Thailand ArabWorld EastAsia&Pacific SouthAfrica MidEast&N.Africa World Brazil Latam&Carib Venezuela Mexico Botswana Turkey Malaysia Russia Argentina Greece Italy S.Korea France Euroarea OECD Japan UK Highincomeavg Germany Sweden Canada NorthAmerica US HongKong Singapore US$/head2005 US$/head Per capita GDP, PPP 2005 US$ (LHS) Per capita GDP, Current US$ (RHS) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 48 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 50. Consumption – an inequality problem It is almost universally acknowledged that China’s export/investment driven economic growth model is not sustainable. The central government has repeatedly tried to jump start domestic consumption in hopes of transforming the growth model, but with limited success. Many blame China’s high savings rate for low consumption, and policies have been set up to discourage savings. We believe the real reason for low consumption is China’s alarming income and wealth inequality, of which a high savings rate is merely a natural consequence. With first-hand date provided by the China Household Finance Survey (CHFS), we believe the key to boosting domestic consumption is to reduce income/wealth inequality. Exhibit 90: China’s household income 2010 (Rmb) Source: CHFS Vast income gap… In 2010, the average household income was Rmb49,955, of which average expenditure was Rmb38,924, and the remaining Rmb11,031 became savings. Income distribution skews heavily toward the top. The highest 5% income-earning households grab 44% of the nation’s total income pie, while the top 10% takes 57% of the total. The income distribution is so uneven that ~80% of households earn below-average incomes. Savings mostly in the hands of a few On average, a household saved Rmb11,031 in 2010. The saving rate was 22.1%. What is more shocking is that 42.3% of households were responsible for all of China’s savings. In other words, more than 50% of families saved nothing in 2010. Breaking down total savings is more shocking: 69.1% of all savings were by the top 5% of households, ranked by total income. The top 10% accounted for 79.8% of all savings, while the top 25% amassed an astonishing 93.2% of all household savings in 2010. Exhibit 91: Income & savings by household Ranked by income % of household that saved Share of total income Share of total savings Top 5% 77.5% 44.0% 69.1% Top 10% 68.8% 57.0% 79.8% Top 25% 56.5% ~70.0% 93.2% Overall 42.3% 100.0% 100.0% Source: CHFS, Jefferies Low income is the constraining factor for low savings For households in the bottom 25% income and asset brackets, only 2.4% saved in 2010. Moving into higher income categories, the percentage of families that saved increases rapidly. For households in the top 25% income category, more than 80% of them had 17.5 28.0 10.6 559 664 275 0 100 200 300 400 500 600 700 Nationwide Urban Rural Thousands Median Household income Top 1% Household income The China Household Finance Survey was conducted in 2011 using 2010 data. The real culprit for low consumption is inequality Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 49 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 51. saved in the surveyed year. It shows that low income families have no income left for savings (or additional consumption) after meeting all necessary expenditures. In essence, over 50% of China’s households are living paycheck to paycheck. Exhibit 92: % of households that saved – by income & asset Income bottom 25% 25%~50% 50%~75% top 25% Asset bottom 25% 2.4% 40.8% 78.2% 87.0% 25%~50% 1.7% 36.8% 63.9% 86.3% 50%~75% 0.7% 23.1% 64.3% 85.3% top 25% 0.9% 10.8% 32.1% 81.9% Source: CHFS, Jefferies Massive wealth disparity According to CHFS, China’s urban household net asset value averaged Rmb2,375k in 2010. Like the income data, the high net asset value does not reveal the massive wealth gap in today’s China. In fact, the median household net asset value was only Rmb373k; the average is 6.4x the median. The gap is somewhat narrower for rural China but does not warrant much comfort: average household net assets are Rmb340k, 2.8x higher than the median of Rmb122k. Household assets are heavily concentrated in the hands of a few. The wealthiest 10% of households amassed 84.5% of all family net assets in China. Exhibit 94: Household wealth comparison (Rmb ’000) Category Urban Households Rural Households Average Median Average Median Net asset 2,375 373 340 122 Financial asset 112 17 31 3 Source: CHFS, Jefferies Bottom half of the households are very illiquid… On average, an urban household has Rmb112k in financial assets, including bank deposits and other forms of savings, such as stocks. The median household’s financial assets are only Rmb17k, accounting for 15% of China’s average household net worth. With half of the households’ financial assets below Rmb17k, families’ liquidity can easily be tested by unforeseen illnesses or a child’s education expenses. Gini Coefficient unusually high The National Bureau of Statistics stopped reporting Gini Coefficients long ago. Based on the CHFS, China’s Gini Coefficient was 0.61 in 2010, one of the highest in the world. The high Gini reflects disparity in labor income, business income and investment income. It is consistent with the vast income and wealth disparity among Chinese households and reflects a lack of state mandated transfer payments. Given poorer households’ higher propensity to consume, we believe significant transfer payments are necessary to reduce the high Gini, narrow wealth gap and boost domestic consumption. 36.8% 63.9% Exhibit 93: % of total owned by the richest top 10% households Source: CHFS, Jefferies 84.6% 61.0% 88.7% 0% 25% 50% 75% 100% Total households assets Total financial assets Total non- financial assets China’s Gini Coefficient was 0.61 in 2010 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 50 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 52. Exhibit 95: GINI coefficient, select countries Source: World Bank, OECD, Jefferies 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 Norway,late2000's Finland,late2000's Hungary,late2000's Germany,late2000's S.Korea,2000's Poland,late2000's Greece,late2000's OECD,late2000's Spain,late2000's Canada,late2000's Japan,late2000's N.Zealand,late2000's Italy,late2000's UK,late2000's US,late2000's Thailand,2009 Russia,2009 Philippines,2009 Uganda,2009 Argentina,2009 Malaysia,2009 DominicanRep,2010 Mexico,late2000's Nigeria,2009 Peru,2009 Ecuador,2010 Chile,late2000's Swaziland,2009 Panama,2009 Paraguay,2009 Brazil,2009 Colombia,2010 Honduras,2009 China,2012 SouthAfrica,2009 GINI Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 51 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 53. Transfer payments unlock consumption Pareto improvement through transfer payments Robin Hood stole from the rich and gave to the poor. This folklore has traction because it is generally understood that the Sheriff and his lords were economically exploiting the good citizens of Nottinghamshire. In a modern market economy, whether the rich are exploiting the poor is the subject of intense debate, one which we will not settle here. We do propose that transfer payments need not deprive the rich under duress to give to the poor. In many if not most cases, the rich in a modern political-economy can and do willingly transfer wealth to the poor, increasing their own economic utility. This is a Pareto efficient outcome, where nobody becomes worse off while at least one person becomes better off. Charity is perhaps the most basic example. Whatever their motives, the wealthy do willingly donate to charity which benefit the needy. Though Marx would call charity a pap used to weaken the revolutionary convictions of the proletariat, within a capitalist system, charity represents a Pareto efficient transfer payment. The wealthy get to bask in their generosity and altruism, real or imagined, and the poor enjoy the economic benefits of the donation. Beyond altruism, the rich in a modern economy may support wealth redistribution because they recognize that a welfare state is, in essence, a social insurance policy which they may need on a rainy day. Perhaps the most compelling reason for the wealthy to support transfer payments, especially in China of late, is to ensure social stability. All the wealth in the world may be no use if the masses are rioting outside one’s chauffeured Mercedes. Joseph Kennedy, Sr. (American financier, first Chairman of the SEC, father of future US President Jack Kennedy) remarked about the Great Depression, "in those days I felt and said I would be willing to part with half of what I had if I could be sure of keeping, under law and order, the other half." Call it what you will: a pap to weaken the resolve of the revolutionary masses, a premium paid for social insurance or a generally accepted part of the social contract in a modern economy, the rich need not be robbed to give to the poor. Transfer payments are generally provided willingly. Transfer payments and the modern economy Empirically, every developed economy has established sophisticated transfer payment systems, redistributing a significant portion of societal income. Overall, taxes and transfer payments within the OECD economies lower total Gini coefficient from 0.46 to 0.32. In those days I felt and said I would be willing to part with half of what I had if I could be sure of keeping, under law and order, the other half. – Joseph Kennedy, Sr., First Chairman of the SEC, on the Great Depression Transfer payments can be Pareto efficient, where nobody becomes worse off while at least one person becomes better off Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 52 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 54. Exhibit 96: GINI coefficient before and after taxes and transfers, OECD countries Source: OECD, Jefferies Ideology plays a role, wealth level plays a bigger role Using taxes and transfer payments, the Scandinavian cradle-to-grave welfare states lower their Gini coefficient to ~0.25 from ~0.43. Turkey, Mexico and Chile, lower income members of the OECD, have the least developed transfer payment systems. The US, the world’s leading champion of free-market principles, still manages to lower its Gini coefficient from 0.49 to 0.38 through progressive taxation and transfer payments. More wealth = more redistribution Empirically, the extent of a nation’s income redistribution appears to be a function of its income level at least as much as its stated or perceived ideological disposition. The comparison between the US and China is especially stark. In recent years, Communist China’s “capitalism with Chinese characteristics” has taken on the distinct historical flavor of the “robber baron” capitalism experienced by the US at the turn of the last century. The free market champion of the US, while certainly no Scandinavia, has adopted an extensive social welfare system (now including universal healthcare) far more extensive than communist China’s. Exhibit 97: Government spending and tax burden as a percentage of GDP, 2011 Source: Heritage Foundation, Jefferies Among 46 major representative economies we tracked, there is a clear positive correlation between per capita GDP and government spending as a percentage of GDP. Government spending in under-developed nations is often below 20% of GDP while 0.24 0.25 0.25 0.26 0.26 0.26 0.26 0.26 0.26 0.27 0.29 0.29 0.29 0.30 0.30 0.30 0.31 0.31 0.31 0.31 0.32 0.32 0.32 0.33 0.33 0.34 0.34 0.34 0.35 0.37 0.38 0.41 0.48 0.49 0.42 0.42 0.41 0.44 0.42 0.47 0.47 0.43 0.47 0.47 0.48 0.48 0.43 0.50 0.38 0.41 0.47 0.44 0.34 0.46 0.46 0.46 0.44 0.46 0.46 0.47 0.53 0.51 0.52 0.50 0.49 0.47 0.49 0.53 0 0.1 0.2 0.3 0.4 0.5 0.6 Slovenia Denmark Norway CzechRep SlovakRep Belgium Finland Sweden Austria Hungary Luxemb… France Netherla… Germany Iceland Switzerl… Poland Greece Korea OECD… Estonia Spain Canada Japan N.Zealand Australia Italy UK Portugal Israel US Turkey Mexico Chile GINI After taxes and transfers Before taxes and transfer 0% 10% 20% 30% 40% 50% 60% France Sweden Denmark Belgium Belarus Finland Hungary Austria Italy Ukraine UK Greece Portugal Netherlands Germany Poland CzechRep Spain Brazil Norway Canada US Japan Australia Russia Egypt Venezuela Kenya Nigeria SouthKorea SaudiArabia Vietnam Iran SouthAfrica India Malaysia Argentina Mexico Turkey Chile China Pakistan Indonesia Thailand Philippines Bangladesh Government spending as percent of GDP Tax burden as percent of GDP There is a clear positive correlation between per capita GDP and government spending as a percentage of GDP Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 53 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 55. topping 50% among European welfare states. As seen in the OECD data, much of this spending is transfer payments used to redistribute income. The fact that China’s government spending constitutes only 21% of GDP (vs. 39% for the US), despite having a declared communist ideology, is largely understandable given its comparably low per capita GDP. Social welfare spending constitutes only 21.2% of China’s government budget compared to 46.7% in the US. As a percentage of GDP, social welfare spending constitutes 4.4% compared to 18.2% in the US. Exhibit 98: Gov’t spending as % of GDP vs. per cap GDP Source: World Bank, Heritage Foundation, Jefferies Exhibit 99: Contribution to GDP by spending Source: Heritage Foundation, CHFS, Jefferies Bang for the buck – transfer to the bottom half For illustration purposes, the CHFS report performed a hypothetical analysis of the effects on China’s Gini coefficient assuming Rmb3.8trn of transfer payments (raising welfare spending to 11.9% of GDP, vs. 18.2% for the US). The conclusion is that the reduction to the Gini coefficient would be most effectively achieved by subsidizing those in the bottom 60% of income levels in China (Gini coefficient falls from 0.61 to 0.42). Significant reductions to the Gini coefficient can even be achieved by subsidizing everyone through transfer payments (Gini coefficient falls from 0.61 to 0.49). Exhibit 100: Effects of transfer payments on Gini coefficient GINI coefficient Transfer payment per family (Rmb) National Urban Rural Before transfer 0.61 0.56 0.60 Subsidize all 9,500 0.49 0.48 0.43 Subsidize bottom 80% 12,800 0.46 0.45 0.38 Subsidize bottom 60% 15,800 0.42 0.44 0.32 Source: CHFS, Jefferies France Sweden Denmark Belgium Belarus Finland Hungary Austria Italy Ukraine UK Greece Portugal Netherlands Germany Poland CzechRep Spain Brazil Norway Canada US Japan Australia Russia Egypt Venezuela Kenya Nigeria SouthKorea SaudiArabia Vietnam SouthAfrica India Malaysia Argentina Mexico Turkey Chile China Pakistan Indonesia Thailand Philippines Bangladesh R² = 0.4374 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000 50,000 Per capita GDP, US$2005 PPP 4.4% 18.2% 16.4% 20.7% 79.2% 61.1% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% China US Non government spending Other government spending Social welfare spending Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 54 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 56. Show me the money Finding the money for generous transfer payment obligations has brought Europe to its knees. It has fuelled heated debate in the US as various prognosticators believe government debt will either depress growth for decades or lead to hyper-inflation. Whatever the case, transfer payments in the US and Europe may be hitting financial limits. China spending under control We do not believe this to be the case for China, which has considerable financial firepower. China’s central government budget deficit was a mere 2.8% of GDP in 2011 compared to 12.0% in the US, 8.8% in Japan and 8.4% in the UK. Exhibit 101: Government budget deficit as percentage of GDP, 2011 Source: Heritage Foundation, Jefferies Tax revenue surging Over the past 10 years, China’s government tax revenue increased at a CAGR of 14% (both local and central government) compared to GDP growth of 10% CAGR. In 2011, China’s tax revenue reached 19% of GDP, up from 12.7% in 2000. In 2011, China’s tax revenue increased by ~Rmb1trillion (~US$160B) from 2010. We expect tax revenue to increase to another trillion Rmb this year. Exhibit 102: China tax revenue Source: China NBS, Jefferies Exhibit 103: China 2011 tax revenue breakdown Source: China NBS, Jefferies Shaking SOEs for dividends, two birds with one stone China’s 100,000 state owned enterprises have come to dominate the economy over the past 10 years. SOE revenue now accounts for about half of China’s economy with an estimated Rmb1.98trn (US$317bn) in profits according to CHFS. Dividends paid out by blue chip listed SOEs can reach an appropriate ~35%, but overall, SOE have hoarded their earnings, paying out 5-10% if anything at all. -5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% Nigeria SaudiArabia Iran Venezuela Belarus Egypt Mexico US Greece Malaysia Ukraine Kenya Pakistan Japan Hungary India Portugal Poland UK France Canada Spain Bangladesh CzechRep Brazil Finland Netherlands Austria Indonesia Italy Vietnam Sweden Belgium Australia SouthKorea Philippines Germany Denmark China Chile Thailand SouthAfrica Russia Turkey Argentina Norway 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Rmb B Local Central government Total 14% 10 year CAGR VAT 27% Enterprise income 19% Consumption and VAT on imports 15% Operations tax 15% Consumption 8% Individual income 7% Other 9% Transfer payments in the US and Europe may be hitting financial limits China’s government tax revenue increased at a CAGR of 14% Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 55 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 57. The retention of earnings by SOEs has been crucial for China’s investment led growth of the past 10 years. This economic model had its genuine achievements but is clearly well past the point of diminishing returns. With investment nearing 50% of the economy and over capacity in nearly every industrial sector, continued retention of earnings has led to SOEs speculating in real estate and the stock market, lavish perks for managers and white elephant investment projects. Forcing SOEs to cough up a proper dividend of ~35% of profits could result in Rmb692bn (US$111B) in additional government revenues per year. Raising revenue from SOE dividends avoids the thorny political pushback of redistributing wealth from China’s new rich, however much it may be justified. The curtailed perks and kickbacks from SOE profits and investment projects can be partially offset by stock price appreciation of listed shares as dividends are paid out. Potential and problems of privatization Besides forcing SOEs to cough up more dividends, a significant amount of revenue can be raised by privatizing SOEs. Using a ballpark 10x earnings multiple, China’s SOEs are worth Rmb19.8trn (US$3.17trn). Assuming the state owns approximately 85% of shares, Rmb16.8trn (US$2.70trn) can conceivably be raised through privatization. Another possibility would be to distribute state owned shares to citizens to spur consumption through the wealth effect. Privatization through share distribution has proven problematic in Eastern Europe and Russia as the savvy and the connected ended up with more than their fair share. Lockup clauses on sales may prevent some of the abuses, but it will have limited effect on driving consumption growth as China’s lower income citizens need cash and services, not paper wealth. Although it may experiment with increases public float (selling down ownership but not past 51%), we believe significant privatization is not likely. After all, China does have a communist government and state ownership of key companies may be required to maintain any remaining ideological pretense. China could always deficit spend Although this is a prescription that China may regret, a democracy with China’s balance sheet would run substantially higher deficits. With government debt at 26% of GDP (perhaps +40% including local government debt), China has room to spare. Government debt in the US, EU and Japan are all above 80% of GDP with Japan at an eye-popping 230%. Exhibit 104: Government debt as percent of GDP, 2011 Source: IMF, Jefferies 0% 50% 100% 150% 200% 250% Japan Italy Portugal US Singapore Belgium France Canada EU UK Germany Egypt Spain India Netherlands Brazil Poland Malaysia Norway Finland Denmark Venezuela Argentina Mexico CzechRep Taiwan Philippines Turkey SouthAfrica Vietnam Sweden Switzerland SouthKorea China Indonesia Australia Nigeria Iran Russia SaudiArabia % of GDP The retention of earnings by SOEs has been crucial for China investment led growth of the past 10 years Raising revenue from SOE dividends avoids redistributing wealth from China’s new rich State ownership of key companies may be required to maintain any remaining ideological pretence A democracy with China’s balance sheet would run substantially higher deficits Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 56 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 58. Transfer payment mechanisms Taxation – diminishing returns set in Technically, taxes are not transfer payments but rather the required source for the payment. But taxation can provide a Gini coefficient effect, if we think of it as negative transfer payments – reduction in taxes is equivalent to a transfer payment and visa-versa. Progressive income taxation (higher rates on higher income) is one of the most common forms of wealth redistribution in modern economies. In China, however, income redistribution through tax relief for low-income households has hit diminishing returns. Progressive taxation The US has experimented with different rates of progressive taxation over the past century, adjusting marginal tax rates for economic, fiscal and political reasons. The top marginal tax rate was approximately 90% between 1942 and 1963. Although this appears egregiously high compared to 35% today, the top marginal tax bracket was applied to income above ~US$3,000,000 (adjusted for inflation) compared to US$388,351 in 2012. After the Great Depression of the 1930’s, President Franklin Roosevelt’s New Deal programs were funded by soaring marginal tax rates on the extremely wealthy. Exhibit 105: US top marginal income tax rate Source: Tax Policy Center, Jefferies Tax exemptions In addition to raising or lowering marginal tax rates and adjusting the income brackets for which they apply, a very common tax relief mechanism for lower income citizens is to institute (or raise) an exemption amount for which taxes are not assessed. This sets a threshold income that needs to be cleared before taxes are owed. In China, the tax free threshold currently stands at Rmb3,500 per month. The threshold was originally scheduled to be raised by Rmb500 per month last year but was increased by Rmb1,000 per month after public consultations. According to CHFS, China’s median monthly household income is a mere Rmb1,467, well below the taxable threshold. The vast majority of China’s households are not subject to national income taxes. In China, redistribution of wealth through more progressive taxation or increased exemptions has reaching diminishing returns as income taxes are assessed on only a small minority of China’s households. 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Exhibit 106: Rural and urban income by education level, monthly (RMB) Source: CHFS, Jefferies Rural Urban Rural Urban Primary school 1,323 2,198 - - Highschool 2,456 3,764 - 264 Vocational 4,648 5,842 1,148 2,342 College/above 10,434 9,685 6,934 6,185 Taxable incAverage inc Education Income redistribution through tax relief has hit diminishing returns Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 57 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 59. Exhibit 107: US marginal income tax rates vs. brackets Note: taxable income is net of US$3,800/year exemption Source: Tax Foundation, Jefferies Exhibit 108: China marginal income tax rates vs. brackets Note: taxable income is net of Rmb3,500/month exemption Source: World Wide Tax, Jefferies Agricultural taxes abolished in 2006 In addition to income tax exemptions, China already provided significant tax relief for rural residents in 2006 by abolishing agricultural taxes. The importance of this historic event cannot be overstated as agricultural taxes had been the primary source of government revenue for centuries. For centuries, Chinese farmers were assessed for taxes based on the size of their families, acreage farmed and livestock kept. The abolition of agricultural taxes was indicative of the change in China’s economy with the agricultural sector falling from 50% of the economy in 1950, to 30% in 1980, to 11% in 2006 to 10% today. No longer dependent on agricultural tax revenue, it was not difficult for the government to scrap agricultural taxes as a feudal relic that placed unnecessary burdens on low income farmers. The shortfall in revenue was easily covered by growing tax revenue from manufacturing, construction and service industries as well as from urban income taxes. Social pensions – infrastructure in place Social pensions are one of the most common forms of transfer payments. Social pensions are non-contributory cash payments to the elderly, meaning they do not require recipient contributions during working years. The goal of social pensions is to reduce poverty for the elderly and provide them with the dignity of a minimum standard of living. Support for social pensions is often highest in economically developed democracies as the proportion of the elderly population, who tend to vote at higher rates, are high. Adoption and implementation of social pensions vary greatly between countries. Aging is a global megatrend, especially in developed countries. Generous social pension benefits in Europe can exceed 30% of per capita GDP with annual spending accounting for over 10% of total GDP. 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 0 250,000 500,000 750,000 1,000,000 1,250,000 1,500,000 1,750,000 2,000,000 2,250,000 2,500,000 2,750,000 3,000,000 3,250,000 Annual taxable income US$/year 2012 1925 1960 Decrease Gini coefficient Increase Gini coefficient Median$46,7022 Top1%$379,200 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000 Monthly taxable income, Rmb/month Urbancollegegrad,Rmb6,185 Urbanhighschoolgrad,Rmb264 Aging is a global megatrend Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 58 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 60. Exhibit 109: Social pensions benefit level, as percent of per capita GDP, select countries, 2012 Source: Pension Watch, Jefferies Not just for rich countries Social pensions are not merely a rich country phenomenon, although spending tends to be lower in developing countries as benefits are less generous and populations are generally younger. India, Thailand, the Philippines, Vietnam, Mexico and other developing countries have all instituted social pension schemes. Exhibit 110: OECD pension spending, 2011 Source: OECD, Jefferies A rudimentary system in place in China In the past five years, China has been aggressively expanding its pension system. According to The Economist, less than 30% of China’s adults were covered by government pensions in 2009. China’s national audit office reported that by August 2012, 622m people were enrolled in a pension scheme: over 55% of adults. These schemes are a patchwork of local, urban, rural, public and private systems. They also involve a mixture of both true non-contribution social pensions as well as systems that combine government and user contributions (similar to schemes in developed economies). China’s National Audit Office claimed that China’s pension system is “basically” in place. For now, these systems are often rudimentary with rural seniors in some areas receiving Rmb55 per month (US$8.81). For now, benefits are low and China’s population remains relatively young (~12.5% over 65 vs. 23% in the OECD). All of this will rapidly change as the one-child policy ages China’s population with demographic certainty. 0% 5% 10% 15% 20% 25% 30% 35% 40% NewZealand Netherlands Ireland Belgium Brazil UK Australia France Sweden Austria SouthAfrica Kenya Denmark Nigeria Finland Italy Spain Greece US Argentina Norway Chile Malaysia Canada Hungary Indonesia Belarus Turkey Mexico Vietnam Bangladesh Philippines HongKong S.Korea Thailand India 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% Italy Belgium Greece Portugal Switzerland Germany Poland Denmark Slovenia Hungary OECD Netherlands Iceland CzechRep Australia Chile Canada Luxembourg Israel Turkey NewZealand Estonia Korea Mexico Private Public Exhibit 111: Rural income vs. pension status Source: CHFS, Jefferies 3,002 1,709 0 500 1,000 1,500 2,000 2,500 3,000 Has pension No pension Rmb/m Social pensions are not merely a rich country phenomenon Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 59 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 61. Exhibit 112: Population pyramid 2010 Source: US Census Exhibit 113: Population pyramid 2015 Source: US Census Exhibit 114: Population pyramid 2025 Source: US Census Healthcare – a key avenue for transfer payments Healthcare is a major avenue for transfer payments in a modern society. Healthcare costs for major illness are often exorbitant even, or perhaps especially, in developed countries that employ advanced (meaning expensive) treatment methods. In all developed countries, even the well-off receive transfer payments during a health crisis as very few are wealthy enough to financially absorb major medical interventions like organ transplants or life-threatening auto accidents. Transfer payments for healthcare generally receive less opposition by free market ideologues as healthcare consumption is less prone to moral hazard when it is subsidized – nobody undergoes chemotherapy just because it is free. The US, previously the lone holdout among developed countries to government sponsored universal healthcare, is finally implementing its own system. Exhibit 115: Healthcare spending, as percentage of GDP, public/private split, select countries Source: World Bank, Jefferies Spending increasing exponentially Per capita spending on healthcare increases exponentially with per capita GDP. What this means is that as a societies get richer, a larger proportion of their resources will be devoted to healthcare. There is much debate about why this is so and whether there are ways to control this trend. Healthcare spending has exceeded 10% of GDP in many Western countries; the US has reached 16.5% of GDP (vs. 4.6% in China). We believe this phenomenon is difficult to stem as growing wealth, for whatever reason, results in an aging population, longer life expectancies and increased demand for healthcare after other consumption opportunities are exhausted (exorbitant spending on end-of-life treatments with little change in outcome). 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% US OECD Highincome France Germany Belgium Canada Greece Denmark EU Netherlands NewZealand Argentina Italy Sweden Spain UK Finland Norway Japan Australia Latam CzechRep Vietnam Turkey Poland S.SaharanAfrica Mexico S.Korea Venezuela Nigeria Middleincome Iran Russia Lowincome Egypt SaudiArabia Malaysia China E.Asia,developing Thailand India Philippines Bangladesh Indonesia US$2005 PPP% of GDP Private spending, 2009 (LHS) Public spending, 2009 (LHS) Per capita healthcare spending, 2010 (RHS) Very few are wealthy enough to financially absorb major medical interventions Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 60 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 62. Exhibit 116: Per capita PPP health care spending vs. per capita PPP GDP Source: World Bank, Jefferies Implementing a universal healthcare system in China Like China’s pension system, its healthcare system is also a patchwork of national, local, urban, rural, public and private schemes. In 2009, China pledged to spend more than US$120 billion over three years on its healthcare system. According to The Economist, by the end of 2011, 95% of citizens had some form of health insurance, up from less than one-third in 2003. In 2005, China has put in place a basic rural health insurance scheme called The New Rural Co-operative Medical Care System (NRCMCS). Under NRCMCS, annual medical coverage costs Rmb50 (US$8) per person of which Rmb20 is paid by the central government, Rmb20 by the provincial government and Rmb10 by the patient. Under the plan, rural patients will be reimbursed 70-80% for treatment at small local hospitals, 60% at county clinics, and 30% for specialist treatment at a modern hospital. Based on results of the CHFS, the health status of rural households has a significant effect on family incomes. Rural families with good overall health have incomes 3x that of families with poor health. The data also showed that incomes of families with rural health insurance are 45% higher than those without. Improving rural health is a proven method to increasing rural incomes. China’s healthcare system is beset by complex conflict-of-interest issues that pit underpaid doctors and underfunded hospitals against financially strapped patients. Out-of-pocket patient expenses have grown since market reforms, and significant resentment has developed over hospital mark-ups for medicine as well as under-the- table payments for services. We believe underfunding is the root cause of many, if not all, of these problems and that China’s healthcare system will be a key avenue for transfer payments. R² = 0.917 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000 50,000 US$/head Per capital GDP, US$ 2005 PPP Exhibit 117: Rural income vs. health status Source: CHFS, Jefferies 2,991 1,996 1,080 0 500 1,000 1,500 2,000 2,500 3,000 Good OK Poor Rmb/m Exhibit 118: Rural income vs. healthcare insurance status Source: CHFS, Jefferies 2,328 1,608 0 500 1,000 1,500 2,000 2,500 Has insurance No insurance Rmb/m Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 61 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 63. Education – the key to long-term growth Like healthcare, education is a key avenue for transfer payments. Compulsory and publicly funded education through secondary school is taken for granted in developed countries. Many developed countries have taken the debate beyond secondary school, as tertiary education appears to be a requirement for the knowledge industries of modern economies. China’s Ministry of Education reports a 99% attendance rate for primary school age children and 80% for both primary and middle school. This is on par with middle income nations. Secondary school enrolment for developed economies is over 90%, suggesting that spending on education has a lot of room for growth. Exhibit 119: Education spending, as percentage of GDP, select countries Source: UNDP, Jefferies Incomes surge with education Based on data from CHFS, rural household income for college educated families is 7.9x higher than families with a primary school education; urban incomes for college educated families are 4.4x higher than primary school families. Household income for college educated families is 6.8x that of the national median, 3.4x for vocational school and 2x for high-school. Exhibit 120: Household income by education level Source: CHFS, Jefferies 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Australia NewZealand Norway Denmark S.Korea Finland Netherlands Spain Greece Italy Belgium France UK Canada US Germany Argentina HongKong Sweden Europe OECD Poland Japan Chile Singapore Russia Mexico Brazil SaudiArabia Latam Indonesia SouthAfrica Iran Malaysia Thailand Philippines Turkey EastAsia China World Egypt Vietnam India S.SaharanAfrica Nigeria % of GDP 9,685 5,842 3,764 2,198 10,434 4,648 2,456 1,323 0 2,000 4,000 6,000 8,000 10,000 12,000 College/above Vocational and junior college Junior and senior highschool Primary school Rmb/m Urban Rural Tertiary education appears to be a requirement for the knowledge industries of modern economies Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 62 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 64. Education = consumption and investment Clearly, education is the path to increasing income levels and is the key to maintaining China’s economic growth in the long term. Spending on education is often categorized as consumption when it is perhaps the purest form of investment to speak of. The returns on investment in human capital through education do not flow through any organization’s income statement or balance sheet and therefore often gets short thrift. According to the New York Times, 80% of China’s school-aged children live in the rural areas. Despite China surpassing 50% urbanization, children disproportionately live in the countryside, partly because many parents work in the city as migrant laborers, and partly because the one-child policy is more relaxed in the countryside. Although 9 years of education are compulsory and state funded, quality and compliance differ dramatically across China. We believe rural education will be a key avenue for transfer payments as education spending counts as consumption. In reality, it is the best long- term investment China can make. Giving it the old college try The income gains for a university education are stark. Requirements for the modern knowledge economy are such that college education and beyond create vast disparities in income levels. China has been expanding its tertiary education system at breakneck speed. Though the job market for new college graduates is showing growing pains, the long term trajectory is clear. For China to move up the income ladder, it must increase the proportion of college educated citizens. Exhibit 121: Enrolment in tertiary education vs. PPP per capita GDP Note: Gross enrolment ratio is the ratio of total enrolment, regardless of age, to the population of the age group that officially corresponds to the level of education shown. Tertiary education, whether or not to an advanced research qualification, normally requires, as a minimum condition of admission, the successful completion of education at the secondary level. Source: World Bank, Jefferies China’s college enrolment is about where it is expected to be at its present level of economic development. We expect the demand for college educated workers to surge as China shifts away from manufacturing and construction to a more knowledge based service economy. Sales people, customer relationship managers, marketers and event planners are all urban service sector jobs that often require a college degree. China’s gross college enrolment (see definition below) is 24%, behind that of Mexico and Malaysia. College enrolments in developed economies range from 60% to over 100%. Increasing government subsidies for tuition and expenses is an obvious avenue for transfer payments. S.Korea Finland US Venezuela Australia Russia Denmark Norway Spain Argentina Sweden Poland Belgium Italy OECD Netherlands EU CzechRep Japan UK France Turkey Thailand Malaysia Latam SaudiArabia World Mexico China Indonesia VietnamIndia Bangladesh S.SaharanAfrica R² = 0.5678 0% 20% 40% 60% 80% 100% 120% 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000 50,000 Per capital GDP, US$ 2005 PPP Spending on education is perhaps the purest form of investment to speak of 80% of China’s school-aged children live in the rural areas Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 63 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 65. Exhibit 122: Enrolment in tertiary education (% gross) Note: Gross enrolment ratio is the ratio of total enrolment, regardless of age, to the population of the age group that officially corresponds to the level of education shown. Tertiary education, whether or not to an advanced research qualification, normally requires, as a minimum condition of admission, the successful completion of education at the secondary level. Source: World Bank, Jefferies Social housing Government subsidized housing is a common avenue for transfer payments, particularly in countries where wealth stratification renders urban housing unaffordable for even the middle class. Europe and the US have extensive public housing projects as well as price stabilization schemes (rent control). In China, the government provides public housing through various sources, such as Low Rental Housing, Economic Housing, Small Commodity Housing, and Relocation & Redevelopment Housing. Before 2005, China built approximately 500k units of economic housing per year to meet housing demand for low-income citizens. In 2009, when the central government decided to resume growth of the social housing scheme, residential housing prices surged. Affordable housing is a key component of China's 12th Five-year Plan. The plan targets the construction of 36 million homes by 2015 to ensure sufficient housing supply for low-income families. The cost of the program will be split between the private and public sectors. Based on channel checks, we estimate the 36mn social housing target can be divided into the following: 1) low rental housing (15-20%); 2) economic housing (10-15%), 3) small commodity housing (20-25%), 4) relocation or redevelopment (30-40%), and 5) dormitory and warehouse (10-15%). 0% 20% 40% 60% 80% 100% 120% S.Korea Finland US NewZealand Venezuela Australia Russia Norway Spain Argentina Sweden Poland Belgium Italy OECD Netherlands EU CzechRep Japan UK France Thailand Malaysia Latam Iran SaudiArabia World Mexico China Indonesia Vietnam India S.SaharanAfrica Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 64 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 66. Exhibit 123: Social housing forecasts (units mn) Source: NBS, Jefferies estimates, Jefferies Exhibit 124: Economic housing completion (units ‘000) Source: NBS, Jefferies Public low rental housing is not for sale, and is expected to be the major component of social housing supply in the next decade. In the long run, the government plans to provide low rental housing to 20% of the total population. Compared with other developed markets France (16%) and Hong Kong (30%), we see the target as realistic and achievable. Social housing development will remain a vital part of a stable and healthy housing market, in our view. With continuing economic growth and social reform, we expect social housing to play a critical role in reshaping China’s residential market and help people in need. We expect the government’s policy to change, in turns, to accommodate changing market conditions. As long as housing needs for low-income families are met, we expect the commodity housing market to become more market- driven. We expect the government to accelerate social housing development in the next 13 years, and social housing to cover 20-30% of total population by 2025. Land and funding are two key constraints for the development of social housing. Local governments are held accountable to achieve respective targets. They usually provide land, contracting out construction and project management to external parties. Since margins on social housing are capped below 5%, many developers are not keen to get involved. According to the Ministry of Urban and Rural Development, new starts of social housing reached 7.22mn units for a total cost of Rmb108bn as Oct 2012, equivalent to RMB150,000/unit. Assume average unit size of 50 sqm, construction cost is about Rmb2,000/sqm, similar to that of commodity housing. 2.31 4.85 5.9 10 7.2 6.0 6.0 6.0 0.0 2.0 4.0 6.0 8.0 10.0 12.0 2008 2009 2010 2011 2012 2013E 2014E 2015E 0% 5% 10% 15% 20% 25% 30% 0 100 200 300 400 500 600 700 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Economic housing completion (units 000) % of total housing units Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 65 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 67. Exhibit 125: China GDP by output and expenditures, breakdown, growth rates, historical and forecasts Source: CEIC, China NBS, Jefferies estimates China GDP by output, share of total (%) 2010 2011 2012E 2013E 2000 2005 2010 2015E 2020E 2025E Primary 10.1% 10.0% 9.7% 9.4% 15.1% 12.1% 10.1% 8.7% 7.3% 6.0% Industry 40.0% 39.9% 40.2% 39.4% 40.4% 41.8% 40.0% 34.9% 28.8% 22.7% Construction 6.6% 6.8% 6.6% 6.4% 5.6% 5.6% 6.6% 6.1% 5.2% 4.3% Secondary 46.7% 46.6% 46.8% 45.8% 45.9% 47.4% 46.7% 41.0% 34.0% 27.0% Tertiary 43.2% 43.3% 43.5% 44.8% 39.0% 40.5% 43.2% 50.3% 58.7% 67.0% Gross Domestic Product 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% China GDP by expenditure, share of total (%) 2010 2011 2012E 2013E 2000 2005 2010 2015E 2020E 2025E Household Consumption 34.9% 35.2% 35.5% 36.3% 46.4% 38.9% 34.9% 39.0% 44.0% 49.0% Government Consumption 13.2% 13.2% 13.3% 13.5% 15.9% 14.1% 13.2% 17.0% 21.0% 24.0% Final Consumption Expenditure 48.2% 48.5% 48.8% 49.8% 62.3% 53.0% 48.2% 56.0% 65.0% 73.0% Fixed Capital Formation 45.6% 46.2% 46.4% 45.8% 34.3% 39.6% 45.6% 41.0% 33.6% 26.7% Other Capital Formation 2.5% 2.8% 2.7% 2.7% 1.0% 1.9% 2.5% 2.4% 2.1% 1.9% Gross Capital Formation 48.1% 48.9% 49.1% 48.5% 35.3% 41.5% 48.1% 43.4% 35.8% 28.7% Net Exports 3.7% 2.6% 2.1% 1.7% 2.4% 5.5% 3.7% 0.6% -0.8% -1.7% 2.1% 1.9% Gross Domestic Product 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% China GDP by output, YoY change (%) 2010 2011 2012E 2013E 95-00 00-05 05-10 10-15E 15-20E 20-25E Primary 7.9% 8.7% 4.0% 3.9% 2.7% 5.1% 7.2% 4.6% 3.5% 2.3% Industry 11.4% 8.8% 8.8% 5.4% 8.3% 10.5% 10.3% 4.8% 2.9% 1.5% Construction 11.6% 11.2% 5.0% 4.8% 6.5% 9.9% 15.0% 5.8% 3.8% 2.7% Secondary 11.5% 9.2% 8.2% 5.3% 8.0% 10.4% 10.9% 5.0% 3.1% 1.7% Tertiary 10.0% 9.6% 8.2% 10.9% 12.4% 10.6% 12.7% 11.0% 10.3% 9.4% Gross Domestic Product 10.4% 9.3% 7.8% 7.6% 8.6% 9.8% 11.2% 7.7% 7.0% 6.5% China GDP by expenditure, YoY change (%) 2010 2011 2012E 2013E 95-00 00-05 05-10 10-15E 15-20E 20-25E Household Consumption 8.9% 10.2% 8.6% 10.0% 9.4% 6.0% 8.8% 10.1% 9.6% 8.8% Government Consumption 11.7% 9.2% 8.0% 9.6% 12.6% 7.2% 9.9% 13.2% 11.6% 9.4% Final Consumption Expenditure 9.7% 9.9% 8.4% 9.9% 10.1% 6.3% 9.1% 11.0% 10.2% 9.0% Fixed Capital Formation 12.1% 10.7% 8.4% 6.1% 9.4% 13.0% 14.4% 5.5% 2.9% 1.7% Other Capital Formation 22.7% 21.7% 5.5% 6.4% -26.7% 25.0% 16.9% 6.9% 4.6% 4.5% Gross Capital Formation 12.6% 11.3% 8.2% 6.1% 5.8% 13.4% 14.5% 5.5% 3.0% 1.9% Net Exports -3.9% -23.9% -12.6% -11.7% 18.3% 29.1% 3.2% -24.4% -211% 24.7% Gross Domestic Product 10.4% 9.3% 7.8% 7.6% 8.6% 9.8% 11.2% 7.7% 7.0% 6.5% Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 66 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 68. Exhibit 126: China and US GDP by expenditure Note: 1980 net exports accounted for -0.3% of GDP Note: 2025E net exports accounted for -2% of GDP Note: 1980 net exports accounted for -3% of GDP Note: 2011 net exports accounted for -4% of GDP Source: CEIC, China NBS, Jefferies Exhibit 127: China and US GDP by output Source: CEIC, China NBS, Jefferies HH Cons 50% Gov Cons 15% Gross Cap Form 35% China 1980 HH Cons 35% Gov Cons 13% Gross Cap Form 48% Net Exports 4% China 2010 HH Cons 48% Gov Cons 24% Gross Cap Form 28% China 2025E HH Cons 66% Gov Cons 16% Gross Cap Form 18% Net Exports 0% US 1950 HH Cons 63% Gov Cons 20% Gross Cap Form 17% US 1980 HH Cons 69% Gov Cons 19% Gross Cap Form 12% US 2011 Primary 30% Secondary 48% Tertiary 22% China 1980 Primary 10% Secondary 47% Tertiary 43% China 2010 Primary 6% Secondary 27% Tertiary 67% China 2025E Primary 7% Secondary 36%Tertiary 57% US 1950 Primary 2% Secondary 30% Tertiary 68% US 1980 Primary 1% Secondary 19% Tertiary 80% US 2011 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 67 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 69. Jefferies’ 2025 Top Picks A new operating environment In 2025, we expect China to become an upper middle income (exchange rate GDP) or high income (PPP GDP) country as defined by the World Bank. At that time, we expect China’s economy to approach a developed world mix by output (more services, less manufacturing/construction) and by expenditure (more consumption, less investment). Hopefully, we have convincingly demonstrated earlier in this report that China’s path towards this end (transfer payments) is clear and the mechanisms tried and true (pensions, healthcare, education and social housing). Visible stories We have scoured our coverage universe for twelve companies we believe to be best positioned to thrive in the China of 2025. Oversight is necessarily a part of this exercise; we are very likely overlooking China’s Apple, the transformational company (or companies) whose story has yet to emerge. There will be dark horses and the time to track them will come. For now, we can only work with companies in front of us, whose stories we can most convincingly and compellingly tell thirteen years in advance. Most likely to succeed Assembled below is our “most likely to succeed” list of companies in the China of 2025. Every one of these companies will benefit from China’s transition to a consumption and services economy. Finance, internet, property, consumer goods and energy are all represented amongst our twelve. Absent are industrials, materials/mining and transportation – industries which drove China’s old growth model. Agricultural Bank of China (1288 HK) With B/S optimization, ABC is the only H-share bank with potential to expand ROE from 2011’s high level of 20%, aided by growth shifting inland from the prosperous East coast, assuming China loosens its LDR regulation and mgmt executes to optimize its B/S. Baidu (BIDU US) Keyword search ad remains the largest segment; display ads will outpace the sector driven by strong growth of online video ads. In our view, in addition to its search market dominance, Baidu also benefits from iQiyi, its online video subsidiary, and its investment in the online travel market. CapitaMalls Asia (CMA SP) CapitaMalls Asia has adopted a vertically integrated capital recycle and co-investment model, and has excellent capabilities across the entire value chain of shopping mall development. Driven by urbanisation and economic reform, CMA’s first-mover advantage helps it capitalise on consumption growth for its existing and future malls. With its proven operating history, its financing advantage on the back of robust background will assist in capturing more growth potential. CRE (291 HK) We favor CRE’s consolidation strategy, which we believe will bear fruit in the long term. Its retail business has maintained momentum in both sales growth and margin; beer saw rising market share and margins. We expect it to become a long-term winner, and its SOE background offers stability. CR Land (1109 HK) CR Land is the only major Chinese developer with a premium retail property portfolio; it has a strong brand, a supportive SOE parent and financing advantage. Thanks to its superior residential products and strong execution, it outperformed peers during the industry downturn. We expect positive rental revisions and strong pipeline to drive Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 68 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 70. robust rental income growth, and see value-accretive asset injection as a positive catalyst. Hang Lung Properties (101 HK) We are bullish on the outlook of China’s domestic consumption, and see Hang Lung as a low-risk, defensive play that can benefit from this secular growth trend. We like its premium assets, excellent management and fortress balance sheet, and expect its market leadership to strengthen with new project acquisitions. We expect positive rental revisions and new mall contributions to drive its earnings and share price. Kunlun Energy (135 HK) Kunlun Energy is an amalgam of parts – upstream E&P, downstream distribution projects, CNG stations, LNG terminals, and a large midstream pipeline. The company’s goal is to become China’s largest downstream distribution company with a focus on developing the natural gas vehicle fuel market, driving long-term earnings growth. In the medium-term, the switch to gas-fired power as base-load power in Beijing will drive earnings. Minsheng Bank (1988 HK) Aided by the growth of the private sector, we see MSB’s sustainable ROE at 14-21% and fair P/B at 1.4-2.3x, assuming China loosens its LDR regulation and mgmt executes to optimize its B/S. In our view, MSB has the additional attraction of being a likely takeover target given its size as well as a diversified, non-government shareholder base. PetroChina (857 HK) In China, we believe natural gas will become a substitute for fuel oil and LPG in the medium term, and for gasoline and diesel to drive vehicles in the long term, which will boost natural gas price. A re-rating for PetroChina is warranted as the company controls the crown jewels of China’s upstream assets and as government intervention in upstream energy markets fades away, in our view. Ping An (2318 HK) We prefer Ping An as a long-term holding in the China insurance space. The company has a clear strategy to become a one-stop-shop integrated financial service house, leveraging its strong distribution and product platforms. We forecast Ping An’s market cap (embedded value) to grow approximately 15% per year on the path to 2025, delivering 4-5x return on today’s share price at the current multiple level. Sands China (1928 HK) Sands China is a mass focused player, and the strategy fits well with the industry’s long- term trend. We think its strong pipeline will help in gaining market share, which may reach 25% by 2025. Favorable mix change and growing contributions from hotel/mall should support higher margins. In addition, we like its premium brand and solid track record. It will be a long-term winner, in our view. Tencent (700 HK) With its largest Internet user base and traffic, strong management team and execution, Tencent is, in our view, the best positioned Chinese Internet company to benefit from the upcoming take-off of mobile games, mobile commerce, online travel, and overall growth in performance and RTB-based display advertisements. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 69 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 71. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFA INDUSTRY NOTE China | Equity Strategy China 24 February 2013 China China 2013: Transformation and Volatility in the Year of the Snake EQUITYRESEARCHASIA 2013 TOP PICKS Company Ticker Target price* AIA 1299 HK 34.5 Capitamalls Asia CMA SP 2.4 China Construction Bank 939 HK 6.9 China Resources Enterprise 291 HK 31.7 COLI 688 HK 26.2 CR Land 1109 HK 26.5 Guangdong Investment 270 HK 7.9 Intime 1833 HK 10.8 PetroChina 857 HK 16 Tencent 700 HK 330 Source: Jefferies estimates, * In trading currency Christie Ju, CFA * Equity Analyst +852 3743 8012 cju@jefferies.com Laban Yu * Equity Analyst +852 3743 8047 lyu@jefferies.com Julian Bu * Equity Analyst +852 3743 8058 jbu@jefferies.com Venant Chiang * Equity Analyst +852 3743 8013 venant.chiang@jefferies.com Sean Darby * Chief Global Equity Strategist +852 3743 8073 sdarby@jefferies.com Jessie Guo, PhD * Equity Analyst +852 3743 8036 jguo@jefferies.com Johnson Leung * Equity Analyst +852 3743 8055 jleung@jefferies.com Rong Li * Equity Analyst +852 3743 8014 rli@jefferies.com Cynthia Meng * Equity Analyst +852 3743 8033 cmeng@jefferies.com Ming Tan, CFA * Equity Analyst +852 3743 8752 ming.tan@jefferies.com * Jefferies Hong Kong Limited Key Takeaway The Year of the Snake will see China shedding its old skin and growing a new one - shifting from export and FAI driven growth to the new paradigm of domestic consumption. We believe 2013 could be a volatile year for Chinese equities, as the market comes to terms with the new growth trajectory. China unveils Income Distribution Plan: On January 1, 2013, Jefferies published a 430 page report, China 2025: A Clear Path to Prosperity. We concluded that China’s economic future will depend on reducing income inequality to drive consumption growth. In early February 2013, China’s State Council published a policy guideline titled: Intensifying Reform of Income Distribution System. From the policy guideline, it is apparent that China's new leaders have reached the same conclusion. Demonstrating strong resolve: We were impressed with the scope, spirit and language of the document. For now, we are inclined to give China’s new leaders the benefit of the doubt as the document pulled no punches and put large swaths of China’s government and economy on notice. All eyes on anti-corruption moves: Of note in this document is a pervasive recognition of China’s entrenched corruption. The document explicitly addresses efforts to root out corruption through transparency, increased monitoring, reporting of assets and harsh punishment for violators. "Four dishes and a soup”: Though symbolic, Xi Jinping’s effort to eliminate “waste at the tip of the tongue” is a move against the corruption of language that has permeated official communication. With the simple phrase “Four dishes and a soup”, Xi Jinping has reset the political tone. Putting SOEs on notice: The policy guidelines push SOEs to operate for China’s welfare (including state and private shareholders), rather than the welfare of the SOE itself, or even worse, its managers and executives. The key policy contained in the guidelines is the increased required SOE dividend pay-out ratio from 5% to 10% of profits. 2013: Haze before sunlight: We expect 2013 to be a volatile year for China equities as the market comes to terms with the developing policy trajectory. We would not be surprised if China stocks ended the year not far from where they began. Secretary (and soon to be President) Xi Jinping's response to wildcards (island dispute with Japan, North Korea, trial of Bo Xilai), could derail carefully laid plans. How to position in the Year of the Snake: We see high uncertainty in the 1st half of 2013; as policy clarity comes into focus, we believe a beta story could emerge by year end. We are positive on the growth outlook for banks, consumer, natural gas, retail malls, internet and IPPs. Our Top Picks are AIA (1299 HK), CapitaMalls Asia (CMA SP), China Construction Bank (939 HK), COLI (688 HK), CRE (291 HK), CR Land (1109 HK), Guangdong Investment (270 HK), Intime (1833 HK), PetroChina (857 HK) and Tencent (700 HK). Jefferies does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Jefferies may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see analyst certifications, important disclosure information, and information regarding the status of non-US analysts on pages 38 to 42 of this report. page 70 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 72. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFA INDUSTRY NOTE China | Equity Strategy China 24 April 2013 China China 2013 (II): Tough Tasks Call for Brave Leaders EQUITYRESEARCHASIA 2013 TOP Picks Top Buy Ideas Ticker TP * AIA 1299 HK 39.0 CapitaMalls Asia CMA SP 2.4 CCB 939 HK 7.8 CRE 291 HK 31.7 CR Land 1109 HK 26.5 COLI 688 HK 28.0 China Unicom 762 HK 16.0 PetroChina 857 HK 15.0 Shanghai Industrial 363 HK 30.0 Tencent 700 HK 330.0 Top Sell Ideas China Cosco 1919 HK 2.6 China Shipping Dev. 1138 HK 3.0 CNBM 3323 HK 8.0 PICC Group 1339 HK 3.6 Yanzhou Coal 1171 HK 5.1 Zoomlion 1157 HK 6.8 Source: Jefferies, *Target price in trading currency Christie Ju, CFA * Equity Analyst +852 3743 8012 cju@jefferies.com Julian Bu * Equity Analyst +852 3743 8058 jbu@jefferies.com Venant Chiang * Equity Analyst +852 3743 8013 venant.chiang@jefferies.com Sean Darby * Chief Global Equity Strategist +852 3743 8073 sdarby@jefferies.com Jessie Guo, PhD * Equity Analyst +852 3743 8036 jguo@jefferies.com Johnson Leung * Equity Analyst +852 3743 8055 jleung@jefferies.com Rong Li * Equity Analyst +852 3743 8014 rli@jefferies.com Cynthia Meng * Equity Analyst +852 3743 8033 cmeng@jefferies.com Ming Tan, CFA * Equity Analyst +852 3743 8752 ming.tan@jefferies.com Laban Yu * Equity Analyst +852 3743 8047 lyu@jefferies.com * Jefferies Hong Kong Limited Key Takeaway While the bird flu, Sichuan earthquake and weak 1Q GDP have generated powerful headwinds, we see early signs of fundamental changes, and are optimistic on the XI-Li New Era. The new leaders have made a strong debut on the global stage, as the island dispute with Japan and the North Korea situation are largely under control. Now they face the real critical challenge to drive domestic consumption growth. “A Clear Path to Prosperity” & “Volatility in the Year of the Snake”: On Jan. 1, 2013, we published China 2025: A Clear Path to Prosperity. We concluded that China’s future will depend on reducing income inequality to drive consumption growth. We forecast China’s GDP will reach US$18trn by 2025, and final consumption will account for 73% of GDP, with household consumption the key growth driver. In our Feb. 24 report, China 2013: Transformation and Volatility in the Year of the Snake, we wrote "We expect 2013 to be a volatile year for China equities as the market comes to terms with the developing policy trajectory". We reaffirm our long-term bullish, near-term cautious view. 1Q GDP a timely reality check: Early in the year, we were mostly alone in assuming a weaker 2013 (GDP of 7.6% vs. 7.8% in 2012), as the market was unanimously expecting a solid rebound. But 1Q13 GDP came in at 7.7%, missed consensus of 8%; q/q annualized growth was just 6.4%. While the headline growth was largely in line with our view, the quality of GDP was worrisome. FAI growth of 20.7% (real) was flat y/y, but retail sales growth of 10.8% (real) was down y/y. 1Q13 indeed was disappointing, with markets in Hong Kong and China both down 2%. Reform must come with pain: China’s Xi-Li Era has just begun. President Xi launched an anti-corruption campaign, which instantly slowed sales in luxury goods and high- end liquor. The Ministry of Railways was dismantled, which should lead to more rational spending. With the existing growth model highly unsustainable and social inequality wider than ever, we see the reform as a necessity, not a choice to Xi and Li. By definition, reform is about changing the existing order. China will have to endure the short-term pain, in order to ensure longer term prosperity, in our view. Tough tasks call for brave leaders: We believe China’s new leaders need to demonstrate great courage and skill to take the country to the next level; true reforms can only happen under strong leaders, not bureaucrats. The “Re-education through Labor” law was suspended; One-Child policy may be abolished; changes to the Hukou system are being considered. We see early signs of fundamental changes, and are cautiously optimistic. Volatility may last longer, stay defensive: We expect high volatilities in both economies and geopolitics, and advocate investors stay with defensive sectors with visible growth and low valuation. We are positive on the outlook for consumer discretionary, oil & gas, banks, retail property, internet, telecom and gas utilities/wind, and are bearish on commodities, coal, industrials and transportation. How to position for the rest of 2013: Since our Feb. 24 report, Jefferies China 2013 Top Pick generated an alpha of 3.0%, compared with Hang Seng Index (+0.4% vs. -2.6%). YTD, they outperformed Hang Seng Index by 4.8% (+2.7% vs. -2.1%). Our Top Buys are AIA, CapitaMalls Asia, China Construction Bank, CRE, CR Land, COLI, China Unicom, PetroChina, Shanghai Industrial and Tencent. We recommend investors avoid China Cosco, China Shipping Development, CNBM, PICC Group, Yanzhou Coal Mining and Zoomlion. Jefferies does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Jefferies may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see analyst certifications, important disclosure information, and information regarding the status of non-US analysts on pages 55 to 60 of this report. page 71 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 73. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFA INDUSTRY NOTE China | Equity Strategy China 27 June 2013 China A Historic Step in Hukou Reform EQUITYRESEARCHCHINA Links to our strategy reports Don't Fight PBOC, Follow the Leader China 2013 (II): Tough Tasks Call for Brave Leaders China 2013: Transformation and Volatility in the Year of the Snake China 2025: A Clear Path to Prosperity Christie Ju, CFA * Equity Analyst +852 3743 8012 cju@jefferies.com Julian Bu * Equity Analyst +852 3743 8058 jbu@jefferies.com Venant Chiang * Equity Analyst +852 3743 8013 venant.chiang@jefferies.com Sean Darby * Chief Global Equity Strategist +852 3743 8073 sdarby@jefferies.com Jessie Guo, PhD * Equity Analyst +852 3743 8036 jguo@jefferies.com Johnson Leung * Equity Analyst +852 3743 8055 jleung@jefferies.com Rong Li * Equity Analyst +852 3743 8014 rli@jefferies.com Cynthia Meng * Equity Analyst +852 3743 8033 cmeng@jefferies.com Ming Tan, CFA * Equity Analyst +852 3743 8752 ming.tan@jefferies.com Laban Yu * Equity Analyst +852 3743 8047 lyu@jefferies.com * Jefferies Hong Kong Limited Key Takeaway While we expect the new leadership to promote fundamental reforms, the timing of Hukou reform, announced by State Council yesterday, was a positive surprise. Hukou reform is critical to China’s economic transition, and is consistent with our long-term bullish view. We see reform accelerating, and advise investors to fasten seat belts ahead of a tough summer. State Council kickstart Hukou reform. China will reform the Hukou (Household Registration) system, in order to promote urbanization. According to a State Council report, China will 1) remove all restrictions on Hukou in small cities/townships; 2) orderly remove restrictions on Hukou in mid-sized cities; 3) gradually loosen conditions for Hukou in large cities; and 4) reasonably set conditions for Hukou in mega cities. This is the first time that the government has explicitly laid out measures for Hukou reform. Relocating rural to urban the key step to urbanization. State Council emphasized that urbanization is essentially an orderly transfer of rural population to cities and towns. A rigid Hukou system has undermined the pace and quality of the urbanization process. From 2010 to 2012, 25mn rural population became urban residents, averaging 8.4mn a year, compared with over 16-20mn rural population moved to cities annually. Hukou means improved equality. Without Hukou, a migrant worker, even with a decent city job, will not have equal rights as city resident on basic social benefits, such as children’s education, healthcare, unemployment insurance, and social housing, etc. The reform of Hukou system is vital for the rural population to truly integrate into urban life. More measures on urbanization. The State Council stressed the importance of establishing the strictest rules on the protection of arable land and conservation of usable land, in order to meet the urbanization demand. It aims to establish public fiscal system and financing mechanism for cities to ensure funding needs for the provision of basic public services as well as construction of infrastructure are adequately addressed. Short term pain for long term gain. In our China 2025: A Clear Path to Prosperity, we outlined a clear path driving the next phase of China's growth. We highlight that a re- balanced economy, with increased consumption and a robust service sector, will develop organically through urbanization and wealth redistribution. However, as followed up in China 2013: Transformation and Volatility in the Year of the Snake, we argue that 2013 could be very volatile, as the market comes to terms with China's new growth trajectory. A tough summer ahead, stay defensive. The first sign of clarity will only return in October, following the third plenum, when we expect major economic reforms to be announced. We see a tough summer ahead, and advocate investors to stay defensive in stocks with strong balance sheet and cash flow, visible earnings growth and reasonable valuation. Our preferred sectors are: Brokers, Conglomerates, Consumer Staples, Gas Utilities, Internet and Telecom. Jefferies does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Jefferies may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see analyst certifications, important disclosure information, and information regarding the status of non-US analysts on pages 2 to 5 of this report. page 72 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 74. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFA INDUSTRY NOTE China | Equity Strategy 16 July 2013 Equity Strategy China 2013 Mid Year Review: “Xi-Li New Deal” Building Momentum EQUITYRESEARCHCHINA Top Buy Ideas Tick er TP * AIA 1299 HK 39.0 CapitaMalls Asia CMA SP 2.4 CRE 291 HK 30.0 CR Land 1109 HK 26.5 China Unicom 762 HK 16.0 Dongfeng Motor 489 HK 15.3 ENN 2688 HK 50.0 PetroChina 857 HK 15.8 Shanghai Industrial 363 HK 30.0 Tencent 700 HK 330.0 Top Sell Ideas Agile 3383 HK 8.5 China Cosco 1919 HK 1.9 China Shipping Dev. 1138 HK 2.2 CNBM 3323 HK 7.2 Daphne 210 HK 4.8 Lonking 3339 HK 1.0 Yanzhou Coal 1171 HK 3.8 Source: Jefferies, *Target price in trading currency Christie Ju, CFA * Equity Analyst +852 3743 8012 cju@jefferies.com Laban Yu * Equity Analyst +852 3743 8047 lyu@jefferies.com Julian Bu * Equity Analyst +852 3743 8058 jbu@jefferies.com Venant Chiang * Equity Analyst +852 3743 8013 venant.chiang@jefferies.com Sean Darby * Chief Global Equity Strategist +852 3743 8073 sdarby@jefferies.com Jessie Guo, PhD * Equity Analyst +852 3743 8036 jguo@jefferies.com Johnson Leung * Equity Analyst +852 3743 8055 jleung@jefferies.com Rong Li * Equity Analyst +852 3743 8014 rli@jefferies.com Cynthia Meng * Equity Analyst +852 3743 8033 cmeng@jefferies.com Ming Tan, CFA * Equity Analyst +852 3743 8752 ming.tan@jefferies.com * Jefferies Hong Kong Limited Key Takeaway China’s new leadership has surprised us with their resolve. Starting the year with an aggressive assault on corruption, they have since engineered a liquidity "crisis", kick-started Hukou reform and announced aggressive natural gas price reform. With timely insights from our Expert Summit, we are confident that China is in the early stage of re-balancing, and the new leaders have the resolve to inflict more short-term pain. 2Q GDP growth slowed to 7.5%, below the 7.7% growth in 1Q13. In the first half, domestic consumption and investment accounted for 99% of GDP growth. While weakness in external demand contributed to the slowdown, we believe it is also a result of the new leadership’s proactive measures. Brace for more short-term pain. Based on the presentation by Liu Mingkang, ex- Chairman of the CBRC, at Jefferies' 2nd Annual Expert Summit, we believe that China’s new leadership recognizes the imbalances, inefficiencies and risks built up in China’s economy and are committed to re-balancing and reform. It is not difficult to conclude that the present leadership is not averse to testing just how much short-term pain the economy can endure. We believe investors should remain in a defensive position ahead of high market volatilities. What is the Premier’s bottom line? Yao Jingyuan, Senior Advisor to Premier Li and former Chief Economist of NBS, was our keynote speaker at the summit. He believes another round of stimulus is the last thing China needs, as slower growth is critical to weed out excess capacity and liquidity to restore economic health. The new leaders are willing to tolerate lower GDP, as long as unemployment is contained. If forced to quantify the government’s bottom line, he sees 6% as the minimum level needed to maintain social stability and economic growth. Liquidity crunch a catalyst for reform. The liquidity “crisis” in June should be ample warning that financial institutions can no longer look to the PBOC for endless credit, while recklessly pursuing short-term yields and disregarding the needs of the real economy. China has ample liquidity (~2x GDP at Rmb104tn) and the leadership vigilantly guards against any financial risk, supported by the full strength of the central government. We expect the crunch will become a major catalyst to drive financial reform. “Xi-Li New Deal” building momentum. With the economy in a precarious position, China has no choice but to pursue the policies of “reform and opening up”. We believe true reform can only happen under strong leaders, and that the new leaders will demonstrate the courage and skill needed to take the country to the next level. We are cautiously optimistic on the “Xi-Li New Deal”, and believe economic reforms are being strategically rolled out, which removes institutional obstacles and builds political momentum. Expect more ahead. In the past six months, we have seen the PBOC strong-arm the banks, announce Hukou reform and implement aggressive natural gas price reform. We expect to see much more, including reforms in interest rate, exchange rate and significant upgrades to China’s social safety net. We believe more fundamental reforms will be announced after the Third Plenum in October. Jefferies does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Jefferies may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see analyst certifications, important disclosure information, and information regarding the status of non-US analysts on pages 47 to 50 of this report. page 73 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 75. Summary of Sector Views In the short run, China must endure the pain of slower growth, in order to weed out excess liquidity and capacity to restore economic health. We expect fundamental reform to accelerate, uncertainties to increase, and advise investors to stay defensive; we prefer companies with strong balance sheet and cash flow, high visibility in earnings growth and reasonable valuation. Internet, Telecom and Utilities are our favorite sectors; we also like passenger vehicles, oil & gas, brokers, consumer staples and retail property. Meanwhile, we remain bearish on coal, metals & mining, industrials, and transport. Auto. We prefer Passenger Vehicles (PV) over Heavy Duty Trucks (HDT). We expect continued headwinds in HDT related names, and PV to benefit from Chinese rise in income level and government’s encouragement towards consumption. Consumer. We are bearish on apparel/sportswear on inventory issue and competition from e-commerce. We stay cautious on jewelry since gold price could face more downside risks. Staples’ growth is relatively better than other subsectors. Energy. We believe there is more downside ahead for coal prices at Qinhuangdao given the sharp drop in coal prices in the mine-mouth in the first half. We believe natural gas will be the clear winner from bold price reform. We are neutral on oil in the near-tem, but are bullish in the long-term when oil becomes a “consumer” fuel in China. Financials. We prefer brokers for supportive policy initiatives. We are neutral on banks as investors are waiting for better macro visibility while market sentiment is still weak. We are cautious on insurance as we see additional downside risk from life insurance pricing de-regulation and P&C’s near-term margin compression. Gaming. We are neutral on the sector. We anticipate GGR headwind in 2H13 as macro slowdown, tight credit and anti-corruption campaign may put downward pressure on luxury spending. Industrial. We stay cautious on the sector. On a relative basis, we prefer contractors over equipment makers. While we are structurally cautious on both construction machinery and rail equipment, tactically we prefer construction machinery over rail equipment. Metals & Mining. We are concerned about the sustainability of China’s cement demand in the long run. However we believe the market has become overly pessimistic about near-term cement demand. We believe the recent fall is due to seasonality, and should recover in 4Q. Property. We expect monetary tightening to continue, and expect residential developers to be impacted negatively in the process of financial reform. We are more positive on leaders in retail property space, as the key beneficiary of domestic consumption growth. Transport. We are bearish on container shipping on deteriorating imbalance in supply and demand. We are cautious on airlines in the near-term, but still prefer it over shipping for brighter long-term growth potential and healthy industry structure. We stay positive on ports due to stabilizing volume and negatives already priced in. TMT, Internet & Tech. We are bullish on the Internet sector, thanks to explosive growth in e-Commerce, rising penetration of smartphones and the transition to mobile. We like telecom for strong cash flow and good dividend. We recommend underweighting Tech into 3Q13, when the supply chain will be negatively impacted by inventory correction, thus leading to sub-seasonal growth. Utilities. We are bullish on the sector as we believe gas distributors should continue to deliver on volume growth despite the macro headwinds, while wind farm expansion will be unfazed by the FAI slowdown given China’s commitment to renewables. We are positive on IPPs as coal prices will continue to fall, offsetting a possible tariff cut. Exhibit 128: Summary of sector views Source: Jefferies Sector Preference Auto - PV - HDT Consumer - Discretionary - Staples Conglomerate Energy - Oil/Gas - Coal Financial - Banks - Broker - Insurance Industrials Macau Gaming Metals & Mining Property - Residential - Retail Transport TMT - Internet - Telecom - Tech Utilities - Gas utilities - IPP - Wind farm Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 74 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 76. Jefferies Top Picks: mid-year performance review In our China 2013: Transformation and Volatility in the Year of the Snake report, we recommended a cautious stance in light of high uncertainties. Defensive, visible growth and cheap valuation were the key words. In our China 2013 (II): Tough Tasks Call for Brave Leaders report, we argued that China’s new leaders have the courage to implement the reforms needed for long term prosperity. Our Top Buys have outperformed the HSI by 3.6%. Tencent was the best performer by far, thanks to strong game growth, rich pipeline and solid ads performance. Our Top Sells dropped 19.9% on average (vs. HSI -3.9%). Zoomlion was the worst performer, down 38%, due to slow volume recovery and tighter credit policy. Exhibit 129: Top Buys performance after rebalancing Source: Bloomberg, Priced as of July 16, 2013 Exhibit 130: Top Sells performance since April 24 Source: Bloomberg, Priced as of July 16, 2013 Looking forward, we recommend investors stay defensive with visible growth and low valuation. We took out COLI and CCB and added Dongfeng and ENN to our Top Buy list. Meanwhile, we took out PICC Group and Zoomlion from the Top Sell list and replaced them with Agile, Daphne and Lonking. Exhibit 131: Valuation matrix for top picks Mkt Cap Price PE PB Div. Yield Company Ticker Rating US$ mn trading 12 13 14 12 13 14 12 13 14 Top Buy AIA 1299 HK Buy 53,486 34.45 17.8 17.1 15.3 2.0 1.9 1.7 1.1% 1.2% 1.4% CapitaMalls Asia CMA SP Buy 6,046 1.96 14.0 32.7 28.0 1.2 1.1 1.1 1.7% 1.5% 1.5% CRE 291 HK Buy 7,604 24.55 15.0 24.8 20.0 1.4 1.4 1.4 1.2% 2.2% 2.8% CR Land 1109 HK Buy 15,931 21.20 11.7 14.0 10.3 1.8 1.6 1.5 1.6% 1.6% 1.6% China Unicom 762 HK Buy 32,851 10.78 28.4 16.4 10.9 1.0 0.9 0.9 1.4% 1.4% 1.4% Dongfeng Motor 489 HK Buy 10,718 9.65 7.2 6.6 5.7 1.2 1.0 0.8 2.0% NA NA ENN 2688 HK Buy 6,191 44.35 25.2 19.2 15.4 4.4 3.7 3.1 1.0% 1.0% 1.0% PetroChina 857 HK Buy 235,672 9.12 11.4 9.4 6.7 1.2 1.1 1.0 3.9% 3.9% 4.6% Shanghai Industrial 363 HK Buy 3,407 24.45 7.7 9.3 8.5 0.8 0.8 0.7 4.4% 4.4% 4.4% Tencent 700 HK Buy 78,756 329.80 37.4 28.7 23.4 11.7 8.7 6.4 0.3% 0.4% 0.4% Average 17.6 17.8 14.4 2.7 2.2 1.9 1.9% 1.9% 2.1% Top Sell Agile 3383 HK UNPF 3,511 7.90 4.3 4.5 4.2 0.8 0.7 0.6 4.9% 2.2% 2.2% China Cosco 1919 HK UNPF 4,834 3.42 NM NM -4.0 1.1 1.5 2.3 0.0% 0.0% 0.0% China Shipping Dev. 1138 HK UNPF 1,787 3.35 122.1 NM NM 0.4 0.4 0.4 0.0% 0.0% 0.0% CNBM 3323 HK UNPF 4,656 6.69 5.1 4.2 4.1 0.9 0.8 0.6 2.9% 3.4% 3.6% Daphne 210 HK UNPF 1,118 5.26 9.1 12.8 11.2 1.8 1.6 1.3 3.4% 0.1% 0.1% Lonking 3339 HK UNPF 855 1.55 30.6 20.4 15.3 0.8 0.8 0.8 0.0% 0.3% 0.3% Yanzhou Coal 1171 HK UNPF 6,363 5.54 3.5 9.5 11.8 0.5 0.5 0.4 6.5% 7.2% 3.2% Average 29.1 10.3 7.1 0.9 0.9 0.9 2.5% 1.9% 1.4% Source: Bloomberg, Jefferies estimates, Priced as of July 16, 2013 -12.8% -7.8% -7.2% -4.7% -4.5% -0.4% -0.3% 0.8% 3.8% 29.6% -20% -10% 0% 10% 20% 30% CCB COLI CR Land CRE PetroChina China Unicom CapitaMalls Asia Shanghai Industrial AIA Tencent Avg. -0.3% vs. HSI -3.9% -37.9% -36.4% -31.8% -11.1% -3.2% 1.2% -50% -40% -30% -20% -10% 0% 10% Zoomlion Yanzhou Coal CNBM PICC Group China Shipping Dev China Cosco Avg.-19.9% vs. HSI -3.9% Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 75 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 77. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 76 of 228 Please see important disclosure information on pages 221 - 226 of this report. INDUSTRY NOTE China | Equity Strategy China 20 September 2013 China Shanghai Free Trade Zone: China’s New Engine for Growth? EQUITYRESEARCHCHINA Links to our strategy reports China 2013 Mid Year Review: “Xi-Li New Deal" Building Momentum Don't Fight PBOC, Follow the Leader China 2013 (II): Tough Tasks Call for Brave Leaders China 2013: Transformation and Volatility in the Year of the Snake China 2025: A Clear Path to Prosperity Christie Ju, CFA * Equity Analyst +852 3743 8012 cju@jefferies.com Julian Bu * Equity Analyst +852 3743 8058 jbu@jefferies.com Venant Chiang * Equity Analyst +852 3743 8013 venant.chiang@jefferies.com Sean Darby * Chief Global Equity Strategist +852 3743 8073 sdarby@jefferies.com Jessie Guo, PhD * Equity Analyst +852 3743 8036 jguo@jefferies.com Johnson Leung * Equity Analyst +852 3743 8055 jleung@jefferies.com Rong Li * Equity Analyst +852 3743 8014 rli@jefferies.com Cynthia Meng * Equity Analyst +852 3743 8033 cmeng@jefferies.com Ming Tan, CFA * Equity Analyst +852 3743 8752 ming.tan@jefferies.com Laban Yu * Equity Analyst +852 3743 8047 lyu@jefferies.com * Jefferies Hong Kong Limited Key Takeaway In our landmark “China 2025: A Clear Path to Prosperity” report, we argued that a clear path exists towards a balanced economy, driving China’s next phase of growth. In subsequent China 2013 strategy pieces, we anticipate volatilities in the near term on political uncertainties and tough external headwinds. We are getting very excited by Shanghai Free Trade Zone—it could be the magic formula everyone is searching for… Recent macro data constructive, outlook improving: In August, China’s industrial production grew at 10.4% yoy; power consumption growth spiked to 13.7%, a two-year high; exports jumped to 7.2%, beating consensus, as container volume for foreign trade continued to strengthen. CPI appears benign at 2.7%. Accelerating FAI and loan mix improvement are the likely drivers. Monthly FAI started to accelerate in June, reversing the deceleration trend in 1H13. Meanwhile, loan mix has been moving toward mid to long term, thanks to improved investment appetite by corporates. Shanghai Free Trade Zone (FTZ) – the real reform is near: Originally a local initiative, Shanghai FTZ is now a focal point for financial and economic reforms, on strong backing of Premier Li Keqiang. To be launched on Oct. 1, Shanghai FTZ will be a critical pilot test to implement long-awaited reforms, including liberalization of interest rates and full convertibility of RMB. For a period of three years, Chinese laws and administrative measures will not be enforced in this region. By adopting the unique “negative list” approach, the role of government in micro economy will be reduced significantly. China’s new engine for growth? In our view, Shanghai FTZ marks a fundamental shift toward a “service-oriented government.” Once proven successful, it will be rolled out on a nationwide basis. In the long run, FTZ will help develop a more efficient and strong financial system. We believe Shanghai Free Trade Zone may become China’s new engine to drive economic growth for many years to come. Which sector should benefit? Brokers could be the biggest beneficiary within financials, as their revenue pool may expand significantly. As a large number of financial institutions and MNCs would move into FTZ, infrastructure investment should be well supported. Property would be a key beneficiary, thanks to surging demand for offices and warehousing, which should drive the need for residential and retail malls. Subsequently, high-end retail products should also benefit. Who are the likely winners? In our coverage universe, we like CapitaMalls Asia (CMA SP), China Merchants Holdings (144 HK), Franshion (817 HK), Haitong Securities (6737 HK), Hang Lung Properties (101 HK), Shanghai Industrial (363 HK), and Sun Hung Kai (16 HK) as Shanghai Free Trade Zone plays. Join our exclusive Shanghai Economic Growth Tour! On Sept 25-27, Jefferies will host an exclusive Shanghai Economic Growth Tour (detailed schedule on page 7) with two- dozen leading corporates, renowned opinion leaders and government think tank. Investors will learn the latest market trends, industry dynamics, consumer sentiments, and explore investment opportunities with Shanghai FTZ. With the launch of the FTZ around the corner, this is the tour you cannot afford to miss! Jefferies does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Jefferies may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see analyst certifications, important disclosure information, and information regarding the status of non-US analysts on pages 26 to 29 of this report.
  • 78. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFA INDUSTRY NOTE China | Equity Strategy China 30 October 2013 China The Third Plenum: A Catalyst for Reform, or the Start of a New Bull Market? EQUITYRESEARCHCHINA Links to our strategy reports Shanghai Free Trade Zone Launched; First Step in Sweeping Reforms Shanghai Free Trade Zone: China’s New Engine for Growth? China 2013 Mid Year Review: “Xi-Li New Deal" Building Momentum Don't Fight PBOC, Follow the Leader China 2013 (II): Tough Tasks Call for Brave Leaders China 2013: Transformation and Volatility in the Year of the Snake China 2025: A Clear Path to Prosperity Christie Ju, CFA * Equity Analyst +852 3743 8012 cju@jefferies.com Julian Bu * Equity Analyst +852 3743 8058 jbu@jefferies.com Venant Chiang * Equity Analyst +852 3743 8013 venant.chiang@jefferies.com Sean Darby * Chief Global Equity Strategist +852 3743 8073 sdarby@jefferies.com Jessie Guo, PhD * Equity Analyst +852 3743 8036 jguo@jefferies.com Johnson Leung * Equity Analyst +852 3743 8055 jleung@jefferies.com Rong Li * Equity Analyst +852 3743 8014 rli@jefferies.com Cynthia Meng * Equity Analyst +852 3743 8033 cmeng@jefferies.com Ming Tan, CFA * Equity Analyst +852 3743 8752 ming.tan@jefferies.com Laban Yu * Equity Analyst +852 3743 8047 lyu@jefferies.com Jessica Li, Ph.D. * Equity Analyst +852 3743 8010 jessica.li@jefferies.com * Jefferies Hong Kong Limited Key Takeaway Endorsed by President Xi, the highly anticipated Third Plenum of the 18th Party Congress promises to tackle deep-rooted conflicts, to drive vital reforms in order to realize the Chinese Dream. Transforming government’s role, breaking up monopoly, improving the social safety net and financial reform are likely key priorities. We see it as a historic event to drive China’s growth to long-term prosperity, could it be the catalyst for a new bull market? Top leader signals fundamental reform ahead. On Oct 29, President Xi Jinping led a Politburo meeting to study how to realize “the Chinese dream” with fundamental reform. Last week, Mr. Yu Zhengsheng, ranked #4 in Politburo’s Standing Committee, highlighted that the upcoming Third Plenum (Nov. 9-12) will explore the issue of deep and comprehensive reforms to drive the future growth of the economy. Yu expects the reform to be unprecedented and broad-based, with vital strength to be fully implemented. Short-term pain for long-term gain. We believe fundamental reform is critical for China to achieve long-term growth sustainability. In our report "China 2025: A Clear Path to Prosperity", we outlined that a rebalanced economy, with increased consumption and a robust service sector, will develop organically through urbanization and wealth redistribution. More importantly, as we followed up in our report "China 2013: Transformation and Volatility in the Year of the Snake", we forecast huge near-term volatility amidst policy uncertainties, as the market comes to terms with China’s new growth trajectory. What to expect from China’s Third Plenum? Under Xi-Li’s new leadership, we have witnessed dramatic changes in China, including the dismantling of the Ministry of Railways, the kickstarting of Hukou reform, accelerated energy price reform, and the launch of the Shanghai Free Trade Zone. We believe only comprehensive and fundamental reform, not changes in bits and pieces, will be the answer to the society’s deep-rooted pressing issues. We expect China’s new leaders to unveil their roadmap for fundamental reform at the Third Plenum, in order to drive China’s long-term prosperity. Top think tank sheds light on eight key areas for reform. Development Research Center (DRC), a top government think tank, published a report on China’s roadmap for reform. The report highlighted eight key areas for major reform, including government’s administration, monopoly, land, financial system, fiscal & taxation, state-owned asset, innovation & green development and international competition. In order to achieve early success and build strong momentum for reform, DRC recommends that the government relax control over market access, improve basic social security and accelerate rural land reform. Jefferies Asia Summit key takeaways. Various industry experts on banking, consumer, energy, Internet, insurance, property, pharma and the Shanghai FTZ presented at our Asia Summit. Key takeaways from their presentations are highlighted inside. RSVP! Join our expert call on Shanghai Free Trade Zone. Dr. Chen is the Deputy Director of Research Center on Free Trade Zone and a consultant for the Shanghai government on the development of the Shanghai FTZ. He believes the FTZ is a necessary response to the domestic slowdown and accelerating economic cooperation among other nations. FTZ aims for full economic liberalization, and its importance parallels that of Shenzhen, Deng Xiaoping's Southern Tour and entry to WTO. RSVP to join our expert call on Shanghai FTZ 4:30pm HKT Monday Nov 4 with Dr. Chen Bo. Jefferies does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Jefferies may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see analyst certifications, important disclosure information, and information regarding the status of non-US analysts on pages 19 to 24 of this report. page 77 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 79. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFA INDUSTRY NOTE China | Equity Strategy China 13 November 2013 China China Has Reached a Consensus; Now Is the Time to Get It Done EQUITYRESEARCHCHINA Links to our strategy reports The Third Plenum: A Catalyst for Reform, or the Start of a New Bull Market Shanghai Free Trade Zone Launched; First Step in Sweeping Reforms Shanghai Free Trade Zone: China’s New Engine for Growth? China 2013 Mid Year Review: “Xi-Li New Deal" Building Momentum Don't Fight PBOC, Follow the Leader China 2013 (II): Tough Tasks Call for Brave Leaders China 2013: Transformation and Volatility in the Year of the Snake China 2025: A Clear Path to Prosperity Christie Ju, CFA * Equity Analyst +852 3743 8012 cju@jefferies.com Julian Bu * Equity Analyst +852 3743 8058 jbu@jefferies.com Venant Chiang * Equity Analyst +852 3743 8013 venant.chiang@jefferies.com Sean Darby * Chief Global Equity Strategist +852 3743 8073 sdarby@jefferies.com Jessie Guo, PhD * Equity Analyst +852 3743 8036 jguo@jefferies.com Johnson Leung * Equity Analyst +852 3743 8055 jleung@jefferies.com Jessica Li, Ph.D. * Equity Analyst +852 3743 8010 jessica.li@jefferies.com Rong Li * Equity Analyst +852 3743 8014 rli@jefferies.com Cynthia Meng * Equity Analyst +852 3743 8033 cmeng@jefferies.com Ming Tan, CFA * Equity Analyst +852 3743 8752 ming.tan@jefferies.com Laban Yu * Equity Analyst +852 3743 8047 lyu@jefferies.com * Jefferies Hong Kong Limited Key Takeaway The communique from the Third Plenum was ahead of our expectations, as China unveils its blueprint for comprehensive, fundamental reform to drive future growth and prosperity. The confidence and determination of the new leaders are unmistakable; we see the consolidation of power as very positive. China has reached a consensus, now is the time to make it happen. Third Plenum ahead of our expectations. We believe the outline of Third Plenum echoes the key themes highlighted in our China 2025 and 2013 strategy reports, and expands into reform of the social democratic system and the judicial system. We think the reform effort is ahead of our and consensus expectations. Importantly, it confirms that China’s new leaders have a plan to lead the nation to “the Chinese Dream”. Fifteen areas highlighted to deepen reform. 1) Stick to and improve the basic economic mechanism; 2) Deepen economic reform to ensure the market will play a “decisive” role in allocating resources; 3) Accelerate transformation of government roles; 4) Set up a modern fiscal system that supports the initiative of both central and local authorities ; 5) New urban-rural relations to take shape; 6) Structure a new mechanism for an open economy; 7) Perfect a socialist democratic system; 8) Overhaul the judicial system; 9) Strengthen oversight/supervision of power; 10) Follow the development path of a socialist culture with Chinese characteristics; 11) Accelerate reforms in the social sector including education, employment, income distribution, social security and public health; 12) Innovate a social governance mechanism; 13) Establish a sound system to protect China’s ecological environment; 14) Develop the army and national defense; and 15) Set up a central committee to comprehensively deepen reform. Central Committee established for deepening reform. The establishment of a Central Reform Committee (likely to be headed by Premier LI) is critically important, in our view, as holistic reform requires top-level and systematic design, a high level authority is crucial to coordinate efforts and ensure successful implementation. We believe the overhaul of the judicial system, albeit having little impact in the near term, is fundamentally important for the healthy development of a market economy. The report touched on the critical issue of local government financing, likely to be resolved through fiscal/tax reform, which should benefit banks and financial sectors. Also, the construction of free trade zones will help facilitate China’s further opening up and full economic liberalization. What to expect going forward? The communique (~5,000 Chinese characters) is a blueprint that outlines China’s growth trajectory. In the coming weeks, we expect more detailed implementation plans to become available, which may include fiscal & tax reform, SOE reform, Hukou reform and changes to the one-child policy, Shanghai Free Trade Zone, long term development of the property sector, etc. In addition, the leaders will set a target for 2014 at the annual Economic Work Conference in December. Who will be the winners and losers? We believe healthcare, clean energy (natural gas, wind/solar), education, auto, consumer, banks, brokerage, and internet are likely to benefit. Coal, raw materials, industrials and property sectors will face more headwinds. The impact on the property sector is mixed: property rights protection and rural land reform are positive in the long run, as increased supply of social housing will curb the demand for commodity housing. We expect a property tax to be launched in Tier 1/2 cities in the next 12-18 months, which may bring fundamental changes to the China property sector. Jefferies does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Jefferies may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see analyst certifications, important disclosure information, and information regarding the status of non-US analysts on pages 4 to 7 of this report. page 78 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 80. Table of Contents The Year of the Horse: China Gallops into a Historic Bull Run Clearing the Path to Prosperity 3 Getting from here to there 9 China 2014: Sector Allocation & Top Picks 2013 Top Picks Performance Review 12 China 2014: Sector Allocation 14 China 2014: Top Buys and Top Sells 16 Our Journey Starts with China 2025 A review of Jefferies’ key China Strategy reports 43 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 79 of 228 Please see important disclosure information on pages 221 - 226 of this report. Jefferies China 2014 Sector View China Macro 80 Agriculture 92 Conglomerate 101 Consumer 107 Energy 112 Financials (Bank, Insurance and Broker) 124 Gaming 141 Healthcare 148 Industrials 154 Metals & Mining 163 Property 179 TMT (Internet, Telecom and Tech) 187 Transportation 208 Utilities 215
  • 81. 2014 China Macro It’s all about supply side reforms! “Time is running out on the current model which has relied on extensive growth – factor accumulation and relocation of labor from the countryside to factories. Without accelerating reform, vulnerabilities will increase as will the probability that China’s convergence process stalls. Moving to high-income status will require transitioning to a growth model that is more reliant on total factor productivity (‘intensive growth’), IMF Country Report, People’s Republic of China, July, 2013 During the past twelve months, China proved its skeptics wrong as it successfully passed through a leadership transition, saw it sidestep a 'mini emerging markets crisis' and keep its financial reform on track. Indeed, apart from some fiscal loosening from 1Q, the central bank kept its monetary policy intact with nominal rates unchanged while the Yuan appreciated against the US dollar. In fact, the appetite for Chinese equities improved through 2H13 as once again companies went through IPOs and as China economic data expanded. We expect a similar pattern in 2014 with China's stock market outperforming its emerging market peers helped by better economic growth compared to Brazil, India and Indonesia. Expectations of tightening in US monetary policy, a firmer US dollar and falling coal prices have generally been a positive for China's equity markets. Despite the better economic data, the Chinese equity market multiple contracted relative to the rest of the world during the last year. It appears that investors have simply kept China’s ROE in line with the rest of the Asian region. Indeed, the market multiple has dropped more than half since the peak in 2007. The communique issued at the end of the four day party conclave or third Plenum conclave laid down broad policy directions but few details. In truth, the discussions were designed to drive a consensus amongst the leadership while setting the parameters for future economic growth. However, there were some interesting nuances that appear to have already cemented in policy shifts. Firstly, two new powerful entities were established; one to spearhead reforms and the other to formulate a coordinated national security strategy. Secondly, they pledged a "decisive" role for the market and an eventual end to state- mandated prices. In particular, this would mean prices for interest rates; land, energy and water would become more market driven. Thirdly, there was a desire to reform the "two-tier" system of land ownership that prevents farmers from selling their land. This ought to help the urbanization process. Lastly, there was a subtle elimination of the distinction between urban and rural land that can be used for construction. This should once again allow farmers to receive higher compensation. We expect a similar pattern in 2014 with China's stock market outperforming its emerging market peers helped by better economic growth compared to Brazil, India and Indonesia. Sean Darby +852 3743 8073 sdarby@jefferies.com Kenneth Chan +852 3743 8079 Kenneth.chan@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 80 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 82. Exhibit 132: China Economic Policy Uncertainty Index Source: www.policyuncertainty.com , Jefferies Exhibit 133: China/Asia ex Japan Price to Earnings Source: FactSet, Jefferies Exhibit 134: China/World Price to Earnings Source: BIS, FactSet, Jefferies Exhibit 135: China/Asia ex Japan ROE Source: FactSet, Jefferies Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 81 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 83. Exhibit 136: China Price to Earnings (12 month forward) Source: FactSet, Jefferies Exhibit 137: China Price to Book (12 month forward) Source: FactSet, Jefferies China will not be alone in undertaking much needed ‘supply side reforms’ as Mexico, India, Indonesia alongside Brazil are all likely to see governments endorse economic change. The good news for China is that India, Indonesia, Turkey and South Africa face elections in 2014 which may make it harder to take unpopular choices. Exhibit 138: Google Web Search of 'Reform' Mentioned Over the Past Year Source: Google Trends, Jefferies Note: the number is on a weekly basis and the data is normalized and presented on a scale from 0-100, each point is divided by the highest point 100,when there is no enough data, 0 is shown. Why are supply side reforms important? Economies can grow by a variety of means but the most important are through positive demographics, productivity enhancement (making goods and services more efficiently), extending credit as well as global trade (benefits of comparative advantage). Supply side reforms allow economies to benefit from deregulation, the introduction of better technology (and foreign investment), easier access to capital as well as the benefit of labor mobility. Supply reforms are difficult to undertake because they tend to involve ‘removing the influence of government’ from the economy. Of course, this works against the interests of the incumbents, which in China’s case is the SOEs. It is an interesting coincidence that most of the emerging markets have arrived at the same point in needing to adopt reforms at the same time. The principal reason is that all the economies have been suffering from stagflation: a combination of inflation in goods, services and assets alongside falling returns from producing the goods. 5 10 15 20 25 30 07 08 09 10 11 12 13 Price to Earnings 2Y Avg +1 SD +2 SD -1 SD -2 SD 0.0 1.0 2.0 3.0 4.0 5.0 07 08 09 10 11 12 13 Price to Book 2Y Avg +1 SD +2 SD -1 SD -2 SD Supply side reforms allow economies to benefit from deregulation, the introduction of better technology (and foreign investment), easier access to capital as well as the benefit of labor mobility. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 82 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 84. Exhibit 139: Labor productivity trends of China and India, 1970-2011 (GDP at constant basic prices per worker, using 2005 PPP, reference year 2010) Source: APO Productivity Database 2013.01, Jefferies A great deal of western world economic thinking on supply side reforms has been the debate over marginal tax rates. However, the story in many developing economies is different. Part of the stagflation problem has been due to relaxed credit conditions that have allowed capital to be misallocated while the comparative advantages that had fuelled growth in the past have either run out or have been competed away. Bottlenecks have also appeared in some economies meaning that it has been impossible to benefit from external trade or cheaper imports. It is easy to forget that China experienced huge supply side reforms when it entered WTO in 2000. The economy also benefited from the birth of the Special Economic Zones (SEZ) in the late 1970s. Indeed, it was a combination of foreign direct investment and urbanization towards the coastal regions where the SEZ were established that set up the economic boom from the late 1990s. Exhibit 140: China FDI (PBOC vs. Ministry of Commerce, US$ bn) Source: CEIC, Jefferies For China, the easy part of its economic growth came through the availability of cheap labour, cheap land and more lately cheap credit. Furthermore up until very recently, the exchange rate was also undervalued and has been only gradually appreciating in REER terms since 2009. These factors have had a diminishing impact on growth and in order for China to raise real incomes it is becoming necessary to do supply side or structural reform. Part of the stagflation problem has been due to relaxed credit conditions that have allowed capital to be misallocated while the comparative advantages that had fuelled growth in the past have either run out or have been competed away. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 83 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 85. Exhibit 141: Chinese Yuan per US$ Source: FactSet, Jefferies Exhibit 142: China Real Effective Exchange Rate Source: BIS, FactSet, Jefferies In fairness, many emerging markets and developed economies are facing the same problems. Indeed, it should be remembered that in order to raise long-term economic growth, Mexico has been undertaking structural reforms such as breaking up the telecommunications duopoly, reforming corporate tax and proposing to allow foreign competition into the Mexican oil industry. Exhibit 143: Productivity vs. GDP per capital by country Source: OECD, Jefferies More recently, Ireland and Spain have undertaken internal devaluations through real wage cuts to narrow the competitiveness gap versus Germany. Japan is also facing structural problems from an aging workforce and excessive public debt-to-GDP. While the BoJ has started financial repression to keep real interest rates negative, Abe is facing the difficult task of introducing structural reform such as reducing tariffs on food imports under the proposed Trans Pacific Partnership (TPP). Many of the reforms that China must undertake are ideological and therefore may take a lot longer to produce underlying economic improvements to standards of living and incomes. Using resources more efficiently helps to make the economy more inclusive and consumer-based. The economy’s growth model has come under a great deal of scrutiny. Its heavy reliance on capital inputs has meant that debt-to-GDP has soared to around 200% while capacity has been built in excess of demand. Furthermore, China’s deteriorating demographics means that it is running out of time and its productive workforce is shrinking. Many of the reforms that China must undertake are ideological and therefore may take a lot longer produce underlying economic improvements to standards of living and incomes. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 84 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 86. Exhibit 144: China fixed asset investment as % of GDP Source: National Bureau of Statistics, CEIC, Jefferies Investors have had a wish list of reforms that follows the below, in no particular order: *Granting farmers, small enterprises and holders of land-use rights and full freehold ownership *The abolition of the one-child policy *Abolishing the Hukou system thereby ensuring that all workers no matter where they are located have access to social benefits for themselves and their family *Letting the Yuan become freely convertible and float freely *Removing the cap on deposit rates that the banks charge their customers and allowing market rates to determine fully the cost of capital within the economy *Removing subsidies such as cheap energy and other for Chinese industries in order to promote efficiencies and reduce the involvement of the government in the economy. In essence, China needs to obtain a ‘reform dividend’ that allows the benefits of better capital allocation and more efficient use of resources to be passed onto its population. There are mixed messages on China’s current competiveness. In the latest World Economic Forum, The Global competitiveness Report 2013-14, China attained an unchanged 29th position from 2012. Interestingly, respondents highlighted that ‘Access to financing ‘and ‘Inefficient government bureaucracy’ were the two most problematic factors for doing business. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 85 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 87. Exhibit 145: The Global Competitiveness Index 2013-2014 rankings and 2012-2013 comparisons Source: World Economic Forum The Global Competitiveness Report 2013-2014, Jefferies Note: * this column shows the rank of each economy based on last year’s sample of 144 economies Exhibit 146: The most problematic factors for doing business in China Source: World Economic Forum The Global Competitiveness Report 2013-2014, Jefferies Note: From the list of factors above, respondents were asked to select the five most problematic for doing business in China and to rank them between 1 (most problematic) and 5. The bars in the figure show the responses weighted according to their rankings In the 2013 Global CEO survey of manufacturing competitiveness conducted by Deloitte Touche Tohmatsu Ltd, China scored the highest marks both for current and future competitiveness in five years. However, the latest Canton fair showed a worrying dip in sales by 20% versus the spring session which ended with a 8.8% rise in orders compared to last year’s October fair in 2012. Deals at the October fair were worth US$32.7bn. Country/Economy Rank (out of 148) Score (1-7) Rank among 2012-2013 economies* GCI 2012-2013 Switzerland 1 5.67 1 1 Singapore 2 5.61 2 2 Finland 3 5.54 3 3 Germany 4 5.51 4 6 United States 5 5.48 5 7 Sweden 6 5.48 6 4 Hong Kong SAR 7 5.47 7 9 Netherlands 8 5.42 8 5 Japan 9 5.40 9 10 United Kingdom 10 5.37 10 8 Norway 11 5.33 11 15 Taiwan, China 12 5.29 12 13 Qatar 13 5.24 13 11 Canada 14 5.20 14 14 Denmark 15 5.18 15 12 Austria 16 5.15 16 16 Belgium 17 5.13 17 17 New Zealand 18 5.11 18 23 United Arab Emirate 19 5.11 19 24 Saudi Arabia 20 5.10 20 18 Australia 21 5.09 21 20 Luxembourg 22 5.09 22 22 France 23 5.05 23 21 Malaysia 24 5.03 24 25 Kore, Rep. 25 5.01 25 19 Brunei Darussalam 26 4.95 26 28 Israel 27 4.94 27 26 Ireland 28 4.92 28 27 China 29 4.84 29 29 GCI 2013-2014 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 86 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 88. Exhibit 147: Global CEO Survey: 2013 Country Manufacturing Competitiveness Index rankings Source: Deloitte Touche Tohmatsu Limited and U.S. Council on Competitiveness, 2013 Global Manufacturing Competitiveness Index As we highlighted in China 2025: A clear path to prosperity, January, 2013 one of the best indicators that China was experiencing better quality growth was through gauging the strength of the services sector. If China was investing efficiently, the valued added from Services would be increasing. To date, there are some signs of success. Exhibit 148: China services consumption per capita by Chinese urban residents as % of total consumption Source: National Bureau of Statistics, CEIC, Jefferies Note: Services consumption includes telecommunication, transport and recreation, education & cultural services Exhibit 149: China service exports as % of total exports Source: State Administration of Foreign Exchange, CEIC, Jefferies Note: Total export includes goods and services export Current competitiveness Competitiveness in five years Rank Country Index score (10=High 1=Low) Rank Country Index score (10=High 1=Low) 1 China 10.00 1 China 10.00 2 Germany 7.98 2 India 8.49 3 United States of America 7.84 3 Brazil 7.89 4 India 7.65 4 Germany 7.82 5 South Korea 7.59 5 United States of America 7.69 6 Taiwan 7.57 6 South Korea 7.63 7 Canada 7.24 7 Taiwan 7.18 8 Brazil 7.13 8 Canada 6.99 9 Singapore 6.64 9 Singapore 6.64 10 Japan 6.60 10 Vietnam 6.50 11 Thailand 6.21 11 Indonesia 6.49 12 Mexico 6.17 12 Japan 6.46 13 Malyasia 5.94 13 Mexico 6.38 14 Poland 5.87 14 Malaysia 6.31 15 United Kingdom 5.81 15 Thailand 6.24 16 Australia 5.75 16 Turkey 5.99 17 Indonesia 5.75 17 Australia 5.73 18 Vietnam 5.73 18 Poland 5.69 19 Czech Republic 5.71 19 United Kingdom 5.59 20 Turkey 5.61 20 Switzerland 5.42 21 Sweden 5.50 21 Sweden 5.39 22 Switzerland 5.28 22 Czech Republic 5.23 23 Netherlands 5.27 23 Russia 5.04 24 South Africa 4.92 24 Netherlands 4.83 25 France 4.64 25 South Africa 4.77 26 Argentina 4.52 26 Argentina 4.58 27 Belgium 4.50 27 France 4.02 28 Russia 4.35 28 Colombia 4.01 29 Romania 4.09 29 Romania 3.98 30 United Arab Emirates 3.93 30 Belgium 3.63 31 Colombia 3.85 31 Spain 3.58 32 Italy 3.75 32 United Arab Emirates 3.58 33 Spain 3.66 33 Saudi Arabia 3.46 34 Saudi Arabia 3.57 34 Italy 3.45 35 Portugal 3.39 35 Egypt 3.45 36 Egypt 3.24 36 Ireland 3.03 37 Ireland 3.23 37 Portugal 2.87 38 Greece 1.00 38 Greece 1.00 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 87 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 89. To be fair, China starts off with some advantages. Firstly, the central bank has adopted reformist zeal and has kept its objectives unchanged despite the economy slowing inadvertently from time-to-time. Secondly, the exchange rate has been allowed to appreciate and its trading band gradually relaxed since it broke away from its peg in 2005. Thirdly, coal prices have dropped and the high global commodity prices that have afflicted the economy over the past year have slipped since 2011. This ought to reduce some pressure on headline inflation while also improving the cash flows of companies which have detrimentally been punished by y-y increases in base metal and energy prices. With coal accounting for around 70% of primary energy use, the slide in thermal coal prices by around 50% ought to have provided Chinese industry with a substantial ‘profit boost’. China’s terms-of-trade are now positive. Exhibit 150: McCloskey Newcastle 6000 kc NAR fob Steam Coal Spot Price (Australia, US$ per metric tonne) Source: Bloomberg, Jefferies Exhibit 151: Citi Commodity Terms of Trade: China absolute value YoY change Source: Bloomberg, Jefferies Despite investor apprehension last year over the health of China’s economy as well as concerns surrounding the high level of credit-to-GDP, China’s economy managed to circumvent the emerging market reverberations that followed the ‘US taper tantrum’ in June and July. The PBOC should be given some recognition for rebalancing the credit allocation within the economy from the more vulnerable shadow banking back to the formal credit channels. Exhibit 152: China: credit developments Source: CEIC data, Haver Analytics, and IMF staff calculations Note: broad credit comprises bank loans, entrusted loans, trust loans, acceptance bills and corporate bonds Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 88 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 90. Exhibit 153: China current account balance (in US$ billion) Source: FactSet, Jefferies Exhibit 154: China current account balance vs. Indonesia current account balance (in US$ billion) Source: FactSet, Jefferies China’s ability to run a current account surplus as well as its capital controls meant that the economy and the equity market was able to ‘side-step’ the US bond and current market aftershocks. Exhibit 155: BRIC stock indexes performance since 2009 (2009=100, in US$) Source: Bloomberg, Jefferies The Chinese authorities’ caution over opening the capital account and its strong FX reserve position has proved that China has a much stronger balance sheet than investors have perceived. The very low amount of debt issued in a foreign currency and the country’s high import cover has meant that China did not face the same problems as India or Indonesia which have had to raise interest rates to support their current account deficits and reassure foreign investors. Furthermore, China’s exchange rate has continued to appreciate against significant falls in the value of the Indian Rupee and the Indonesian Rupiah. This helped China’s total returns during the past six months as well as helping to reduce inflation. Indeed, China’s capital account returned to a surplus ytd. c The Chinese authorities’ caution over opening the capital account and its strong FX reserve position has proved that China has a much stronger balance sheet than investors have perceived. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 89 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 91. Exhibit 156: BRICs GDP & current account forecasts Source: IMF, Jefferies Note: P is positive current account surplus to GDP, N is negative current account surplus to GDP Exhibit 157: China capital and financial account balance of payments (in US$ billion) Source: FactSet, Jefferies In this respect, the Chinese economy is positioned much better than many emerging economies to any change in US interest rates in 2014. While we don’t expect any immediate change to the Fed funds rate, it is likely that the long end of the yield curve will become more sensitive to the ending of QE or any tapering measures. The improving tone to global trade, subdued inflation pressures in China as well as ongoing financial measures ought to ensure that China’s equity markets outperform its emerging market peers in 2014. Exhibit 158: BRICs stock market valuations and profitability Source: FactSet, Jefferies 2013 2014 2013 2014 China 7.6 7.3 P P Brazil 2.5 2.5 N N India 3.8 5.1 N N Russia 1.5 3.0 P P GDP % y-y (constant price) Current Account PE (X) PB(X) ROE(%) Dividend Yield (%) China 9.3 1.3 11.8 2.6 Brazil 11.3 1.0 8.4 3.7 India 13.8 2.1 14.7 1.4 Russia 6.0 0.7 12.7 3.3 Forward 12 Month Last 12 Month The Chinese economy is positioned much better than many emerging economies to any change in US interest rates in 2014. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 90 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 92. Exhibit 159: China Return on Equity (12 month forward) Source: FactSet, Jefferies Exhibit 160: China FY1 Earnings Revision Source: FactSet, Jefferies Note: Earnings revision= no. of up estimates minus no. of down estimates/total no. of estimates Exhibit 161: China FY2 Earnings Revision Source: FactSet, Jefferies Note: Earnings revision= no. of up estimates minus no. of down estimates/total no. of estimates Exhibit 162: Weighting of China in an Asia ex Japan portfolio vs its five-year average Source: EPFR, Jefferies Exhibit 163: Equity Market Flows into China Source: Bloomberg, EPFR, Jefferies Exhibit 164: Weighting of China in a GEM portfolio vs its five-year average Source: EPFR, Jefferies 10 12 14 16 18 20 22 07 08 09 10 11 12 13 Return on Asset 2Y Avg +1 SD +2 SD -1 SD -2 SD (0.4) (0.3) (0.2) (0.1) 0.0 0.1 0.2 07 08 09 10 11 12 13 FY1 Earnings Revision Ratio (4wma) FY1 Earnings Revision Ratio (6mma) (4) (2) 0 2 4 6 8 10 Dec-00 Feb-02 Apr-03 Jun-04 Aug-05 Oct-06 Dec-07 Feb-09 Apr-10 Jun-11 Aug-12 50 55 60 65 70 (5,000) 0 5,000 10,000 15,000 20,000 25,000 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13 Aug-13 All Funds (LHS, US$mn, cumulative) ETFs (LHS, US$mn, cumulative) Mutual Funds (LHS, US$mn, cumulative) MSCI China (RHS, US$) (2) 0 2 4 6 8 Nov-00 Feb-02 May-03 Aug-04 Nov-05 Feb-07 May-08 Aug-09 Nov-10 Feb-12 May-13 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 91 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 93. 2014 China Agriculture Profound Reform in China's Farming Key Takeaway We believe farmland transfer will accelerate in 2014, which is necessary to tackle the deteriorated economics of grain production and promote mechanized and high tech farming. Our math illustrates farmers should gain more from land transfer, than from farming alone. We see agricultural machinery and high tech farming sectors as beneficiaries of farmland consolidation while we are dismissive of farmland value appreciation concept. Deteriorated economics of grain production is threatening food security China's grain market is largely closed, for food security purposes. The closed market helps to keep grain prices high and maintain production margins so that farmer incentives are not diminished by cost inflation. However, despite continually rising grain prices, grain production economics deteriorated in 2012, mainly due to fast rising labor costs, which threatens food security. We believe China now needs to reform its high cost and inefficient farming caused by smallholding farmland. Industrial-scale farmland is a way out China's grain production is largely based on intensive man-hours and fertilizer usage. For comparison, US grain production is more efficient and cost-saving under industrial- scale farmland where mechanization and high tech farming has been easily applied. Farmland transfer to accelerate in 2014 Farmland transfer helps to consolidate smallholding farmland into industrial-scale. As of 2012, ~22% of farmland had been consolidated, according to Ministry of Agriculture. The Third Plenum held in Nov highlighted three points regarding land transfer: 1) to accelerate building a “new farming system” (industrial-scale farming), 2) to grant farmers more property rights (farmland and rural construction land usage right) and 3) to improve the development scheme for urbanization. We believe farmland transfer will accelerate in 2014 given government's urging and the threat to food security. Farmers' benefit Our math illustrates farmers will gain more from land transfer, than from farming alone. We estimate farmland rental rate after land consolidation could reach Rmb688/mu to justify 10% IRR of grain production. For smallholding grain production in 2012, farmers' disposable income (ignoring labor costs) was Rmb684/mu, and net income (deducting labor costs) was Rmb344/mu. More importantly, farmers could be liberated from farming to work in secondary/tertiary industries. Beneficiary of accelerating farmland transfer In medium/long term, we believe farmland consolidation will benefit the agricultural machinery sector and high tech farming sectors such as seed cultivation and special agri-chemicals. Within those sectors are companies such as First Tractor (38 HK, $6.14, NC), Dunhuang Seed (600354 CH, Rmb6.56, NC) and Yangnong Chem (600486 CH, Rmb32.78, NC). Some in the A-share market expect farmland value appreciation after land transfer. We believe this is irrational. Farmland is not allowed to be used as property land and its value is unlikely to appreciate to property land levels in our view. Jack Lu +852 3743 8020 jlu@jefferies.com Laban Yu +852 3743 8047 lyu@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 92 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 94. Deteriorated Economics of Grain Production Closed grain market; regional pricing Under condition of grain supply independency, the Chinese government closes the grain market for food security, allowing a small amount of imports via trading quota. Otherwise, domestic grain prices and production would be seriously affected by cheaper global prices in our view, threatening China’s food security. Moreover, the government has set purchase price floors for rice and wheat to protect production margins since 2004. The floor prices have continually been raised in recent years, incentivizing domestic production. On the back of China’s closed grain market, China can in general disregard international prices when raising floor prices. Without pricing regulation, we believe Chinese farmers’ incentives would have steadily diminished due to cost inflation, and grain production growth over the past decade would have been unlikely. Exhibit 165: Corn prices at harvest: China vs. US Source: NDRC Prices Division, USDA Exhibit 166: Wheat prices at harvest: China vs. US Source: NDRC Prices Division, USDA Exhibit 167: Rice prices at harvest: China vs. US Source: NDRC Prices Division, USDA Exhibit 168: Soybean prices at harvest: China vs. US Source: NDRC Prices Division, USDA Deteriorated economics Despite increasing gain prices, production margins deteriorated in 2012 due to a fast rise in labor costs and material & service costs. We suspect the government will likely be cautious in raising grain prices to pass through cost inflation given such a high spread between China and global grain prices. Rising grain prices have a negative impact on social stability, in our view. - 50 100 150 200 250 300 350 400 2004 2005 2006 2007 2008 2009 2010 2011 2012 US$/ton China US - 50 100 150 200 250 300 350 400 2004 2005 2006 2007 2008 2009 2010 2011 2012 US$/ton China US - 50 100 150 200 250 300 350 400 450 500 2004 2005 2006 2007 2008 2009 2010 2011 2012 US$/ton China US - 100 200 300 400 500 600 700 800 2004 2005 2006 2007 2008 2009 2010 2011 2012 US$/ton China US Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 93 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 95. Exhibit 169: Grain production profit margin per mu Source: NDRC Prices Division Exhibit 170: Grain production costs per mu Source: NDRC Prices Division Exhibit 171: China corn production costs per mu Source: NDRC Prices Division Exhibit 172: China wheat production costs per mu Source: NDRC Prices Division Exhibit 173: China rice production costs per mu Source: NDRC Prices Division Cost Structure Analysis We see significant differences of farming cost structure between China and US. The latter enjoys low cash costs due to mechanization and high tech farming, on back of industrial-scale farmland. Smallholding farmland generating high costs With smallholding farmland, China’s farming is still largely based on intensive man- hours and fertilizer usage. For gain production, labor and fertilizer costs per mu account for ~50% and ~20% of total respectively. China’s per acre fertilizer usage is about 2.5 times of US, while man-hours spent are ~20 times. This farming system is more costly and inefficient compared to the US. With continued increasing labor costs in recent years, we believe China will be pressured to maintain production due to deteriorated economics. China has low value added per worker in agricultural sector Although China has the largest agricultural sector in the world, value added per worker is far lower than that of western industrial scale farms. In 2010, 38% of China’s workers were employed in agriculture compared to 1.5% of US workers. The average in the US added ~100 times as much value as the average farmer in China. 0 100 200 300 400 500 600 2004 2005 2006 2007 2008 2009 2010 2011 2012 Rmb/mu Rice Wheat Corn 200 400 600 800 1,000 2004 2005 2006 2007 2008 2009 2010 2011 2012 Rmb/mu Rice Wheat Corn 0 200 400 600 800 2004 2005 2006 2007 2008 2009 2010 2011 2012 Labor costs Material and service costs Rmb/mu 0 200 400 600 800 2004 2005 2006 2007 2008 2009 2010 2011 2012 Labor costs Material and service costs Rmb/mu 0 200 400 600 800 1,000 2004 2005 2006 2007 2008 2009 2010 2011 2012 Labor costs Material and service costs Rmb/mu Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 94 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 96. Exhibit 174: Rural population, 2010 (% of total) Source: World Bank Exhibit 175: Employment in agriculture (% of total) Source: World Bank Industrial scale farmland creates efficiency and low costs For comparison, most US famer households hold industrial-size farmland. Mechanization can replace high-cost labor and a high-tech farming approach is the key to drive yields. There are 3.3 hectares of arable land per farmer in the US vs. ~0.09 hectares in China. The US has realized 100% coverage of mechanization with soil machines, seeders, harvesters, threshers, combined harvester-threshers, tractors as well as specialized planes for fertilization and applying pesticide, to replace man-hours. High tech farming includes high quality seed cultivation, efficient fertilizer formula and agri- chemicals research and development. Exhibit 176: Corn Planting Cost Structure: China vs. US Source: NDRC Prices Division, USDA 0% 10% 20% 30% 40% 50% 60% 70% 80% Vietnam India Thailand Pakistan Egypt China Indonesia Philippines Italy Turkey Malaysia Russia Germany Spain Mexico S.Korea US Brazil Australia Argentina 0% 10% 20% 30% 40% 50% 60% India Pakistan Nigeria Thailand Indonesia China Egypt Turkey Iran Brazil Mexico Malaysia Russia Spain Japan Italy France Germany US Argentina Corn planting cost structure comparision: China vs. US As a % of China 2012 US$/acre Rmb/mu Cent/kg total costs Seed 50.0 52.0 11.3 6.9% Fertilizer 148.9 155.0 33.6 20.4% Chemicals 13.2 13.8 3.0 1.8% Custom service - - - 0.0% Fuel and power 21.6 22.5 4.9 3.0% Machinary lease fees 80.9 84.2 18.3 11.1% Labor costs 382.6 398.4 86.4 52.5% Irrigation 13.9 14.5 3.1 1.9% Land rental rate 17.6 18.4 4.0 2.4% Total 728.8 758.8 164.6 100.0% US Normalized As a % of Five Year Avg. US$/acre Rmb/mu Cent/kg total costs Seed 79.0 86.8 14.3 17.7% Fertilizer 136.1 149.6 24.7 30.5% Chemicals 26.6 29.3 4.8 6.0% Custom service 14.5 15.9 2.6 3.2% Fuel and power 32.0 35.2 5.8 7.2% Repairs 20.9 22.9 3.8 4.7% Labor costs 26.7 29.4 4.9 6.0% Irrigation 0.1 0.1 0.0 0.0% Depreciation of machinery 84.8 93.1 15.4 19.0% Taxes and insurance 8.6 9.4 1.6 1.9% General farm overhead 16.9 18.5 3.1 3.8% Total 446.2 490.3 81.0 100.0% Difference % Cash cost 112% 100% 163% Total cost 63% 55% 103% Seed 7% Fertilizer 20% Chemicals 2% Fuel and power 3% Machinary lease fees 11% Labor costs 53% Irrigation 2% Land rental rate 2% Seed 18% Fertilizer 30% Chemicals 6% Custom service 3% Fuel and power 7% Repairs 5% Labor costs 6% Depreciation of machinery 19% Taxes and insurance 2% General farm overhead 4% Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 95 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 97. Exhibit 177: Wheat Planting Cost Structure: China vs. US Source: NDRC Prices Division, USDA Exhibit 178: Rice Planting Cost Structure: China vs. US Source: NDRC Prices Division, USDA Wheat planting cost structure comparision: China vs. US As a % of China 2012 US$/acre Rmb/mu Cent/kg total costs Seed 53.6 55.8 14.6 7.8% Fertilizer 160.5 167.1 43.7 23.4% Chemicals 15.2 15.9 4.1 2.2% Custom service - - - 0.0% Fuel and power 30.9 32.2 8.4 4.5% Machinary lease fees 106.6 111.0 29.0 15.6% Labor costs 279.9 291.4 76.1 40.9% Irrigation 28.0 29.2 7.6 4.1% Land rental rate 10.3 10.7 2.8 1.5% Total 685.1 713.3 186.4 100.0% US Normalized As a % of Five Year Avg. US$/acre Rmb/mu Cent/kg total costs Seed 14.2 15.6 8.4 6.3% Fertilizer 43.6 47.9 25.7 19.2% Chemicals 13.0 14.3 7.7 5.7% Custom service 9.3 10.2 5.5 4.1% Fuel and power 18.4 20.2 10.8 8.1% Repairs 18.7 20.6 11.0 8.3% Labor costs 19.8 21.8 11.7 8.7% Irrigation 0.5 0.5 0.3 0.2% Depreciation of machinery 72.3 79.5 42.6 31.9% Taxes and insurance 6.7 7.4 4.0 3.0% General farm overhead 10.3 11.3 6.1 4.5% Total 226.9 249.3 133.7 100.0% Difference % Cash cost 375% 350% 119% Total cost 202% 186% 39% Seed 8% Fertilizer 23% Chemicals 2% Fuel and power 5% Machinary lease fees 16% Labor costs 41% Irrigation 4% Land rental rate 1% Seed 6% Fertilizer 19% Chemicals 6% Custom service 4% Fuel and power 8%Repairs 8% Labor costs 9% Depreciation of machinery 32% Taxes and insurance 3% General farm overhead 5% Rice planting cost structure comparision: China vs. US As a % of China 2012 US$/acre Rmb/mu Cent/kg total costs Seed 46.4 48.3 12.6 5.3% Fertilizer 136.4 142.0 37.1 15.6% Chemicals 47.0 49.0 12.8 5.4% Custom service - - - 0.0% Fuel and power 34.4 35.8 9.4 3.9% Machinary lease fees 141.3 147.1 38.4 16.2% Labor costs 409.7 426.6 111.5 47.0% Irrigation 21.4 22.3 5.8 2.5% Land rental fee 34.9 36.4 9.5 4.0% Total 871.6 907.5 237.1 100.0% US Normalized As a % of Five Year Avg. US$/acre Rmb/mu Cent/kg total costs Seed 68.3 75.0 12.9 9.0% Fertilizer 113.2 124.4 21.3 14.9% Chemicals 78.6 86.3 14.8 10.3% Custom service 53.0 58.3 10.0 7.0% Fuel and power 143.4 157.6 27.0 18.9% Repairs 31.1 34.2 5.9 4.1% Labor costs 71.1 78.1 13.4 9.4% Irrigation 14.4 15.9 2.7 1.9% Depreciation of machinery 136.9 150.4 25.8 18.0% Taxes and insurance 20.7 22.8 3.9 2.7% General farm overhead 28.4 31.2 5.4 3.7% Total 759.1 834.1 143.1 100.0% Difference % Cash cost 47% 39% 112% Total cost 15% 9% 66% Seed 5% Fertilizer 16% Chemicals 5% Fuel and power 4% Machinary lease fees 16% Labor costs 47% Irrigation 3% Land rental fee 4% Seed 9% Fertilizer 15% Chemicals 10% Custom service 7% Fuel and power 19% Repairs 4% Labor costs 9% Irrigation 2% Depreciation of machinery 18% Taxes and insurance 3% General farm overhead 4% Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 96 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 98. Farmland Transfer to Accelerate in 2014 A little history of Farmland Reform Before the Chinese revolution (in 1949), landlords (~5% of rural population) took over ~50% of Chinese farmland. Most of the farmers did not have their own farmland and were employed by landlords to do heavy farming work for extremely low pay. In 1950, farmland reform was implemented nationwide after establishment of PRC. The farmland was reclaimed by the government from landlords and re-allocated to farmers. The “Chinese Land Reform Law” was issued at that time, regulating: 1) farmland could be freely used by farmers without timing limit, but 2) farmland was not allowed to be transferred. This reform significantly incentivized farmers and improved agricultural productivity. This law was abolished in 1987. In the late 1950s, for the purpose of “accelerating construction of communism”, government consolidated smallholding farming into larger scale commune production. ~120mn of rural households were combined into ~74k units of “agricultural cooperative community” in 1958. Egalitarianism was employed in income allocation. As a result, productivity declined dramatically without a motivation mechanism and farmers’ life became even tougher during this era of “rural community” between 1957 and 1980. In the early 1980s, the government under the leadership of Mr. Deng Xiaoping restored the smallholding farming system to incentivize productivity. Every rural household owns usage right of farmland and gains profit from crops after paying some royalties. This farmland reform has been implemented up until now. Farmers were incentivized and continually increased grain production for decades. In late 1990s, China also achieved grain supply independence. However, smallholding farming has been always been a bottleneck for agricultural mechanization and high tech farming. Farmers’ needs now are not just food and clothes, but the same living quality as urban residents, which smallholding farming cannot grant them in our view. Migrant workers a special group under China’s unbalanced economy Rural population accounted for ~47% of 13.5bn Chinese total as of 2012. Chinese rural people are not just farmers. Most of the young people migrate to urban regions to seek work opportunities, leaving children and older parents at their rural homes. They usually come back to rural homes at the busy season for farming and Chinese Spring Festival. For the past decade, the number of migrant workers has increased significantly, accounting for 41% of the total rural population in 2012. We believe this special group was created by China’s unbalanced economy between urban and rural areas. The urban economy has grown fast in past decades creating plenty of work opportunities, while the rural economy, largely depending on smallholding farming, is poor and lags behind. Exhibit 179: Chinese population division Source: NBS 0 200 400 600 800 1000 1200 1400 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 million Urban population Rural population Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 97 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 99. Exhibit 180: Number of migrant worker Source: NBS Exhibit 181: Average monthly salary of migrant workers Source: NBS Farmers’ income structure has significantly changed With increasing income from secondary or tertiary industries, Chinese farmers have seen a structural change in disposable income. Planting only takes ~30% of individual income on average vs. ~80% in 1980s. On the other hand, proportion of non-farming income has been increasing. The key to increasing farmers’ income We don’t believe it is sustainable for the government to keep raising grain prices to increase farmers’ income. We believe the key to increasing farmers’ income is to increase their working hours in secondary/tertiary industries, while reducing hours in agriculture. Farmland transfer will help, in our view, by consolidating farmland and promoting mechanization and high tech farming. Rural Land Transfer to Accelerate Some highlights of relevant regulations Planting has become less important in terms of farmers’ income. Accelerating urbanization and an increasing number of migrant workers over the past decade has led to some inefficient use of farmland or even idle farmland. To solve these problems, China has issued some regulations regarding rural land transfer, including “Chinese Rural Land Contract Law” in 2002 and “Rural Land Using Right Transfer Regulation” in 2005. Below are some highlights of those regulations regarding farmland transfer: Farmland is not allowed to switch to non-farming land in the process of land transfer. Any organization or individual is not allowed to force farmers to transfer land. All the gain from land transfer belongs to farmers; any organization or individual is not allowed to take profits. Rural Land can be transferred via land swaps, leasing, shareholding, cooperative operation and subcontracting. Contract term of land transfer signed between owners and renters should be 30 years or less (as the owners of farmland have land use rights for 30 years). 0% 10% 20% 30% 40% 50% 0 50 100 150 200 250 300 2008 2009 2010 2011 2012 million Western China Central China Other Eastern China Zhu River Delta Yangzi River Delta As a % of rural total population (RHS) 0 500 1,000 1,500 2,000 2,500 2008 2009 2010 2011 2012 Rmb Eastern China Central China Western China Exhibit 182: 2012 Chinese farmers’ disposable income breakdown Source: NBS Planting crops 29.1% Livestock breed 6.0% Salary income 41.1% Agricultural production subsidy 2.0% Pension and other welfare 5.7% Others 16.2% Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 98 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 100. Some problems Approximately 21.5% of farmland had been consolidated through land transfer as of 2012 according to Ministry of Agriculture. It appears slow as land transfer has been allowed for a decade. We think the reasons for this include: Lack of rural social insurance including pension and medical insurance, making farmers unwilling to give up their land. Inadequate agent services leading to unshaped land transfer market mechanism, causing poor information access and mispricing. Incomplete laws and regulations to ensure farmers’ benefit from land transfer. Migrant workers’ jobs are usually unstable with temporary contracts in cities, and they have concerns on transferring farmland which could ensure their living. Farmland transfer to accelerate in 2014 The Third Plenum held in Nov highlighted three points regarding land transfer: 1) to accelerate building a “new farming system” (industrial-scale farming), 2) to grant farmers more property rights (farmland and rural construction land using right), and 3) to improve the development scheme for urbanization. We have seen that the government is urging urbanization and building a social insurance system for farmers. In addition, some pilot projects for “Land Transfer Trust” have been carried out in Anhui and Hainan Province this year, to figure out better ways for land transfer. We believe farmland transfer will accelerate in 2014. This is necessary as the economics of China’s grain production has deteriorated in our view. Farmers’ Benefit from Farmland Transfer After consolidation into industrial-scale farmland, the required margins of grain production will be lowered as industrial scale farmland generates larger grain production. In addition, labor cost will decrease significantly due to mechanization. From the economics analysis of grain production under the smallholding and industrial scale farmlands respectively, we have seen farmers’ gain from land transfer is more than farming alone. With 10% IRR, we estimate farmland rental rate after land consolidation could reach Rmb688/mu to justify the economics of grain production. For smallholding grain production in 2012, disposable income (ignoring labor costs) was Rmb684/mu and net income (deducting labor costs) was Rmb344/mu. Exhibit 183: Farmland transferred as a % of total farmland area Source: Ministry of Agriculture, Jefferies 0% 20% 40% 60% 80% 100% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E 2017E Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 99 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 101. Exhibit 184: Economics of grain production under smallholding farmland Source: NDRC Pricing Division Exhibit 185: Economics of grain production under industrial-scale farmland Source: NDRC Pricing Division, USDA, Jefferies P&L of grain production (Rmb/mu) Revenue 1,105 Seed 52 Fertilizer 154 Chemicals 26 Fuel and power 30 Irrigation 22 Land rental fees 22 Machinary lease fee 114 Total material & service expense 421 Disposable income 684 Labor cost 372 Net income 312 P&L of grain production (Rmb/mu) Revenue 1,105 Seed 52 Fertilizer 154 Chemicals 26 Fuel and power 30 Irrigation 22 Labor costs 30 Land rental fee 688 Total expense 1,003 Cash inome 102 IRR 10% Capital 1,020 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 100 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 102. 2014 China Conglomerates Consolidation of state-owned assets to accelerate Key takeaways We believe the reforms unveiled by the Third Plenum will have a profound impact on SOEs. To strengthen and solidify the state-owned sector on the one hand and to introduce private capital into the sector on the other will inevitably lead to SOE consolidation and privatization of state-owned assets. In addition, a clearer divide between what markets can do and what the government can do means SOEs will increasingly concentrate on areas such as infrastructure utilities or sectors critical to national security. Infrastructure a key consolidation focus Therefore, we expect SOEs to consolidate and acquire state-owned infrastructure utility assets, such as water supply/distribution/treatment, natural gas distribution, toll road/bridge, etc. We also expect SOEs to acquire land/property, simply because the government is a big owner of real estate. During the process, already listed SOEs will likely benefit more by leveraging capital markets. Competition to increase; SOEs must be adaptive However, we also expect SOEs to face increasing competition from private capital, as China opens up the public sector, clears up excessive administrative obstacles to investments, and promotes more equal funding access to private businesses. We believe SOEs can meet the competitive challenges by deepening reforms: 1) less administrative intervention; 2) appoint professional managers who can exercise business discretion; 3) implement modern corporate practices such as incentive plans. Shanghai Industrial is the most preferred name We like its balanced portfolio, which derives ~65% of earnings from infrastructure and consumer segments with stable growth outlook. While its property business has encountered tremendous challenges, we believe the worst is already behind us and improvements are on the way. Importantly, we believe the company will have ample opportunities to acquire or consolidate state-owned infrastructure and real estate assets in Shanghai. We believe its growth outlook will be further enhanced as a result. The stock’s valuation remains attractive at the current level. China Travel the least preferred We believe there is limited growth potential in China Travel’s existing operations. We see low likelihood for the company to consolidate attractive state-owned assets in areas of tourism attractions, scenic spots, etc. While the company is moving into tourism real estate to enhance growth, a lack of track record and high competition will increase uncertainty. Although its valuation is not expensive, we don’t see large share price upside. Ambitious SOE reforms unveiled by Third Plenum Third Plenum’s decision on SOE reform was ahead of expectations The Third Plenum of the 18th CPC concluded on November 12th and issued a decision on the 15th outlining comprehensive reforms. We believe the reforms will provide tremendous opportunities to SOEs to grow scale, enhance their potential, and lift their competitiveness. Inevitably as a result of reform, we expect SOEs to face more competition and enjoy privileges over time. We highlight key reform targets and their major implications below. 1. To allow the market to play a decisive role in the allocation of resources. It suggests that SOE should have more discretion on business operations, and administrative intervention must be reduced. It also suggests that many privileges enjoyed by SOEs will be removed. Christie Ju +852 3743 8012 cju@Jefferies.com Rong Li +852 3743 8014 rli@jefferies.com Leon Liao +853 3743 8021 lliao@jefferies.com Eric Chen +853 3743 8016 echen@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 101 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 103. 2. To consolidate and develop the state-owned economy, which must hold a dominant position and play a leading role in the entire economy; to constantly enhance the vitality, control and influence of the state-owned economy. It suggests that promoting SOEs’ scale, growth potential and competitiveness is a paramount task of the leadership. 3. To advance diverse forms of ownership, including state-owned, collectively-owned and privately-owned; to allow state ownership to grow into mixed ownership. This suggests state-owned assets could continue to be at least partially privatized, or injected into listed SOEs. China will continue to introduce private capital into state ownership. 4. To perfect the management system for state-owned assets; to form state-owned asset management companies. It suggests that SOEs’ ownership will be separated from management. In future the state will not intervene in SOEs’ business operations, and shift its focus to strategic asset allocations between different sectors/industries. 5. To adhere to modern corporate practices. This suggests market-oriented business decision-making, wider implementation of incentive plans, and also stresses the need to separate ownership from management. 6. To raise SOEs’ dividend pay-out ratio to 30% by 2020. SOEs’ profits must be used for the public good. Currently SOEs only pay 5-15% of profits to the state, and this ratio will be increased to 30%. It will dampen SOEs’ investment impulse and force them to become more selective in choosing new projects. Leadership’s determination is the guarantee; well-run SOEs will benefit By implementing these reforms, we believe China will succeed in 1) preserving and enhancing the value of state-owned assets; 2) making SOEs a cornerstone and stabilizer of the economy; 3) having SOEs provide important societal and national functions which privates companies are not capable of; 4) making SOEs commercial and accountable, and competing in a level playing field. The key to accomplish these goals lies in the new leadership’s execution abilities, in which we have high confidence, thanks to a strong track record built on anti-corruption, sweeping reforms of government working style, etc., in no more than a year. In the end, we believe SOEs’ profitability will go to new levels. Listed SOEs’ share prices will benefit handsomely as well. Obviously, not all will survive: some SOEs that can’t adapt to market mechanisms will fare worse and be consolidated by others. SOE performance has ample room to improve The share of SOEs’ assets in the Chinese economy declined from over 70% in 1998 to 50% in 2010 after the Third Plenum in 1993 kicked off sweeping SOE reforms. The share has stabilized over the last two years. With half of the country’s assets still in the hands of SOEs, a well-functioning SOE sector is critical to the Chinese economy. The average profitability for the Chinese SOEs as a class is well below that of the non- state firms. A disproportionate share of SOE profits is generated from the few monopolies because of limits on competition. Further, their profitability, measured in ROE, has trended down to high single digits after peaking at 16% in 2007. In contrast to a stabilizing share of state assets in the economy (around 50%), the value added from the state sector has been steadily falling, down from 40% in 2004 to 25% in 2012. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 102 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 104. Reforms will promote SOEs’ scale, growth potential, and competitiveness SOE consolidation will accelerate; listed SOEs to benefit even more Going forward, we expect SOEs to concentrate investments in sectors that either provide public services or are critical to national security. Those operating in natural monopoly industries would be run like private companies. The state owns a huge amount of assets in the form of infrastructure utilities and land, two areas where SOEs are ubiquitous. To advance diverse forms of ownership and support SOEs to enhance vigour, control and influence, we believe partial privatizations through M&A or injections will accelerate. Listed SOEs that can leverage the capital market will gain advantages over non-listed ones. For China Conglomerates under our coverage, we expect future consolidation to occur mostly in infrastructure utilities and real estate. Infrastructure utilities and real estate are the focus We have mapped major sector exposures for China Conglomerates under our coverage. Besides Fosun International, the rest are all SOEs. Their exposures are concentrated in three broadly defined sectors: consumer, infrastructure utilities and real estate. Exhibit 186: China Conglomerates – mapping of major sector exposures & consolidation focus Source: Jefferies The consumer sector is very diverse and has distinct subsectors that have few commonalities with each other. China Conglomerates’ exposure to consumer are also diverse, ranging from brewery, winery, department store, tobacco and packaging, to retail travel agency, etc. In addition, the consumer sector is market-oriented and highly competitive, therefore not an area naturally suitable for SOEs. In our view, infrastructure utilities and real estate businesses are more suitable to SOEs and China Conglomerates in general. There is a significant amount of infrastructure utilities and real estate assets still in the hands of local governments or entities controlled by them. As China promotes diverse forms of ownership and introduces private capital into state-owned assets, we believe local governments will continuously Infrastructure utilities Property Consumer Metal & Mining Industrial Healthcare Financial Beijing Enterprises Natural Gas, Water Treatment Beer Shanghai Industrial Toll Road, Water Treatment Residential & Investment Property Tobacco, Package Printing SOEs Guangdong Investment Water Supply, Toll Road, Power Investment Property Department Store Tianjin Development Utility Transmission, Port Winery Elevator CITIC Pacific Tunnel, Power Residential & Investment Property Iron Ore, Steel China Travel Power Residential & Tourism Property Theme Park, Resort, Travel Agency Private Fosun International Residential & Investment Property Retail Iron Ore, Steel Fosun Pharma Insurance, P/E and Stock Market Investment SOE's Conslidation Focus Company Sector Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 103 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 105. privatize these assets by leveraging the capital markets. Listed SOEs will become the preferred platform for asset injections. We expect the trend to last for years. Infrastructure utilities include natural gas supply/transmission, water supply/treatment, toll road, toll bridges/tunnels, and power supply/transmission, etc. These assets provide essential public services where SOEs have a responsibility on behalf of the state. Moreover, due to the natural monopolistic nature of infrastructure utilities, SOEs face less competition in their operations. All that is required is diligence and care to maintain high-quality infrastructure, with fewer requirements to face constantly changing markets. SOEs are widely involved in the real estate business, including residential development, investment properties and hotel operations. To raise capital, we believe local governments will continue to sell or partially privatize their real estate assets by holding public auctions or injections into listed local SOEs. Even through public auctions, local SOEs will still be preferred consolidators, in our view. Separate ownership from management; Temasek model China style? While separating ownership from management could deprive SOEs of certain preferential treatments, it will also make it possible to introduce modern corporate governance practices by appointing professional senior management delivering value to shareholders, rather than quasi government officials who aren’t fully qualified and may serve a different agenda. Established in 2003 to exercise supervision over SOEs, the SASAC (State-owned Asset Supervision and Administration Council), as the name goes, at the best just supervises and stops short of acting as shareholders. In fact, according to a recent speech of Huang Shuhe, Deputy Director for the SASAC, over 40% of prefectural-level SASAC officials fail to perform their duties and 35% of these local SASACs don’t even appraise earnings performance for their supervised SASACs. To reform the issues, the state will establish state-owned asset management companies (SAMCs) that would represent the government as shareholder. The role of SAMCs would transform from overseeing business operations into managing asset values. With the goal of preserving/enhancing the value of state-owned assets and serving the nation’s strategic interest, they will increase or decrease asset allocations to certain sectors through actively trading these assets when feasible. Each SAMC could specialize in certain sectors. Finally, a portion of state assets could be transferred to the national pension fund with the flow of returns being used to help meet future pension obligations. Adhere to modern corporate practices; implement incentive plans This is closely related to separating ownership from management. Only when SASACs or future SAMCs act as shareholders rather than government superiors, will the SOEs truly begin to follow modern corporate practises. Only then can the board of directors, general meeting of shareholders and senior managers each serve their proper functions in a balanced way. Otherwise, despite the existence of the corporate organs, SASAC appointed senior management is unlikely to truly act in the full interests of the shareholders. Management incentive plans in SOEs are rare. Among listed SOEs, only a small percentage have stock options plans for senior management. We expect incentive plans to be implemented on a wider basis, and align shareholder/management interests. Raise dividend pay-out ratio to 30% China will require SOEs to raise their dividend pay-out ratio to 30% from the current 5- 10% level. The dividend will be transferred to fund part of China’s fiscal budget. If this mandate is enforced, it will effectively constrain SOEs’ investment impulse and force them to become more selective in terms of evaluating project returns. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 104 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 106. SOE may enjoy fewer privileges over time; forcing reforms to deepen China’s SOEs, in particular the giant ones in so-called strategic industries, enjoy privileges, both explicit and implicit, in doing business in China. The privileges come in the form of cheaper and easier credits, priority access to business opportunities and protection against competition. The connections paralyze the invisible hand of the market, misallocating valuable resources, dampening competition, undermining efficiency gains and creating room for corruption and bribery. The mechanism is also in part responsible for China’s investment-led economy supported by ever increasing debt, which is unbalanced and unsustainable. In this context, separating state ownership from management will eradicate the channels for vested interests in the government or their offshoots at SOEs to profit via economic privileges. In addition, since last year, the new leadership has firmly pushed through the elimination or delegation of 334 administrative approvals across ministries in the central government, as part of the reform initiative to transform government’s role in the economy. We believe the privileges enjoyed by SOEs, in terms of easy access to attractive projects, cheap credits, and government’s preferential treatment on approvals will be gradually removed, if not all. As China opens up the public sector to private capital, competition in infrastructure utilities will also intensify. SOEs must respond to these challenges by deepening reform, such as putting in place professional managers, eliminating administrative interventions, maintaining a flexible employee force, implementing incentive plans, etc. Obviously, not all SOEs will survive in the end. Shanghai is leading SOE reform Recent developments of the state sector at Shanghai provided us with some hints of how some local SOEs can benefit from this round of reform. Shanghai has the second largest SOE portfolio Shanghai Municipal Government has the second largest SOE portfolio, only behind the central government. Compared to their much bigger peers under the central government, the SOEs in Shanghai are mostly regional players in competitive industries such as consumer, pharma, real estate and infrastructure. This means bolder reform can be carried out on them more easily with less systemic risks. Shanghai is again championing SOE reforms In October, Shanghai SASAC reportedly planned to roll out a SOE reform pilot plan targeting 2015 for completion of the reform. The core parts are further deregulation, stock option-based incentives for management and modified performance appraisal mechanisms. Further, the reform will be implemented in conjunction with the Shanghai FTZ initiative. Then we saw the merger of Jiefang Daily Group with Wenhui Xinmin Group, two of the most influential state-owned media businesses in Shanghai, to become Shanghai New Media Group. We acknowledge the merger was not purely market-driven and in part reflected local officials’ desire to “manage” public opinions, but an equally important consideration is to position the merged media group to better compete in a digital media era. We expect more of this kind of restructurings, e.g. asset injections, divestitures and mergers, to happen among the SOEs in Shanghai. This, combined with a refined corporate governance and incentive system, will likely be an enabler for better growth for those companies with strong management. We see consistency between the approach adopted by the Shanghai government and where the third plenum points. For example, the city plans to use a business-based regulation/supervision practice to manage its SOE portfolio. SOEs that provide public services will be run in a different way from those operating in competitive businesses. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 105 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 107. The latter will be turned into public companies with diverse shareholding structure and market liquidity through securitization, which also facilitates the improvement of corporate governance and introduction of effective incentive system to attract/retain professional and competent senior management. Infrastructure utilities can provide huge potential We believe in the long run, SOEs will only remain in sectors that either provide an essential public services or critical to national securities. Managed properly, infrastructure utility businesses will still provide huge growth potential. We believe the environmental business is a good example. Water treatment We believe urbanization and local governments’ heightened efforts for environmental protection will continue to drive demand for modern and professionally-operated water services facilities. The market remains highly fragmented with lots of growth potential. However, opportunities for greenfield BOT projects in tier 1-2 cities are becoming rare; upgrading existing facilities and operation & management (O&P) model will be more common. Leading players such as Shanghai Industrial will continue to expand capacities primarily through M&A. Earnings growth will be more driven by top-line rather than margin expansion, even counting in potential tariff increases. Stock recommendations Our top pick in the China Conglomerate space is Shanghai Industrial. We also like Guangdong Investment for its strong recurring cash and balance sheet, as well as large capacity for expansion. We see Tianjin Development as a small cap value play that can potentially benefit enormously from asset injections. The least preferred name is China Travel. Shanghai Industrial As the window company of Shanghai Municipal Government, Shanghai Industrial is the preferred consolidator of the city’s infrastructure and real estate assets. We like its balanced portfolio, which derives ~65% of earnings from infrastructure and consumer segments with stable growth outlook. While its property business has encountered tremendous challenges, we believe the worst is already behind and improvements are on the way. Importantly, we believe the company will have ample opportunities to acquire or consolidate state-owned infrastructure and real estate assets in Shanghai. We believe its growth outlook will be further enhanced as a result. The stock’s valuation remains attractive at the current level. Guangdong Investment The window company of Guangdong Provincial Government, Guangdong Investment is the monopoly raw water provider to Hong Kong, and controls ~50% of the market in Shenzhen. Together with its premium investment properties and additional utilities business, the company generates the strongest free cash flow among all China Conglomerate peers. We believe the company has ample capacity to acquire state- owned assets, and increase dividend payout at the same time. Water tariff negotiation with Hong Kong government in 2014 will serve as a positive share price catalyst. Tianjin Development The company’s net cash accounts for ~70% of its market capitalization, while its existing businesses are still cash generative. We believe Tianjin Development, a flagship listco of the Tianjin Municipal Government, will engage in major M&A to re-establish a core business to restructure the company. China Travel We believe there is limited growth potential for China Travel’s existing operations. We see low likelihood for it to consolidate attractive state-owned assets in areas of tourism attractions and scenic spots, etc. While the company is moving into tourism real estate to enhance growth, a lack of track record and high competition create uncertainty. Although its valuation is not expensive, we don’t see large share price upside. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 106 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 108. 2014 China Consumer Key takeaways The 3rd Plenum blueprint will benefit the consumer sector in the next few years, in our view. We take a positive view on the 2014 outlook: staples are likely to enjoy improving margins, retail could recover moderately, sportswear has seen turnaround signals; jewellery could see business normalization. We remain negative on footwear and apparel. Top Picks: CRE (291 HK), Huishan (6863 HK), Intime (1833 HK), Anta (2020 HK). Top Sell: Belle (1880 HK). Implication of the 3rd Plenum The 3rd Plenum unveils a blueprint for comprehensive, fundamental reform to drive China’s growth and prosperity in the next two decades. The previously promoted consumption driven model is set to perform in a more balanced economic and social environment. We think the following aspects will have a prolonged impact on the consumer sector: Farmland reform. The government is likely to grant farmers equal rights to their property and encourage urbanization. We think this guidance and its subsequent measures will allow farm land to be traded at market price. Should this reform take place, it will have deep implications for the consumer sector: 1) Farmers could make better profits from trading their land at market price. We expect farmers to upgrade their lifestyle, stimulating consumption of ready-to-drink beverages, dairy products, processed meat and snacks; and more frequent visits to chain restaurants. We expect acceleration of supermarkets replacing wet markets; and development of department stores and electronic products stores in emerging small towns. Consumption of low to mid end branded footwear and apparel is likely to increase. 2) Free trade of land could encourage large scale production of agri-products and facilitate efficiency, cost control and better understanding of supply/demand mechanism. This could help reduce the volatility of agri-prices and make large-scale planting of some niche agri-products easier. Consequently, it would help downstream food and beverage companies to reduce cost pressure and supply crunch. Taxation reform. The government is determined to set up a modern fiscal system that supports initiatives by both central and local authorities. Albeit the detailed measures are unclear at this stage, the market expects taxation reform to encourage well-run companies and discourage loss-making companies. In addition, the market expects to reduce tax payments by low-income individuals. We think this reform will improve overall consumer sentiment and expectation, thus benefiting the consumer discretionary sectors. Agri-supply and pricing offer favourable backdrop Prices of most major agri-products pulled back in 2H13 from 1H13 and 2H12. Most agri- products, including wheat, rice, soybean, sugar, and palm oil, have sufficient inventory, with rising or stable stock-to-use ratios. We expect prices of these major agri-products to drop or at most rise mildly in 2014. This should aid gross margin expansion or at least ease margin pressure on F&B companies in 1H14. One outlier is raw milk powder: globally and domestically prices have risen substantially due to unfavourable weather and lower inventory. We expect global raw milk powder price to continue to rise in 2014. This should benefit upstream dairy farms and dairy companies with integrated value chains. Jessie Guo, PhD +852 3743 8036 jguo@jefferies.com Edwin Fan, CFA +852 3743 8037 efan@jefferies.com Kevin Chee +852 3743 8022 kchee@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 107 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 109. Relaxation of one-child policy From one to two. It was announced on Nov. 15 that China will allow couples to have a second child if either of them comes from a one-child family. Such a policy has been expected by the market for almost a year. The government expects to promote a more balanced development of the population in the long term, and replenish the aging population for a sustainable economic growth. The one-child policy was implemented in the late 1970s, allowing married couples to have only one child. The policy began to be relaxed in late 1990s when 27 provinces allowed two children if both parents are from only-child families. The relaxation was adopted in Hubei, Ganshu and Inner Mongolia province in 2002, and Henan province last adopted it in November 2011. In this round of relaxation, the central government granted provincial governments the rights to come up with a detailed timetable for the implementation of this policy and highlighted that the timing of implementation should not have a large gap between provinces. Impact on newborns. The birth rate in China is decreasing, down from 2.1% in 1990 to 1.4% in 2000 and 1.2% in 2012. Only 16.4m babies were born in 2012. According to a study by the China Academy of Social Sciences, the new policy could add 1mn births, implying an additional 6.3% births. The study indicates that there is very low likelihood of additional newborns exceeding 2mn. There are a number of uncertain factors: 1) As living and education costs rise quickly in cities, some families are reluctant to have more than one child. This, nonetheless, is hard to estimate precisely as the case for families willing to have more than one child. 2) Most families with couples born in the 1980s and/or late 1970s have already fulfilled the two- child condition. This suggests a substantial increase of new-borns is unlikely. 3) It’s hard to predict the timing at which families will have the second child. Implication. We think this policy encourages short-term momentum in the baby care sectors: infant formula, diapers, hygiene products, trolleys, health/medical care, etc. This could potentially cause increased demand for baby formula from overseas, including Hong Kong. High-end raw milk powder price could be pushed up as well. However, we think improvement of business fundamentals can only happen in 2015 by the earliest. Inflation remains low China CPI rose slightly by 0.1ppt mom to 3.2% in Oct, above 2.6% in August. Non-food CPI remained unchanged at 1.6% in Oct; water, electricity & fuel rose by 0.1ppt to 0.6%; and food CPI rose 0.4 ppt to 6.5%. We believe CPI will stay at low single digits by the year end and next year. Inflation will not become a concern in the medium term, in our view. Consumer sentiment is improving All three leading indicators for consumer sentiment have been very volatile since 2011 but the September reading showed strong rebound: 1) The consumer confidence index rose 2.0 to 99.8. 2) The consumer expectation index rose 2.1 to 94.2. 3) The consumer satisfaction index rose 1.9 to 103.5. Retail is likely to recover in 2014 Retail sales growth was range-bound around 13% in June to Oct. 2013 vs. 12.6% in 1H13 but is still lower than 14.3% in 2012. Jewellery delivered the highest growth, at 25% in 2H13, followed by F&B at 14.6%, whereas apparel and footwear growth remained sluggish in the low teens. We think 2013 could be a tough year for retail space and expect a moderate recovery in 2014, driven by 1) Improving macro outlook, 2) Rising consumer sentiment, 3) Implementation of policies announced at the 3rd Plenum. 4) Recovery of the US economy, which could boost exports, hence the Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 108 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 110. confidence and consumption appetite of employees working in a wide array of export- related industries. Sector preference We are positive on F&B sector due to the following reasons: 1) As mentioned earlier, favourable agri-backdrop and lower inflation can improve F&B companies’ margins or at least ease gross profit margin pressure. 2) Potential land reform is set to bring consumption upgrade, which should become the new growth engine of many F&B companies. 3) Hostile competition and heavy promotional activities have abated among leading players. 4) New product development remains active, which, together with stable consumption of existing products, should be able to secure a low- to mid- teens top line growth for the sector. 5) Most F&B companies have strong balance sheets with rich cash. 5) Relaxation of one-child policy should benefit the baby care industry moderately in the medium term. Key catalysts: lower than expected agri-prices, stable macro backdrop, favourable weather. Key risks: higher than expected agri-prices, slow implementation of policies, poor weather; tight competition; food safety issue. We are positive on sportswear. This sector has suffered from a multi-year downcycle. However, we see signals of bottoming-out: 1) Inventory turnover months of sportswear brands had declined to 4-6 months from the peak of 8-9 months in 2011/12. 2) We have seen less aggressive discount promotion in retail stores. We forecast ASP increase of 5% yoy in 14e vs. about 1% or flattish sales growth in 13e. 3) SSSG is likely to improve due to low base and rising ASP. We forecast 7-8% SSSG in 14e (vs. 1% in 13e and -7% in 12). In particular, Anta’s and Li Ning’s revenue growth could reach 8% in 14e. 4) Cotton price is expected to drop 7% yoy to USD0.78/lb in 2014e. This, together with the above-mentioned ASP rise should partly offset rising labour costs. We expect on average 0.3-1ppt GP margin expansion. 5) We expect operating leverage to happen, which could bring 0.8ppt net profit margin expansion for Anta. Li Ning is even likely to turn from a loss to small profits. Key catalysts: Better than expected SSSG and trade fair orders; positive results announcements; further normalization of inventory. Key risks: Softening demand, faster than expected rise of rental and staff costs, competition from international sportswear brands. We are neutral on retail. We believe the improving macro backdrop will benefit the retail environment. We expect it to recover from the trough. However, we think a substantial re-rating of the sector faces a number of challenges: 1) It suffered from over-expansion in the past few years and fierce competition in large cities. The long-expected nation-wide consolidation has yet to appear. SSS growth had declined to single digits for many department operators, and even outperformers can only deliver low-teens growth. We expect on average 1-2ppt SSS growth rise in 2014e. 2) E-commerce has become a serious threat. China’s e-commerce generated sales of USD190-210bn, similar to the scale in US. The fast growth at large scale shapes the transformation of the traditional retail format: retailers who are quick to adopt e- commerce are likely to win; retailers with mass market positioning who are slow to adopt e-commerce are set to lose market share and even lose their first-mover advantage in traditional retail. Key catalysts: Faster than expected M&As; rising consumer sentiment; capacity reduction. Key risks: Irrational fast expansion; tight competition; faster than expected rise of labour and rental costs, poor weather; E-commerce boom. We are neutral on Jewellery. Gold price movement is a major driver of this sector. We do not expect strong top line growth in the wake of bearish gold price outlook. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 109 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 111. 1) We expect gold price to drop to USD1,250/ounce in 14e from USD1,450/ounce in YTD. We believe gold mining industry’s short-covering over the past 10 years, one of the most important fundamental drivers pushing gold price up, has gone. Rising interest rates will dampen investment demand and also implies that central banks are likely to become net sellers of gold. 2) “Gold Rush” in April-June 2013 has front-loaded demand for gold products. We expect 3% SSS decline and 5% revenue growth in 14e for jewellery names. 3) Gross and net profits are set to improve on sales mix normalization. Sales contribution from gold is expected to drop to c60% in 2014e from 70% at its peak during the “Gold Rush”. In contrast, non-gold jewellery’s contribution to revenue will increase from 30% to 40%. This suggests margin expansion, since gold delivers merely 10% gross margin whereas non-gold delivers 40% gross margin. We expect jewellers’ overall gross margin to improve by 1.3-1.6ppt in 14e and net profit margin to improve by 0.1-0.6ppt in 14e due to rising rental and staff costs. Key catalysts: Announcement of Q413 operations in Jan-Feb 2014; M&As; sharp movement of gold price. Key risks: gold price volatility; weak traffic, irrational store expansion. We remain negative on footwear and apparel. Although fundamentals have been weak for a long time, we think this sector is unlikely to make a turnaround in 1H2014: 1) E-commerce becomes a serious challenge to dilute traffic of traditional footwear and apparel brands. Leading companies have not made a success in rolling out their own E- platforms. 2) Inventory remains high. We expect apparel/footwear’s SSSG to remain weak at 0-3%, and overall revenue to grow at 2-6%. 3) Despite the lower cotton price, we expect gross margin to drop by 0.2-0.8ppt in 2014e due to rising labour cost and lower ASP as a result of heavy promotion (20-40% on apparel, 30-60% on footwear). 4) Operating deleverage should persist in 2014e due to staff costs and frequent staff turnover. We expect apparel/footwear to demonstrate 0.3-1ppt net margin decline in 14e, while net profit growth ranges between -5 to +2%. Key catalysts: Poor Q413 operational update in Jan-Feb 20144Q, M&As. Key risks: SSSG recovers earlier than our expectation; faster than expected sector recovery. Sector valuation and stock picks Staples trade at 23x 14e PE, vs. historical median of 24x. Retailers trade at 14x 14e PE vs. historical median of 17x; whereas apparels trade at 14x 14e PE, vs. historical median of 18-20x. Staples underperformed HSCEI by 3% in the past one month, while retailers underperformed by 7% and apparels underperformed by 6%. Top Picks: CRE (291 HK), Huishan (6863 HK), Intime (1833 HK), Anta (2020 HK). Top Sells: Belle (1880 HK). Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 110 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 112. Exhibit 187: Coverage summary Source: Jefferies Coverage Tickers Market cap Valuation (USDm) (HKD) method Staples CRE 291 HK 8,570 Buy 32.5 SOTP Huishan 6863 HK 5,724 Buy 3.5 SOTP Tingyi 322 HK 16,492 Hold 20.5 Blended DCF/ PE Mengniu 2319 HK 8,309 Hold 27.1 Blended DCF/ PE Biostime 1112 HK 5,314 Hold 60.0 23x forward PE CMD (a) 1117 HK 2,617 Hold 2.6 Blended DCF/ PE China Foods 506 HK 1,238 Hold 5.3 SOTP Want Want 151 HK 18,865 Unpf 9.0 Blended DCF/ PE Tsingtao (H) 168 HK 10,888 Unpf 55.6 Blended DCF/ PE Tsingtao (A) 600600 CH 10,888 Unpf RMB39.4 Blended DCF/ PE Department stores and cosmetics Intime 1833 HK 2,326 Buy 10.5 17x forward PE Springland 1700 HK 1,351 Buy 5.0 13x forward PE Parkson 3368 HK 992 Hold 4.4 11.5x forward PE Golden Eagle 3308 HK 2,778 Hold 12.0 15x forward PE Lifestyle 1212 HK 3,514 Hold 18.0 15x forward PE L'Occitane 973 HK 3,322 Hold 24.2 24x forward PE Jewellery and watch retailers Chow Tai Fook 1929 HK 16,510 Buy 14.0 18x forward PE Chow Sang Sang 116 HK 2,244 Hold 21.0 11x forward PE Hengdeli 3389 HK 1,208 Hold 1.7 10x forward PE Luk Fook 590 HK 2,276 Unpf 21.1 7.5x forward PE Footwear and sportswear Anta 2020 HK 3,457 Buy 13.3 Blended DCF/ PE Li Ning 2331 HK 1,165 Hold 4.7 DCF Daphne 210 HK 721 Hold 3.2 10.5x forward PE Belle 1880 HK 10,705 Unpf 8.2 13x forward PE Apparel Giordano 709 HK 1,469 Buy 8.5 DCF Li Lang 1234 HK 787 Hold 4.2 8x forward PE Trinity 891 HK 654 Hold 2.8 13x forward PE Rating PT Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 111 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 113. 2014 China Energy We All Want to Change the World Key takeaways We believe three themes will drive energy equities in 2014, 1) market pricing, 2) SOE restructuring and 3) environmental regulations. None of these themes are new, but Third Plenum reforms will provide the political cover and administrative structure to cut through inertia and vested interests, in our view. On these themes, we reiterate Buy recommendation for PetroChina and Sinopec and Underperform ratings on coal stocks. Market pricing The initial Third Plenum communiqué stated that the markets will play a "decisive" role in allocating resources. The previous language was that markets would play a "basic" role. We believe this formulation has profound implications for China's energy industry, where regulated prices have been the norm. Details in the 60 point follow-up document specifically called for market pricing of petroleum, natural gas, water, electricity, transportation and telecommunications. SOE restructuring The initial Third Plenum communiqué reiterated the central role of SOEs in China's economy, giving fodder to the reform pessimists. The 60 point follow-up document, however, has changed the mandate of SOEs from being levers of central planning to value maximizers of state assets, a profound change, in our view. Environmental regulations The key environmental regulatory concept contained in Third Plenum reforms is that negative externalities of resource consumption must be priced and borne by consumers. Resource taxes, emission trading and stricter emissions standards are mechanisms that can reduce environmental damage. Invigorated environmental regulations will negatively affect the economics of highly polluting resources, with limited scope for emissions reduction and significant substitution potential by alternatives. That means coal, in our view. Sinopec, Buy, refining losses are history We believe refining losses are history. With China importing ~60% of its oil consumption, decisive market pricing of petroleum is a necessity. Subsidizing fuel prices at the expense of energy security (and the environment), is a losing strategy. Impending GuoIV fuel standards and required long-term refinery expansions should support future refining margins, in our view. PetroChina, Buy, the poster boy of SOE reform We believe PetroChina will be the poster boy of SOE reform. The unprecedented corruption purge of senior management is not just an investigation into PetroChina, in our view, but a maneuver against entrenched SOE interests. We believe PetroChina may become a "pilot project" for SOE reform with experiments in "mixed ownership" structures and SOE-private sector partnerships — all geared towards optimizing efficiency, improving management, reducing corruption and maximizing value. With natural gas prices being reformed, we believe eliminating the inefficiencies and leakages plaguing the company will have a renewed urgency. Coal, Underperform, restricting the dirtiest resource The Kuznets curve hypothesis stipulates that while rapidly developing economies will see pollution increase with per capital income, at some point, emissions trends reverse as growing wealth leads to environmental awareness. China consumes coal because it is not rich enough to choose cleaner alternatives. This is changing. Third Plenum reforms demonstrate societal demand for cleaner air. We believe additional costs and restrictions to coal consumption will limit demand and prices You say you want a revolution Well, you know We all want to change the world —The Beatles Laban Yu +852 3743 8047 jguo@jefferies.com Jack Lu +852 3743 8020 efan@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 112 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 114. Sinopec: Roll With the Changes Refining margins have been strong after tweaks to the fuel pricing mechanism earlier this year. Impending GuoIV fuel standards and required long-term refinery expansions should support future refining margins, in our view. Concerns remain, but we believe the refining sector has turned a corner as environmental and economic rationality trump energy subsidies. Higher refining margins China tweaked its fuel pricing mechanism earlier this year. We had doubts that smaller, more frequent price adjustments would lead to higher margins. But based on our calculations, we found that Sinopec GRMs (gross refining margins) was ~US$4/bbl Jan- Apr, before the new fuel pricing mechanism, and ~US$6/bbl after. We believe the NDRC is not only adjusting fuel prices more often but has also been taking into account lower inflation, regional crack spreads and marginal producers when setting fuel prices. Exhibit 188: Sinopec gasoline, diesel and crude throughput prices (US$/bbl) Source: Sinopec, Jefferies Exhibit 189: Sinopec gasoline, diesel and crude throughput prices (US$/mmBtu) Source: Sinopec, Jefferies Exhibit 190: Estimated Sinopec GRM Source: Sinopec, Jefferies $60 $70 $80 $90 $100 $110 $120 $130 $140 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 US$/bbl Diesel Gasoline Crude oil 10.00 12.50 15.00 17.50 20.00 22.50 25.00 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 US$/mmBtu Diesel Gasoline Crude oil -15 -10 -5 0 5 10 15 20 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 US$/bbl Sinopec GRM 1 month forward Sinopec GRM 60 per. Mov. Avg. (Sinopec GRM) So, if you're tired of the same old story, oh, turn some pages I will be here when you are ready to roll with the changes – REO Speedwagon Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 113 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 115. Air quality trumps subsidies We believe subsidizing energy at the expense of the environment and energy security is a long-term losing strategy. Implementation of EuroIV (renamed GuoIV in China) fuel has been delayed for 3 years as regulators and operators bicker over financing. Meanwhile China's air has become ever more intolerable. The NDRC's subsequent pricing guidance for GuoIV (gasoline/diesel price increases of Rmb290/370 per ton) results in an estimated ~US$3.85/bbl increase to GRM when fully implemented, according to our calculations. Management believes costs will only increase marginally as much of the capex has already been spent. We believe risks to refining margins are to the upside. Euro IV finally After a delay of +3 years, China has finally committed to implementing Euro IV fuel standards in 2014 (Jan 1 for gasoline, yearend for diesel). From Euro III, Euro IV is the next generation of vehicle emissions standards, implementing advanced vehicle fuel and emissions management systems. The technical gist Emissions control systems on the vehicle removes nitrous oxides (NOx), carbon monoxide (CO) and unburned hydrocarbons (HC) using computerized fuel injection, exhaust gas recirculation and, most importantly, a three-way catalytic converter (removes NOx, CO and HC). A catalytic converter cannot function correctly if the sulphur dioxide (SO2) content of emissions exceeds its design parameters. The more advanced the catalytic converter, the lower SO2 levels it can tolerate in the exhaust. Exhibit 191: China and EU diesel sulphur levels Source: European Commission, DieselNet, Jefferies Exhibit 192: China and EU gasoline sulphur levels Source: European Commission, DieselNet, Jefferies - 250 500 750 1,000 1,250 1,500 1,750 2,000 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 ppm Euro I, 2000 ppm Euro II, 500 ppm Euro III, 350 ppm Euro IV, 50 ppm Euro V, 10 ppm ChinaEU - 250 500 750 1,000 1,250 1,500 1,750 2,000 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 ppm Euro I, 2000 ppm Euro II, 500 ppm Euro III, 150 ppm Euro IV, 50 ppm Euro V, 10 ppm ChinaEU Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 114 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 116. Target price Exhibit 193: Sinopec target price derivation Source: Sinopec, Jefferies Upstream and debt Refining & Margeting DACF 2014E (Rmb m) 104,785 Refining EBIT (2014E) 21,930 x Target multiple 4.75 Marketing EBIT (2014E) 46,068 EV (Rmb m) 497,730 Sum 67,998 Minus net debt (YE13) (306,434) Less income tax (17,000) Less ARO and other (21,591) Earnings 50,999 Market cap (Rmb m) 169,705 x Target multiple 10.00 ÷ Exchange rate (Rmb/HK$) 0.79 Market cap (Rmb m) 509,988 Target market cap (HK$m) 215,963 ÷ Exchange rate (Rmb/HK$) 0.79 ÷ Shares outstanding 122,111 Target market cap (HK$m) 648,999 Upstream price (HK$/share) 1.77 ÷ Shares outstanding 122,111 Share price (HK$/share) 5.31 Chemicals EBIT (2014E) 4,507 Target price (HK$/share) 7.29 Less income tax (1,127) Rounded to HK$0.10 7.30 Earnings 3,380 Latest price 6.38 x Target multiple 10.00 Upside 14.4% Market cap (Rmb m) 33,800 ÷ Exchange rate (Rmb/HK$) 0.79 A-share target (RMB/share) 5.73 Target market cap (HK$m) 43,013 Rounded to RMB0.10 5.70 ÷ Shares outstanding 122,111 Latest price 4.76 Share price (HK$/share) 0.35 Upside 19.7% Other EBIT (2014E) (2,657) Less income tax 664 Earnings (1,993) x Target multiple 7.00 Market cap (Rmb m) (13,948) ÷ Exchange rate (Rmb/HK$) 0.79 Target market cap (HK$m) (17,750) ÷ Shares outstanding 122,111 Share price (HK$/share) (0.15) Sinopec-A and H Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 115 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 117. PetroChina: Run Through the Jungle We have entered the jungle (PetroChina's 20F's), machete in hand, to clear away overgrowth. We believe that PetroChina's disclosures are insufficient. We cannot explain billions of dollars of revenue shortfalls/losses. Hopefully, a reformed PetroChina can. To be sure, PetroChina is not an Enron, whose business model was fraudulent. In our view, PetroChina has superb assets which have, unfortunately, sprung all kinds of leaks. Page 1, not 216 In our 2011 initiation, we wrote, " We believe PetroChina’s disclosures are insufficient and modelling can be difficult. ‘Other’ revenues and costs exist throughout business segments. This is perhaps a necessity for large state-owned giants which need accounting flexibility to satisfy various constituents." We regret putting this on page 216 and giving a mealy- mouthed excuse for poor disclosures. An SOE needing to satisfy many constituents is perfectly acceptable; poor disclosures are not, in our view. Exhibit 194: PetroChina E&P segment shortfall Source: PetroChina, Jefferies Exhibit 195: Sinopec E&P segment shortfall Source: Sinopec, Jefferies Volumes x Price = Revenue... NOT! As a matter of principle, energy/commodity producers should never violate Volumes x Price = Revenue. Unfortunately, not only have PetroChina's upstream revenues (FAS69) fallen far short of Volumes x Price, the company neglected to disclose wellhead natural gas prices prior to 2010. To illustrate, according to FAS69, PetroChina's upstream revenues declined in 2012 despite increasing volumes, flat oil, and higher gas prices. We calculated a revenue shortfall of Rmb63B (US$10B) in 2012. Other businesses always lose money? Using the FAS69 "clean" upstream P&L disclosure, we can back out an implied P&L for the non-upstream businesses embedded in the E&P segment. These "businesses" have always lost money. Not just a little money, Rmb25B in 2012 and Rmb48B in 2011 (US$4B and US$7B). What are these businesses? Why do they always lose money? The opposite of a "house of cards" We urge caution to short sellers itching to have a go at PetroChina as corruption investigations expose the company to years of headline risk. What we have unearthed, we believe, is not a "house of cards" with fraudulent profits; quite the opposite, we believe PetroChina has superb assets which, unsurprisingly, have attracted many unhelpful "constituents". Corruption investigations sweep away "house of cards" enterprises, but strengthen companies whose quality assets are beleaguered by graft. A past mistake, compounded We believe PetroChina was created by mistake. In the mid-1990's, PetroChina was given the bulk of China's upstream assets while Sinopec got the good refiners. This was considered an equitable split when oil prices were below US$20/bbl. Nobody could have foreseen the oil price surge that sent cash gushing through PetroChina's E&P 4% 6% 8% 10% 12% 14% 0 20,000 40,000 60,000 80,000 100,000 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Rmb m Revenue discrepency (LHS) Implied losses from other operations (LHS) Percent of segment revenue (RHS) -2% 0% 2% 4% 6% 8% 10% 12% 14% (5,000) (2,500) - 2,500 5,000 7,500 10,000 12,500 15,000 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Rmb m Revenue discrepency (LHS) Implied losses from other operations (LHS) Percent of segment revenue (RHS) Whoa, thought it was a nightmare, low, it's all so true They told me, don't go walkin' slow, the devil's on the loose Better run through the jungle Better run through the jungle Better run through the jungle, don't look back to see – Creedence Clearwater Revival Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 116 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 118. segment — a gusher that we believe has sprung substantial leaks. See You're my Favorite Mistake. Not an auditing problem… a disclosure problem We believe the leakages and shortfalls that we have been highlighted are a disclosure problem rather than an auditing problem. Auditors, rightfully, are on guard for exaggerated earnings – over reporting revenues or under reporting costs. PetroChina, we believe has done the opposite. Revenues come in lower than expected and extra costs seem to arbitrarily appear in the E&P segment. PetroChina is in no way exaggerating its earnings. What it is doing, at least from our vantage point, is obfuscating where revenues come from and where costs go. We have repeatedly brought this up with management without much satisfaction. We have again pressed our case with management and have been told that our inquiry has been transferred to the related departments in Beijing who will give us a reply at the earliest convenience. Assets galore We believe PetroChina is alone among the Big 3 oil and gas companies with quality upstream assets (It's You I'm Fighting For). PetroChina's E&P segment is a cashflow gusher which has unsurprisingly attracted many unhelpful "constituents”. We calculate that an unencumbered E&P segment generated over US$20B in free cashflow in 2012, vs. US$11B after leakages from revenue shortfalls and losses from other "businesses". Get free stuff According to the FAS69 disclosure, PetroChina's proved reserves were worth US$274B at YE12 (~HK$8.24/share less YE14 debt). Shareholders are getting probable/possible reserves, pipelines, gas price reform, refiners and chemical plants, more or less, for free. The Petroleum Faction The South China Morning Post reported that China's top leaders have agreed to investigate Zhou Yongkang. In this corruption sweep, where neither "tiger" nor "fly" are safe, we believe Mr. Zhou is THE tiger in the cross-hairs; rounding up associates is standard police procedural. Mr. Zhou was the chairman of CNPC in the late ‘90s and a member of the last Politburo Standing Committee. According to the SCMP, Zhou Yongkang is being investigated because of the immense wealth his family accumulated through oil and real estate. Riding a wave of oil money Mr. Zhou was officially the lowest ranking member of the recently retired Politburo Standing Committee. Nevertheless, Mr. Zhou built a substantial power base as his portfolio included the entire domestic security apparatus, the budget of which he expanded to exceed that of the military. The Wall Street Journal has written extensively on China’s petroleum and internal security political faction controlled by Mr. Zhou and funded by the oil industry. This has been an open secret for years. US diplomatic cables published by Wikileaks claimed that it was well known that Zhou Yongkang controlled China’s oil and gas sector. We believe the discrepancies and shortfalls in PetroChina’s accounts and the corruption investigations could be related to the political patronage networks that Mr. Zhou needed to fund. Backing the wrong horse According to press reports, Mr. Zhou was Bo Xilai's champion and was politically weakened by Bo's downfall. Mr. Bo, for those behind on China political intrigue, is the former Chongqing party boss just tried for accepting bribes and abusing power. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 117 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 119. Mr. Zhou’s position on the Standing Committee was the seat for which Bo Xilai was actively and publicly campaigning. This, reportedly, had nobody’s support on the Standing committee… apart from Zhou Yongkang himself. As reported in the press, many in the Party believed the security apparatus built up by Mr. Zhou was too powerful and a potential threat to the state. They were not going to let Mr. Zhou pass it off to his chosen successor, Bo Xilai. After Zhou Yongkang’s retirement, the security apparatus portfolio has been demoted from direct supervision by a Politburo Standing Committee member, in effect taking the controls away from any one person. Where do we go from here? We have in mind two precedents: Sinopec and the Ministry of Railways. Sinopec – Bring in THE CLEANER! In 2007, Sinopec’s chairman, Chen Tonghai, was arrested for corruption. In 2009, he was officially convicted of taking US$29m in bribes. Chen Tonghai’s “dissolute” private life was laid bare by the press in a lurid mistress scandal that riveted China. His replacement, Su Shulin, a hardnosed Party operative, was parachuted in from CNPC to “restore party discipline.” Su Shulin was brought in as "the cleaner". Mr. Su has a reputation for low key technocratic formality – long on party procedures and discipline, short on color and public personality. Mr. Shu left Sinopec in 2011 to become the governor of Fujian Province. Under his watch, shortfalls from Sinopec’s E&P segment were substantially curtailed. Ministry of Railways – DRAW-AND QUARTER them! Under the leadership Railway Minister Liu Zhijin, China built the world’s longest high speed rail network in about 5 years’ time. In our opinion, this was an epic accomplishment that drew on the remarkable talents of Mr. Liu. Unfortunately, as is so often the case, remarkable talents are bedeviled by similarly grand appetites, showboating and corner-cutting. In 2013, Mr. Liu was arrested on corruption charges. He was convicted in July, receiving a suspended death sentence (which is, in essence, life imprisonment). Shortly before the arrest of Mr. Liu, China dissolved the Ministry of Railways, splitting its functions into three separately managed entities. PetroChina – The poster-boy of SOE reform One way or another, we believe PetroChina will be made the poster-boy of SOE reform. The company usually has either the first or second highest market capitalization in China (currently second to ICBC), firmly in the global top 10. If SOE reform is a theme of the new leadership, what better example can there be than PetroChina? We do not believe business can possibly go on as usual with five executives under investigation, including a former chairman. Reuters has reported that insiders likened the corruption investigations to a volcanic eruption. If China's leadership were to decide that the roots of corruption can be traced to PetroChina's scale, the company could go the way of the Ministry of Railways. We believe both a cleaner-scrubbed and a broken-up PetroChina could release value currently encumbered by the leakages and discrepancies we have found. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 118 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 120. Our Meeting with Management We met PetroChina in Beijing recently to discuss what we believe were discrepancies in company disclosures. Management indicated interest in our reports from investors as well as independent board members. The 90-minute meeting was attended by 3 people from the finance department and 4 from the Secretariat of the Board. We came away with some confidence that future disclosures will improve but remain unsatisfied with explanations for the revenue shortfall. With all due respect Management began by assuring us that the discrepancies we found are not possible given multiple layers of internal controls and independent audits. With all due respect to them, in light of other public auditing failures, the failure of bond rating agencies and investigations of PetroChina executives for "serious violations of discipline", we can take nothing for granted. As we all know, equity research is prone to conflicts (see disclosures), but when done right, we believe it can and should be an important oversight mechanism in equity markets. We believe PetroChina is currently under an immense amount of scrutiny. Improving disclosures can only dispel suspicions if none are warranted. The problem with reported volumes Management took issue with our revenue calculations by pointing out that there is a difference between production and sales volumes. Management attributed this difference to: 1) inventory build, 2) internal use for oil and gas production and 3) natural losses. Combined, management indicated that the three factors resulted in sales lagging production volumes by ~5-10%. The problem with reported prices Management took issue with our revenue calculations by pointing out that the reported realized prices and the realized prices used in the Results of Oil and Gas Producing Activities disclosures are different. Evidently, reported realized prices is a weighted average of segment sales prices which includes imported volumes, not just self- produced volumes. Other losses explained? Management assured us that losses from other businesses embedded in the E&P segment are minimal if we had used the correct volumes and prices to calculated revenues. We believe we should be given the correct volumes and prices to calculate revenue. Our thoughts 1) PetroChina does not report sales volumes. In our opinion, it should. 2) Some oil and gas companies are able to report volumes and prices by region as well as by product type (crude oil, NGL, SCO and bitumen). We believe PetroChina should be able to separate realized prices between self-produced oil and imports. 3) Production and sales volumes more or less match for US listed E&Ps, differing (when they do) by small additions and subtractions to and from inventory. 4) US listed E&Ps report production numbers net of internal use and natural losses. The accounting literature is ambiguous on the correct treatment (which has esoteric implications for reported reserves) but we find gross production numbers unappealing in principle. 5) The ~5-10% appears to underestimate volume discrepancies. To match Results of Oil and Gas Producing Activities, sales volumes fall short of production by 0-11% (~36% of EBIT in 2012). We believe earning impactful swings in volumes should be reported. The "we don't understand" principle Regarding company disclosures, as always, if we don't understand, we will ask management and hope our questions are addressed. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 119 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 121. The Restless Pull of the Price You Pay Higher-than-expected upstream price increases According to the NDRC's natural gas price reform announcement, non-residential consumers of domestically produced and pipeline imported natural gas can expect to pay an average of Rmb0.26/cm under the two-tiered pricing mechanism. Including residential users, the price increase comes out to be ~Rmb0.21/cm. Somehow, ENN's is being charged a price hike of Rmb0.49/cm. Because ENN volumes are growing ~24% per annum vs. the 10% used to calculate the ~Rmb0.21/cm increase, it should be exposed to a larger proportion of more expensive incremental gas. Even so, we calculate that ENN's price hike should have been Rmb0.28/cm. Perhaps ENN is sourcing much of its gas from LNG imports which, in theory, is now fully market priced. PetroChina reported 3Q13 upstream realized natural gas prices US$6.35/mcf (vs. US$5.07/mcf in 1H13). This is equivalent to an Rmb0.275/cm price increase, above the NDRC estimate of Rmb0.26/cm. Energy substitution (and markets) work We have always had conviction that natural gas price increases can easily be absorbed by the market because of substitution demand. Many investors have a hard time wrapping their head around the seemingly counter-intuitive idea that higher natural gas prices lead to higher demand in China. We have addressed this issue extensively in the report I See Skies of Blue. Econ 101 Below, we have diagrammed what higher natural gas prices leading to higher volumes in a rationed market looks like. Exhibit 196: Natural gas supply and demand in China with price controls Source: CNOOC, Jefferies Driving on through the night, unable to break away From the restless pull of the price you pay — Bruce Springsteen Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 120 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 122. Target price Exhibit 197: PetroChina SOTP target price derivation Source: PetroChina, Jefferies Upstream and debt Refining & chemicals DACF 2014E (Rmb m) 340,359 EBIT (2014E) 7,215 x Target multiple 7.50 Less income tax (1,515) EV (Rmb m) 2,552,691 Earnings 5,700 Minus net debt (YE14) (484,166) x Target multiple 10.00 Market cap (Rmb m) 2,068,526 Market cap (Rmb m) 72,155 ÷ Exchange rate (Rmb/HK$) 0.79 ÷ Exchange rate (Rmb/HK$) 0.79 Target market cap (HK$m) 2,622,836 Target market cap (HK$m) 91,490 ÷ Shares outstanding 183,021 ÷ Shares outstanding 183,021 Upstream price (HK$/share) 14.33 Share price (HK$/share) 0.50 Pipeline Other EBIT ex-import losses (2014E) 50,334 EBIT (2014E) (10,932) Less income tax (11,074) Less income tax 2,296 Earnings 39,261 Earnings (8,637) x Target multiple 14.00 x Target multiple 10.00 Market cap (Rmb m) 549,651 Market cap (Rmb m) (86,365) ÷ Exchange rate (Rmb/HK$) 0.79 ÷ Exchange rate (Rmb/HK$) 0.79 Target market cap (HK$m) 696,943 Target market cap (HK$m) (109,509) ÷ Shares outstanding 183,021 ÷ Shares outstanding 183,021 Share price (HK$/share) 3.81 Share price (HK$/share) (0.60) Import losses Unencumbered value 18.52 EBIT (2014E) (20,807) Tax savings 5,202 Leakage Earnings (15,605) Missing revenue (27,869) x Target multiple 1.50 Other cash losses (28,478) Market cap (Rmb m) (23,408) Total (56,347) ÷ Exchange rate (Rmb/HK$) 0.79 x Target multiple 7.50 Target market cap (HK$m) (29,681) EV (Rmb m) (422,601) ÷ Shares outstanding 183,021 ÷ Exchange rate (Rmb/HK$) 0.79 Share price (HK$/share) (0.16) Target market cap (HK$m) (535,848) ÷ Shares outstanding 183,021 Marketing Upstream price (HK$/share) (2.93) EBIT (2013E) 16,715 Less income tax (3,510) Investigation discount, H-share Earnings 13,205 Unencumbered value 18.52 x Target multiple 7.00 x Discount factor -20% Market cap (Rmb m) 92,434 Investigation discount (HK$/sh) (3.70) ÷ Exchange rate (Rmb/HK$) 0.79 Target market cap (HK$m) 117,204 Target price ÷ Shares outstanding 183,021 Target price (HK$/share) 11.89 Share price (HK$/share) 0.64 Rounded to HK$0.25/share 12.00 Latest price 8.69 Upside 38% Investigation discount, A-share Unencumbered value (Rmb/sh) 14.60 x Discount factor -10% Investigation discount (Rmb/sh) (1.46) Target price (Rmb/share) 10.84 Rounded to Rmb0.10/share 10.80 Latest price 8.12 Upside 33% PetroChina A and H Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 121 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 123. Coal: Everything Dies, Honey, That's a Fact We spent one week October visiting coal experts, company management and mines in China. The trip strengthened our conviction that coal prices will fall, that substantial amounts of low cost coal will be debottlenecked and that the recent bounce is temporary. We believe the summer price collapse was due to forced dumping of lignite coal (which is volatile in hot weather). Recent price recovery is restocking rather than actual demand and will be ephemeral, in our view. A mystery... solved? All summer long, we scratched our little heads, wondering why coal prices kept plummeting despite hot weather, economic stimulus and weak coal production. We came up with some possible explanations — increased coal quality, increased power plant efficiency, under-reported production, de-stocking of unseen inventory. Coal experts confirmed that all of the explanations have some merit but the key was a forced sell-off of lignite inventories in Inner Mongolia. Lignite coal is chemically volatile and prone to spontaneous combustion in hot weather, forcing inventory de-stocking in the summer. A coal price anamoly A coal price anomaly suggests that the current rally will be short lived. The coal quality premium has been shrinking as prices bounced. On a per kcal basis, the 5,000 kcal blend is now more expensive than the 5,500 kcal blend. This is not normal as lower quality coal incurs greater costs. We believe lignite blends are being restocked after a forced inventory dump this summer. The rally will end when inventories normalize, in our view. Paying more for inferior coal? At the present moment, on a per kcal basis, the 5,000 kcal blend is now more expensive than the 5,500 kcal blend at Qinhuangdao. This should not be the case as lower quality coal incurs more costs (e.g., transportation, processing, emissions etc.) per kcal. Over the past 5 years, the 5,000 kcal blend and the 4,500 kcal blend has traded at an average discount of 5.6% and 11.5%, respectively, versus the benchmark 5,500 kcal blend. Now the 5,000 kcal blend is trading on a 1.1% premium to the benchmark and the 4,500 kcal discount has collapsed to 3.1%. Exhibit 198: Premium/discount versus 5,500 kcal blend Source: SXCoal, Jefferies -30% -25% -20% -15% -10% -5% 0% 5% 10% 15% 20% Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Rmb/kcal Premium blend 5800kcal Premium blend 5500kcal Blend 5000kcal Ordinary blend 4500kcal Well, I got a job and tried to put my money away But I got debts that no honest man can pay So I drew what I had from the central trust And I bought us two tickets on that coast city bus Now, baby, everything dies, honey, that's a fact... – Bruce Springsteen Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 122 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 124. A restocking rally We believe lignite blends are being restocked after a forced inventory dump this summer. We believe (and we are theorizing here) that many power plants are designed to burn lower quality coal forcing them to rebuild inventories. We believe the coal price rally will reverse when inventory levels normalize. Exhibit 199: QHD benchmark prices Source: SXCoal, Jefferies Exhibit 200: QHD benchmark prices, Rmb/kcal Source: SXCoal, Jefferies I've been working on the railroad Late 2013, Shenhua will commission two rail lines — Bazhun (200 mtpa, linking the Shaanxi/Inner Mongolia to the Daqing railway and eventually to QHD port) and Zhunchi (200mtpa, linking Inner Mongolia to Shanxi and eventually to the Huanghua port). In 2014, the Second Lanxin railroad will be completed (300 mtpa, linking Xinjiang coal mines to Chongqing). Late 2014, the Zhongnan rail line will be completed (200 mtpa, linking southern Shanxi to Shandong's Rizhao port). In 2017, Mengxi- Huazhong railroad will be completed (200 mtpa, a north-south line linking Inner Mongolia to Jiangxi Province). We believe these projects will unleash substantial volumes of low cost coal in the short, medium and long term. We re-iterate our Underperform rating on Shenhua Energy, China Coal and Yanzhou Coal. Well below consensus in 2014 Coal prices are trending very close to our full year 2013 estimate. We believe benchmark 2014 QHD coal prices will be 7% lower YoY. Our 2014 earnings estimate for Shenhua, China Coal and Yanzhou Coal are 27%, 22% and 42% below consensus, which appears to believe coal prices will recover appreciably from present levels. Nothing to see here. Look to IPPs instead We do not believe it is time to bottom fish in coal equities (we would only do that when companies reach their leverage limits). The IPP sector will be the long-term beneficiary of a declining coal sector, in our view. 350 400 450 500 550 600 650 700 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Rmb/ton Premium blend 5800kcal Premium blend 5500kcal Blend 5000kcal Ordinary blend 4500kcal 0.080 0.085 0.090 0.095 0.100 0.105 0.110 0.115 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Rmb/kcal Premium blend 5800kcal Premium blend 5500kcal Blend 5000kcal Ordinary blend 4500kcal Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 123 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 125. 2014 China Financials China Banks: Reform to Drive Re-Rating Key Takeaway The full Third Plenum report promises fundamental changes that we expect to drive a re-rating of the H-share banks. Plans include KPI changes that factor indebtedness & excess capacity that should result in behavioural changes of local govt officials, and measures to improve local govt finances and their transparency. Better growth is in store, with rural reform driving consumption/urbanization & less govt interference boosting private/foreign investments, in our view. We prefer big & low P/B banks, top pick BOC. Big positives – Stronger local govt finances, greater transparency, faster urbanization & better growth: We believe investors are most concerned about the Chinese banks’ asset quality, which impedes the sector’s re-rating. In this regard, we are pleased to find the full Third Plenum report contain several positive details, including (1) higher KPI weighting of factors that include excess capacity and new debt in appraising govt performance; (2) greater transfers from central govt to reduce local govt fiscal expenditures; (3) property & consumption tax to increase the recurring income of local govt; (4) building a transparent budget system that consolidates liabilities on accrual basis; (5) building a debt mgmt and risk warning mechanism; (6) allowing local govt to issue bonds to finance urbanization; and (7) linking fiscal transfers from the central govt to urbanization. Delivering on these plans will reduce the mismatch between central and local govt finances and its opacity, and more importantly, drive behavioural changes in local govt officials that should resolve local govt debt and excess capacity overhangs, in our view. To drive better-quality growth, positive details in the full Third Plenum report include: (1) rural reform to give farmers more land rights to share, profit from, sell, or collateralize collective assets; (2) scrapping Hukou restrictions in small cities (with full integration into urban housing and social security systems) and gradually relaxing it in mid-sized cities; (3) removal of govt approvals in non-strategic areas to encourage private investments; and (4) easing restrictions on foreign access to some service industries. We believe these plans will improve labour mobility, increase consumption and boost market-driven investments. Small negatives – Greater competition, tighter liquidity & regulation: With interest rate (IR) deregulation and more private entrants (especially Internet firms) in the banking industry, competition is likely to heighten, albeit first at the expense of underground banking, which serves the under-penetrated segments traditionally ignored by the banking system; banks that are able to quickly replace BR- loans to SOEs with BR+ loans to smaller borrowers should benefit too and mitigate the NIM pressure from IR deregulation, in our view. To keep China’s overall debt levels and inflation under control, PBOC is likely to maintain a relatively tight monetary stance, though this usually translates into higher NIM for the banks as their loan pricing power increases, assuming a crunch does not ensue that leads to asset quality stress. However, the smaller banks may be susceptible to interbank regulation given the rapid growth in high-risk assets, like trust beneficiary rights (TBR), on their balance sheets. Stay positive given compelling risk-reward – Prefer big and low P/B banks, top pick BOC: Our base-case PT-implied 2014E P/B of 1.04x implies 19% upside and 24% total return (TR), and risk-reward looks compelling with our bull-case PT implying 39% TR and our bear-case PT still delivering 8% TR. We prefer the big banks given smaller banks’ susceptibility to potential interbank regulation, though low P/B banks like CNCB (998 HK, Buy) and CQRCB (3618 HK, Buy) have enough safety margins, in our view. Our top pick is BOC (3988 HK, Buy) as we believe the bank will benefit from greater RMB internationalization, and is less susceptible to RMB-IR deregulation as it has the highest proportion of non-interest income & overseas assets, which may also benefit from potentially stronger USD & higher Fed rates. Ming Tan, CFA +852 3743 8752 mtan@jefferies.com Baron Nie, CFA, AIAA +852 3743 8747 Baron.nie@jefferies.com Jaclyn Wang +852 3743 8746 jwang@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 124 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 126. Revisiting Valuation Re-Rating Re-rating to be driven by greater confidence in the “B” and “E” in P/B and P/E metrics: The H-share banks are trading at “optically” low 2014E P/B and P/E of 0.87x and 5.0x (vs. Asia’s 1.23x and 10.0x), respectively, despite 2014E ROE of 18.7% (Asia 13.8%) and profit growth of 11.8% (Asia 9.4%) due to the significant lack of confidence in China’s asset quality, which potentially threatens book value (via write- offs) and earnings (via provisioning). Thus, we believe asset quality concern is a bigger overhang than IR deregulation. With the execution of tasks laid out in the Third Plenum likely to improve investors’ confidence in the Chinese banks’ asset quality, the probability of re-rating is high, in our view. Our base-case PT-implied 2014E P/B of 1.04x implies 19% upside and 24% total return (TR). Exhibit 201: Risk-reward looks compelling with our bull-case PT implying 39% TR and our bear-case PT still delivering 8% TR Source: Bloomberg, Jefferies estimates VALUATION MATRIX BASE Risk- 50% 50% PT 19-Nov-13 Upside/ 2013E Expected JEF 3M ADT Ticker RF Beta ERP loading COE DDM Fair P/B (LC) Bear Bull 2013E 2014E Price (LC) (Downside) Yield TR Rating LC mn 1398 ICBC-H 4.0% 1.26 6.0% 1.0% 12.5% 5.00 8.67 6.80 5.90 7.70 1.46x 1.27x 5.55 22.5% 6.0% 28.5% BUY 1,284 939 CCB-H 4.0% 1.18 6.0% 1.5% 12.5% 5.99 9.82 7.90 6.90 8.90 1.43x 1.25x 6.24 26.6% 6.0% 32.6% BUY 1,676 1288 ABC-H 4.0% 1.48 6.0% 0.5% 13.4% 3.68 5.62 4.70 4.20 5.10 1.39x 1.22x 3.97 18.4% 5.7% 24.1% BUY 459 3988 BOC-H 3.6% 1.15 6.0% 2.5% 13.0% 3.67 6.09 4.90 4.30 5.50 1.15x 1.02x 3.70 32.4% 6.6% 39.0% BUY 1,068 3328 BCOM-H 4.0% 1.40 6.0% 2.0% 14.3% 4.76 8.29 6.50 5.60 7.40 0.89x 0.80x 5.75 13.0% 5.6% 18.6% HOLD 153 3968 CMB-H 3.9% 1.56 6.0% 1.5% 14.7% 14.65 20.83 17.70 16.20 19.30 1.31x 1.13x 17.08 3.6% 4.4% 8.1% BUY 361 998 CNCB-H 3.9% 1.32 6.0% 2.5% 14.3% 3.04 7.29 5.20 4.10 6.20 0.86x 0.75x 4.51 15.3% 3.9% 19.2% BUY 169 1988 MSB-H 4.0% 1.30 6.0% 3.5% 15.3% 8.48 15.34 11.90 10.20 13.60 1.32x 1.07x 9.44 26.1% 4.2% 30.2% BUY 563 3618 CQRCB 4.0% 1.68 6.0% 2.0% 16.0% 3.40 5.73 4.60 4.00 5.10 0.92x 0.81x 4.11 11.9% 6.0% 17.9% BUY 56 H-share average 3.9% 1.37 6.0% 1.9% 14.0% 1.19x 1.04x 18.9% 5.4% 24.3% BULL Risk- 25% 75% Bull PT 19-Nov-13 Bull Upside/ 2013E Bull JEF 3M ADT Ticker RF Beta ERP loading COE DDM Fair P/B (LC) Bear Bull 2013E 2014E Price (LC) (Downside) Yield Exp'd TR Rating LC mn 1398 ICBC-H 4.0% 1.26 6.0% 1.0% 12.5% 5.00 8.67 7.70 5.90 7.70 1.65x 1.44x 5.55 38.7% 6.0% 44.8% BUY 1,284 939 CCB-H 4.0% 1.18 6.0% 1.5% 12.5% 5.99 9.82 8.90 6.90 8.90 1.61x 1.41x 6.24 42.6% 6.0% 48.6% BUY 1,676 1288 ABC-H 4.0% 1.48 6.0% 0.5% 13.4% 3.68 5.62 5.10 4.20 5.10 1.51x 1.32x 3.97 28.5% 5.7% 34.1% BUY 459 3988 BOC-H 3.6% 1.15 6.0% 2.5% 13.0% 3.67 6.09 5.50 4.30 5.50 1.29x 1.14x 3.70 48.6% 6.6% 55.2% BUY 1,068 3328 BCOM-H 4.0% 1.40 6.0% 2.0% 14.3% 4.76 8.29 7.40 5.60 7.40 1.02x 0.91x 5.75 28.7% 5.6% 34.3% HOLD 153 3968 CMB-H 3.9% 1.56 6.0% 1.5% 14.7% 14.65 20.83 19.30 16.20 19.30 1.42x 1.23x 17.08 13.0% 4.4% 17.4% BUY 361 998 CNCB-H 3.9% 1.32 6.0% 2.5% 14.3% 3.04 7.29 6.20 4.10 6.20 1.03x 0.90x 4.51 37.5% 3.9% 41.4% BUY 169 1988 MSB-H 4.0% 1.30 6.0% 3.5% 15.3% 8.48 15.34 13.60 10.20 13.60 1.51x 1.22x 9.44 44.1% 4.2% 48.2% BUY 563 3618 CQRCB 4.0% 1.68 6.0% 2.0% 16.0% 3.40 5.73 5.10 4.00 5.10 1.02x 0.90x 4.11 24.1% 6.0% 30.1% BUY 56 H-share average 3.9% 1.37 6.0% 1.9% 14.0% 1.34x 1.16x 34.0% 5.4% 39.4% BEAR Risk- 75% 25% Bear PT 19-Nov-13 Bear Upside/ 2013E Bear JEF 3M ADT Ticker RF Beta ERP loading COE DDM Fair P/B (LC) Bear Bull 2013E 2014E Price (LC) (Downside) Yield Exp'd TR Rating LC mn 1398 ICBC-H 4.0% 1.26 6.0% 1.0% 12.5% 5.00 8.67 5.90 5.90 7.70 1.26x 1.10x 5.55 6.3% 6.0% 12.3% BUY 1,284 939 CCB-H 4.0% 1.18 6.0% 1.5% 12.5% 5.99 9.82 6.90 6.90 8.90 1.25x 1.09x 6.24 10.6% 6.0% 16.6% BUY 1,676 1288 ABC-H 4.0% 1.48 6.0% 0.5% 13.4% 3.68 5.62 4.20 4.20 5.10 1.25x 1.09x 3.97 5.8% 5.7% 11.5% BUY 459 3988 BOC-H 3.6% 1.15 6.0% 2.5% 13.0% 3.67 6.09 4.30 4.30 5.50 1.01x 0.89x 3.70 16.2% 6.6% 22.8% BUY 1,068 3328 BCOM-H 4.0% 1.40 6.0% 2.0% 14.3% 4.76 8.29 5.60 5.60 7.40 0.77x 0.69x 5.75 -2.6% 5.6% 3.0% HOLD 153 3968 CMB-H 3.9% 1.56 6.0% 1.5% 14.7% 14.65 20.83 16.20 16.20 19.30 1.20x 1.03x 17.08 -5.2% 4.4% -0.7% BUY 361 998 CNCB-H 3.9% 1.32 6.0% 2.5% 14.3% 3.04 7.29 4.10 4.10 6.20 0.68x 0.59x 4.51 -9.1% 3.9% -5.2% BUY 169 1988 MSB-H 4.0% 1.30 6.0% 3.5% 15.3% 8.48 15.34 10.20 10.20 13.60 1.13x 0.92x 9.44 8.1% 4.2% 12.2% BUY 563 3618 CQRCB 4.0% 1.68 6.0% 2.0% 16.0% 3.40 5.73 4.00 4.00 5.10 0.80x 0.71x 4.11 -2.7% 6.0% 3.3% BUY 56 H-share average 3.9% 1.37 6.0% 1.9% 14.0% 1.04x 0.90x 3.0% 5.4% 8.4% PT-implied P/BScenario PT (LC) Scenario PT (LC) Bull PT-implied P/B Scenario PT (LC) Bear PT-implied P/B Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 125 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 127. Exhibit 202: H-share banks are trading at 2014E P/B and P/E of 0.87x and 5.0x (vs. Asia’s 1.23x and 10.0x), respectively, despite 2014E ROE of 18.7% (Asia 13.8%) and profit growth of 11.8% (Asia 9.4%) due to asset quality concerns CHINA BANK COMPS Rmb/HK$ PT Upside/ JEF YTD HK CH 1.267 HK (HK$) CH (Rmb) (LC mn) 2013E 2014E 2013E 2014E 2013E 2014E 2013E 2014E 2013E 2014E 2013E 2014E (LC) Downside Rating Total Rtn 1398 601398 ICBC-H 5.55 3.82 1,753,908 1.18x 1.03x 1.19x 1.04x 4.1x 3.8x 5.9x 5.5x 6.0% 6.5% 10.1% 9.1% 6.80 22.5% BUY 7.2% 939 601939 CCB-H 6.24 4.34 1,552,957 1.14x 0.99x 1.14x 1.00x 3.9x 3.5x 5.8x 5.4x 6.0% 6.5% 9.8% 8.9% 7.90 26.6% BUY 6.5% 1288 601288 ABC-H 3.97 2.58 1,083,259 1.18x 1.03x 1.18x 1.03x 3.8x 3.5x 6.2x 5.7x 5.7% 6.2% 8.4% 7.6% 4.70 18.4% BUY 10.3% 3988 601988 BOC-H 3.70 2.82 1,008,002 0.88x 0.78x 0.89x 0.78x 3.6x 3.3x 5.5x 4.9x 6.6% 7.4% 8.0% 7.2% 4.90 32.4% BUY 14.0% 3328 601328 BCOM-H 5.75 4.14 407,204 0.79x 0.71x 0.79x 0.71x 3.4x 3.1x 5.4x 4.9x 5.6% 6.1% 8.1% 7.1% 6.50 13.0% HOLD 4.4% 3968 600036 CMB-H 17.08 11.02 354,819 1.26x 1.09x 1.30x 1.12x 4.2x 3.9x 6.3x 5.9x 4.4% 5.1% 11.8% 10.3% 17.70 3.6% BUY 7.7% 998 601998 CNCB-H 4.51 4.08 232,048 0.75x 0.65x 0.75x 0.66x 2.9x 2.5x 5.2x 4.4x 3.9% 4.6% 6.2% 5.5% 5.20 15.3% BUY 2.5% 1988 600016 MSB-H 9.44 8.73 304,384 1.05x 0.85x 1.05x 0.85x 3.0x 2.5x 4.8x 4.1x 4.2% 4.9% 9.5% 8.4% 11.90 26.1% BUY 10.2% 3618 CQRCB 4.11 3.24 38,223 0.83x 0.73x 0.84x 0.74x 3.4x 3.0x 5.0x 4.5x 6.0% 6.6% 8.6% 7.4% 4.60 11.9% BUY 2.1% Average 1.01x 0.87x 1.01x 0.88x 3.6x 3.2x 5.6x 5.0x 5.4% 6.0% 8.9% 7.9% 18.9% 7.2% US$/HK$ A/H Trough P/B Mkt Cap HK CH 7.76 Premium vs 2013E (US$ mn) 2013E 2014E 2013E 2014E 2013E 2014E 2013E 2014E 2013E 2014E 2013E 2014E 2013E 2014E 2013E 2014E 1398 601398 ICBC -12.8% -31% 226,019 21.7% 20.4% 1.43% 1.41% 15.2% 14.8% 10.3% 7.9% 10.5% 11.0% 1.1% 1.4% 233% 192% 2.6% 2.6% 939 601939 CCB -11.9% -25% 200,123 20.9% 19.6% 1.44% 1.39% 15.2% 14.2% 9.6% 7.5% 10.4% 10.8% 1.1% 1.3% 247% 226% 2.8% 2.9% 1288 601288 ABC -17.7% -31% 139,595 20.5% 19.5% 1.19% 1.18% 15.0% 14.2% 13.8% 9.0% 9.2% 9.4% 1.5% 1.7% 300% 275% 4.5% 4.6% 3988 601988 BOC -3.4% -29% 129,897 17.5% 17.5% 1.21% 1.22% 11.9% 12.8% 9.9% 12.0% 9.1% 9.2% 1.1% 1.3% 206% 184% 2.4% 2.5% 3328 601328 BCOM -8.8% -14% 52,475 15.6% 15.3% 1.12% 1.08% 11.7% 11.7% 7.6% 9.3% 9.9% 9.8% 1.1% 1.2% 228% 207% 2.4% 2.5% 3968 600036 CMB -18.3% -27% 45,724 21.4% 19.8% 1.36% 1.36% 15.4% 15.8% 11.4% 15.0% 9.5% 9.8% 0.8% 1.0% 292% 252% 2.3% 2.4% 998 601998 CNCB 14.6% -21% 29,903 15.3% 15.9% 1.01% 1.04% 12.4% 14.2% 4.1% 17.9% 8.8% 9.2% 1.0% 1.3% 251% 224% 2.5% 2.8% 1988 600016 MSB 17.2% -39% 39,225 24.1% 22.9% 1.34% 1.46% 23.6% 23.5% 16.8% 17.6% 8.3% 9.6% 1.2% 1.5% 234% 195% 2.7% 2.9% 3618 CQRCB -33% 4,926 17.7% 17.1% 1.29% 1.21% 14.2% 13.3% 13.0% 9.8% 10.8% 10.6% 1.2% 1.5% 271% 223% 3.3% 3.2% Average -5.1% -28% 19.4% 18.7% 1.27% 1.26% 15.0% 14.9% 10.7% 11.8% 9.6% 9.9% 1.1% 1.3% 251% 220% 2.8% 2.9% Ticker Mkt Cap P/B P/TB P/PPOP P/E Profit Growth Price on 19-Nov-13 Dividend Yield P/Deposits LLR/LoansNPL LLR/NPLTicker T1 CARROAE BV GrowthROAA ASIA BANK COMPS Ticker LC (US$ mn) 2013E ** 2014E ** 2013E ** 2014E ** 2013E ** 2014E ** 2013E ** 2014E ** 2013E ** 2014E ** CHINA-H Average 1.01x 0.87x 5.6x 5.0x 5.4% 6.0% 19.4% 18.7% 10.7% 11.8% 601398 CH ICBC-A 3.82 226,019 1.03x 0.90x 5.2x 4.8x 6.9% 7.4% 21.7% 20.4% 10.3% 7.9% 601939 CH CCB-A 4.34 200,123 1.00x 0.88x 5.1x 4.8x 6.8% 7.3% 20.9% 19.6% 9.6% 7.5% 601288 CH ABC-A 2.58 139,595 0.97x 0.85x 5.1x 4.7x 6.9% 7.5% 20.5% 19.5% 13.8% 9.0% 601988 CH BOC-A 2.82 129,897 0.85x 0.76x 5.3x 4.8x 6.8% 7.6% 17.5% 17.5% 9.9% 12.0% 601328 CH BCOM-A 4.14 52,475 0.72x 0.65x 4.9x 4.5x 6.1% 6.7% 15.6% 15.3% 7.6% 9.3% 600036 CH CMB-A 11.02 45,724 1.03x 0.89x 5.1x 4.8x 5.4% 6.2% 21.4% 19.8% 11.4% 15.0% 601998 CH CNCB-A 4.08 29,903 0.86x 0.75x 5.9x 5.0x 3.4% 4.0% 15.3% 15.9% 4.1% 17.9% 600016 CH MSB-A 8.73 39,225 1.23x 1.00x 5.6x 4.8x 3.5% 4.2% 24.1% 22.9% 16.8% 17.6% 601166 CH Industrial Bank * 11.21 35,048 1.03x 0.86x 5.0x 4.4x 3.9% 4.5% 21.7% 21.3% 20.4% 18.6% 600000 CH SPDB * 9.97 30,519 0.90x 0.77x 4.9x 4.3x 4.7% 5.0% 19.9% 19.2% 11.6% 14.0% 601818 CH Everbright Bank * 2.86 18,977 0.88x 0.76x 4.6x 4.0x 4.5% 4.5% 20.4% 19.0% 13.8% 15.3% 000001 CH Ping An Bank * 13.82 18,591 1.11x 1.00x 7.3x 6.8x 1.7% 2.1% 15.6% 15.3% 10.1% 13.9% 600015 CH Huaxia Bank * 7.97 11,646 0.84x 0.75x 4.8x 4.4x 4.1% 4.2% 17.5% 17.2% 13.9% 15.4% 601169 CH Bank of Beijing * 7.84 11,322 0.84x 0.73x 5.1x 4.4x 4.9% 5.5% 17.5% 17.8% 13.2% 16.1% 002142 CH Bank of Ningbo * 9.05 4,283 1.00x 0.85x 5.6x 4.7x 3.5% 4.3% 19.9% 20.1% 19.4% 16.5% 601009 CH Bank of Nanjing * 8.36 4,073 0.88x 0.77x 5.5x 4.8x 4.4% 4.8% 17.1% 17.2% 13.4% 14.8% CHINA-A Average 0.95x 0.82x 5.3x 4.7x 4.8% 5.4% 19.2% 18.6% 12.5% 13.8% 2388 HK BOC Hong Kong * 25.80 35,187 1.73x 1.63x 12.4x 11.5x 5.1% 5.4% 14.3% 14.5% 5.2% 7.7% 11 HK Hang Seng Bank * 124.40 30,679 2.29x 2.16x 10.6x 14.2x 4.4% 4.4% 23.9% 15.7% 9.2% -20.8% 23 HK Bank of East Asia * 34.20 10,098 1.23x 1.17x 13.6x 13.3x 3.1% 3.1% 9.7% 9.3% -6.9% 3.0% 302 HK Wing Hang Bank * 104.00 4,124 1.52x 1.43x 16.6x 16.1x 2.3% 2.5% 9.6% 9.4% 4.7% 4.9% 2356 HK Dah Sing Bank * 14.08 2,273 1.07x 1.00x 10.5x 10.2x 2.7% 2.9% 9.7% 9.8% 18.4% 3.2% 440 HK Dah Sing Financial * 46.20 1,767 0.82x 0.78x 10.3x 9.7x 2.9% 3.1% 8.0% 8.2% 7.0% 5.8% 1111 HK Chong Hing Bank * 35.05 1,967 1.99x 1.91x 31.0x 30.7x 1.3% 1.3% 6.5% 6.3% -9.8% 0.8% HONG KONG Average 1.52x 1.44x 15.0x 15.1x 3.1% 3.2% 11.7% 10.5% 4.0% 0.7% 2882 TT Cathay FHC * 44.85 18,226 1.96x 1.82x 17.2x 17.1x 1.8% 2.0% 12.0% 11.3% 180.6% 1.3% 2881 TT Fubon FHC * 41.90 14,563 1.32x 1.24x 12.4x 11.8x 2.6% 2.7% 11.0% 11.1% 214.8% 6.0% 2886 TT Mega FHC * 23.80 10,064 1.22x 1.16x 12.1x 11.3x 4.5% 4.6% 10.3% 10.3% 60.6% 8.5% 2891 TT CTBC FHC * 19.10 9,544 1.39x 1.29x 13.7x 11.3x 3.3% 3.8% 11.6% 12.1% N.A. 20.3% 2885 TT Yuanta FHC * 15.55 5,225 0.98x 0.97x 21.4x 18.4x 2.8% 3.2% 4.9% 5.3% 319.1% 14.0% 2892 TT First FHC * 17.85 5,246 1.09x 1.03x 13.9x 12.9x 2.4% 2.5% 8.1% 8.3% N.A. 8.7% 2880 TT Hua Nan FHC * 16.95 5,214 1.10x 1.05x 15.7x 14.4x 2.4% 2.8% 7.2% 7.3% 7.1% 8.7% 2888 TT Shin Kong FHC * 10.10 3,199 0.95x 0.86x 7.2x 11.4x 0.2% 0.3% 14.3% 8.1% -162.1% -33.7% 2883 TT China Development FHC * 8.51 4,343 0.78x 0.75x 18.3x 15.2x 2.5% 3.3% 5.1% 5.1% -205.3% 13.5% 2801 TT Chang Hwa Bank * 17.45 4,593 1.15x 1.08x 13.9x 15.5x 0.5% 0.5% 7.6% 6.6% -0.5% -1.2% 2890 TT Sinopac FHC * 14.60 4,070 1.11x 1.04x 11.4x 11.3x 2.3% 2.4% 9.9% 9.4% N.A. 1.9% 2887 TT Taishin FHC * 14.80 3,773 1.12x 1.03x 8.3x 9.8x 2.2% 1.9% 14.0% 10.4% -348.4% -16.0% 2884 TT E.Sun FHC * 19.95 3,743 1.31x 1.20x 12.7x 11.5x 1.7% 2.0% 11.2% 11.0% 86.1% 10.4% TAIWAN Average 1.19x 1.12x 13.7x 13.2x 2.3% 2.5% 9.8% 9.0% 15.2% 3.3% 055550 KS Shinhan Financial * 45,500 20,442 0.82x 0.77x 11.1x 9.6x 1.5% 1.8% 7.6% 8.1% 230.8% 14.9% 105560 KS KB Financial * 40,300 14,751 0.61x 0.58x 11.2x 8.7x 1.5% 1.9% 5.5% 6.8% 116.5% 28.1% 086790 KS Hana Financial * 40,400 11,096 0.58x 0.55x 10.0x 8.2x 1.3% 1.7% 6.4% 7.0% -736.6% 22.8% 053000 KS Woori Financial * 12,550 9,584 0.53x 0.50x 12.4x 8.0x 1.3% 1.9% 4.3% 6.4% 111.1% 54.3% 024110 KS Industrial Bank of Korea * 12,150 6,333 0.53x 0.50x 8.5x 7.2x 3.0% 3.3% 6.4% 7.1% -21.1% 15.9% 138930 KS BS Financial * 16,350 2,996 0.90x 0.83x 8.9x 7.8x 2.1% 2.5% 10.5% 11.0% 340.9% 12.9% 139130 KS DGB Financial * 16,800 2,134 0.82x 0.75x 8.6x 7.5x 2.2% 2.6% 10.0% 10.5% 394.2% 14.6% KOREA Average 0.69x 0.64x 10.1x 8.1x 1.8% 2.3% 7.2% 8.1% 62.2% 23.4% ROAE Profit Growth19-Nov-13 Mkt Cap P/B P/E Dividend Yield Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 126 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 128. Source: Bloomberg, Jefferies estimates; * Bloomberg consensus; ** Fiscal Year ending March 2014 & March 2015 respectively Ticker LC (US$ mn) 2013E ** 2014E ** 2013E ** 2014E ** 2013E ** 2014E ** 2013E ** 2014E ** 2013E ** 2014E ** 8306 JP Mitsubishi UFJ Financial * 658 93,422 0.79x 0.75x 11.0x 10.9x 2.2% 2.3% 7.2% 6.9% 0.4% -0.1% 8316 JP Sumitomo Mitsui Financial * 5,080 72,007 1.00x 0.93x 9.7x 10.8x 2.3% 2.4% 10.8% 8.9% -9.8% -10.5% 8411 JP Mizuho Financial * 219 53,123 0.88x 0.83x 9.3x 10.2x 2.7% 2.8% 9.5% 8.0% 3.7% -9.8% 8309 JT Sumitomo Mitsui Trust * 499 19,525 0.99x 0.94x 13.7x 13.0x 2.0% 2.1% 7.4% 7.1% 6.7% 5.0% 8308 JP Resona * 528 12,301 0.97x 0.90x 8.3x 9.2x 2.8% 2.8% 9.8% 8.5% -37.4% -12.6% 8355 JP Shizuoka Bank * 1,158 7,721 0.89x 0.85x 15.9x 17.5x 1.3% 1.3% 5.8% 5.2% -18.1% -9.1% 8332 JP Bank of Yokohama * 556 7,302 0.80x 0.77x 12.7x 12.7x 2.1% 2.1% 6.6% 6.3% 3.1% -0.2% 8303 JP Shinsei Bank * 241 6,644 0.96x 0.89x 13.0x 11.7x 0.4% 0.5% 7.6% 7.9% -2.1% 9.7% 8331 JP Chiba Bank * 729 6,398 0.84x 0.80x 13.6x 13.7x 1.6% 1.7% 6.3% 5.9% 4.2% -0.8% 8304 JP Aozora Bank * 298 4,929 0.95x 0.93x 9.3x 9.5x 4.7% 4.7% 8.9% 8.4% 4.5% -3.5% JAPAN Average ** 0.91x 0.86x 11.7x 11.9x 2.2% 2.3% 8.0% 7.3% -4.5% -3.2% BBCA IJ Bank Central Asia * 10,200 21,692 4.06x 3.42x 18.5x 15.9x 1.3% 1.5% 23.4% 23.0% 14.7% 16.6% BMRI IJ Bank Mandiri * 7,750 15,598 2.08x 1.78x 10.5x 9.2x 2.5% 2.8% 21.2% 20.8% 10.8% 14.6% BBRI IJ Bank Rakyat * 7,750 16,492 2.38x 1.98x 9.5x 8.5x 2.7% 3.1% 27.5% 25.5% 7.7% 10.5% BBNI IJ Bank Negara * 4,450 7,158 1.67x 1.47x 10.1x 9.0x 2.5% 2.9% 17.7% 17.5% 17.0% 12.7% BDMN IJ Bank Danamon * 3,850 3,183 1.18x 1.08x 9.2x 8.4x 3.3% 3.4% 13.4% 13.1% -0.4% 8.9% INDONESIA Average 2.27x 1.95x 11.6x 10.2x 2.5% 2.7% 20.6% 20.0% 10.0% 12.7% May MK Malayan Banking * 9.65 26,871 1.81x 1.71x 13.3x 12.6x 5.3% 5.5% 14.3% 14.1% 9.0% 8.2% PBK MK Public Bank * 18.20 20,035 3.18x 2.82x 15.4x 14.0x 3.0% 3.2% 21.6% 21.3% 7.1% 10.3% CIMB MK CIMB Group * 7.42 18,027 1.77x 1.61x 12.7x 11.5x 3.3% 3.5% 15.0% 14.6% 0.7% 12.1% HLBK MK Hong Leong Bank * 14.22 8,040 1.82x 1.64x 12.9x 11.6x 2.9% 3.2% 14.7% 14.9% 8.9% 9.7% HLFG MK Hong Leong Financial * 15.14 5,010 1.42x 1.27x 10.4x 9.2x 2.4% 2.6% 14.4% 14.3% 2.8% 13.0% AMM MK AMMB Holdings * 7.24 6,859 1.66x 1.51x 12.1x 10.9x 3.4% 3.7% 14.3% 14.4% 10.0% 10.6% RHBC MK RHB Capital * 7.64 6,079 1.18x 1.09x 11.0x 9.6x 3.0% 3.3% 11.1% 11.7% -2.0% 14.9% AFG MK Alliance Financial * 5.00 2,433 1.79x 1.66x 13.5x 12.3x 3.8% 4.1% 13.6% 13.9% 6.7% 9.0% AHB MK AFFIN Holdings * 4.20 1,973 0.97x 0.91x 10.1x 9.5x 3.7% 3.9% 9.9% 9.9% -1.7% 7.3% MALAYSIA Average 1.73x 1.58x 12.4x 11.3x 3.4% 3.7% 14.3% 14.3% 4.6% 10.6% BPI PM Bank of Philippine Island * 94.00 7,670 3.09x 2.79x 17.6x 16.9x 2.3% 2.3% 18.5% 17.0% 17.8% 3.2% BDO PM BDO Unibank * 78.25 6,429 1.64x 1.52x 13.5x 14.9x 2.1% 1.8% 12.8% 11.0% 46.2% -11.1% MBT PM Metropolitan Bank & Trust * 79.65 5,016 1.58x 1.45x 11.1x 13.4x 1.4% 1.5% 16.3% 11.4% 29.2% -19.5% PNB PM Philippine National Bank * 85.20 2,123 1.15x 1.06x 13.8x 13.0x 0.0% 0.0% 10.8% 8.0% 41.3% 3.0% CHIB PM China Banking Corp * 60.70 1,988 1.85x 1.73x 14.4x 13.1x 2.6% 2.9% 13.2% 13.7% 13.6% 9.8% UBP PM Union Bank of Philippines * 124.70 1,835 1.57x 1.42x 9.8x 10.5x 2.9% 2.8% 19.8% 17.4% 7.7% -6.6% PHILIPPINES Average 1.81x 1.66x 13.3x 13.6x 1.9% 1.9% 15.3% 13.1% 26.0% -3.5% SCB TB Siam Commercial Bank * 166.00 17,837 2.26x 1.97x 11.4x 10.2x 3.1% 3.5% 21.1% 20.4% 22.7% 12.3% KBANK TB Kasikornbank * 179.50 13,601 1.96x 1.68x 10.1x 8.9x 2.1% 2.5% 20.4% 19.7% 17.2% 13.8% BBL TB Bangkok Bank * 199.00 12,026 1.29x 1.18x 10.2x 9.3x 3.7% 4.1% 13.1% 13.2% 12.3% 9.8% KTB TB Krung Thai Bank * 19.90 8,805 1.37x 1.23x 9.0x 7.8x 4.4% 5.2% 16.0% 16.5% 31.4% 15.5% BAY TB Bank of Ayudhya * 38.50 7,404 1.88x 1.65x 14.5x 11.8x 2.5% 3.1% 13.4% 14.9% 10.5% 25.1% TMB TB TMB Bank * 2.80 3,866 2.04x 1.86x 22.0x 15.1x 1.5% 2.3% 9.9% 12.8% 253.5% 42.1% TCAP TB Thanachart Capital * 34.50 1,318 0.88x 0.80x 5.1x 6.8x 4.4% 4.6% 18.8% 12.3% 45.3% -20.7% KKP TB Kiatnakin Bank * 42.00 1,115 1.00x 0.94x 7.9x 7.1x 6.2% 6.9% 12.9% 13.4% 31.2% 11.1% TISCO TB Tisco Financial * 41.50 1,052 1.49x 1.32x 7.4x 7.0x 5.7% 6.0% 21.4% 20.0% 18.6% 7.9% THAILAND Average 1.58x 1.40x 10.9x 9.3x 3.7% 4.2% 16.3% 15.9% 49.2% 13.0% DBS SP DBS * 16.94 33,281 1.24x 1.17x 11.7x 10.9x 3.4% 3.5% 10.9% 11.0% -6.1% 7.7% OCBC SP OCBC * 10.43 28,765 1.42x 1.32x 13.6x 12.7x 3.3% 3.4% 10.7% 10.9% -33.4% 7.9% UOB SP UOB * 21.11 26,718 1.35x 1.26x 11.9x 11.3x 3.3% 3.5% 11.7% 11.5% 1.3% 4.5% SINGAPORE Average 1.33x 1.25x 12.4x 11.6x 3.3% 3.5% 11.1% 11.1% -12.7% 6.7% CBA AU Commonwealth Bank of Australia * 77.20 117,223 2.69x 2.54x 15.4x 14.8x 5.0% 5.2% 18.2% 18.0% 8.1% 4.0% WBC AU Westpac Bank * 32.54 95,301 2.13x 2.06x 14.1x 13.5x 5.8% 5.8% 15.5% 15.7% 7.6% 5.0% ANZ AU ANZ Bank * 31.92 82,498 1.86x 1.77x 13.1x 12.3x 5.4% 5.7% 14.8% 14.9% 9.5% 6.3% NAB AU National Australia Bank * 34.07 75,403 1.79x 1.72x 12.8x 12.0x 5.9% 6.3% 14.6% 14.7% 16.9% 6.8% AUSTRALIA Average ** 2.12x 2.02x 13.8x 13.2x 5.5% 5.8% 15.8% 15.8% 10.5% 5.5% HDFCB IN HDFC Bank * 659.40 25,464 3.68x 3.08x 18.7x 15.2x 1.0% 1.2% 21.2% 22.2% 22.2% 24.1% ICICIBC IN ICICI Bank * 1,085.45 20,191 1.72x 1.56x 13.2x 11.5x 2.1% 2.3% 13.6% 14.3% -1.5% 15.5% AXSB IN AXIS Bank * 1,146.50 8,667 1.42x 1.24x 9.2x 7.9x 1.8% 2.1% 16.4% 16.8% 11.7% 17.5% KMB IN Kotak Mahindra Bank * 737.20 9,133 4.90x 4.25x 35.3x 29.7x 0.1% 0.1% 14.9% 15.1% -27.4% 18.8% IIB IN IndusInd Bank * 425.65 3,595 2.59x 2.24x 16.8x 13.5x 0.9% 1.1% 16.4% 17.6% 25.0% 24.0% YES IN YES Bank * 365.30 2,122 1.81x 1.50x 8.7x 7.2x 1.8% 2.2% 23.3% 22.8% 18.2% 21.5% SBIN IN Stata Bank of India * 1,822.95 20,092 1.17x 1.07x 10.1x 8.4x 2.2% 2.5% 12.1% 13.2% -31.1% 21.7% BOB IN Bank of Baroda * 639.25 4,337 0.79x 0.71x 6.1x 5.2x 3.3% 3.7% 13.5% 14.0% -6.8% 16.8% PNB IN Punjab National Bank * 543.00 3,093 0.57x 0.51x 4.6x 3.8x 4.7% 5.4% 12.6% 13.9% -16.2% 23.6% BOI IN Bank of India * 237.50 2,280 0.57x 0.52x 4.8x 4.1x 4.1% 4.6% 12.3% 12.9% 5.8% 17.6% UNBK IN Union Bank of India * 131.80 1,267 0.48x 0.43x 4.2x 3.3x 5.7% 6.4% 11.5% 12.9% -12.6% 25.2% INDIA Average ** 1.79x 1.55x 12.0x 10.0x 2.5% 2.9% 15.3% 16.0% -1.2% 20.6% Private 2.69x 2.31x 17.0x 14.2x 1.3% 1.5% 17.6% 18.1% 8.0% 20.2% PSU 0.72x 0.65x 6.0x 5.0x 4.0% 4.5% 12.4% 13.4% -12.2% 21.0% 5 HK HSBC * 86.50 209,185 1.16x 1.11x 11.8x 10.9x 4.6% 5.1% 10.4% 10.7% 26.4% 10.3% 2888 HK Standard Chartered * 183.80 57,532 1.25x 1.17x 10.8x 10.0x 3.7% 4.1% 11.1% 12.3% 8.0% 10.5% REGIONAL Average 1.21x 1.14x 11.3x 10.4x 4.2% 4.6% 10.8% 11.5% 17.2% 10.4% ASIA Average 1.36x 1.23x 10.8x 10.0x 3.3% 3.6% 14.2% 13.8% 14.6% 9.4% GREATER CHINA Average [CH, HK, TW] 1.12x 1.01x 9.3x 8.9x 3.9% 4.3% 15.3% 14.6% 11.3% 8.3% NORTH ASIA Average [GCH, SK, JP] 1.04x 0.95x 9.8x 9.3x 3.4% 3.8% 13.2% 12.7% 14.7% 8.1% SOUTH-EAST ASIA Average [INDO, MY, PH, SG, TH] 1.75x 1.57x 12.0x 11.0x 3.1% 3.3% 15.7% 15.1% 20.4% 8.6% SOUTH ASIA Average [SEA, AU, INDIA] 1.79x 1.61x 12.2x 11.0x 3.1% 3.4% 15.6% 15.4% 14.5% 11.1% ROAE Profit Growth19-Nov-13 Mkt Cap P/B P/E Dividend Yield Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 127 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 129. 2014 Forecasts We expect relatively stable 2014E profit growth (12%, up 1ppt, YoY) and ROE (19%, flat YoY), anchored by loan/deposit/non-int. income growth (albeit decelerating) and stable NIM & CIR, which offset slightly higher NPL formation rate & credit cost. Big 4’s profit to grow slower than the smaller banks: We expect the Big 4 banks’ to deliver profit growth of 9% on avg in 2014 (led by BOC’s 12% given its steadier non- int. income growth with its more diversified business platform), vs. 14% for the smaller banks (led by CNCB as its provisioning normalizes, assuming it reaches CBRC’s LLR/loan coverage target of 2.5% in 2013). We are above consensus: Our 2014E profit growth of 12% for the H-share banks on avg is 3ppt higher than Bloomberg consensus, driven by our higher 2014E profit estimates for MSB (11% above consensus), BOC (9% above), and CMB (6% above). Key 2014 trends include: Net int. income up 12% YoY on avg, driven by loan growth of 13%, while NIM stays flat. We are not expecting PBOC to change the benchmark interest rates (BR) now that lending rates are free-floating. The probability of a higher ceiling on deposit BR is low in 2014, as the introduction of deposit insurance and negotiable certificates of deposit (NCD) in the interbank market (likely on a limited scale) takes precedence, in our view. Thus, although deposit competition is likely to remain intense, which will test each bank’s asset- liability mgmt ability, we expect higher loan pricing as a result of tighter liquidity to offset the funding cost pressure. Non int. income up 15% YoY on avg, decelerating from 2013E’s 26% (9M13A up 27% YoY) due to a larger base effect. Pre-provision operating profit up 12% YoY on avg as we expect cost- income ratio to remain stable at 34%, with opex growth of 13% reasonably sufficient to keep pace with wage inflation and discretionary investment needs. Asset quality and credit cost: We expect the H-share banks’ end-2014 NPL balances to increase 32% YoY on avg. as NPL formation rate rises 5bps to 48bps, driving their NPL ratio up 22bps to 1.34%. Given the banks’ strong loan loss reserve (LLR) coverage, we expect credit cost to increase by only 3bps YoY on avg to 58bps, which will keep LLR/NPL at a still-high 220% while LLR/loan ticks up to 2.9%. Profitability and capital adequacy: With 2014E ROE of 19% and greater restraint in RWA growth driving capital generation, we see the H-share banks’ CT1 CAR rising 32bps YoY on avg to 9.9% in 2014. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 128 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 130. Exhibit 203: We expect relatively stable 2014E profit growth and ROE, anchored by loan/deposit/non-int. income growth (albeit decelerating) and stable NIM & CIR, which offset slightly higher NPL formation rate & credit cost Source: Company data, Bloomberg, Jefferies estimates P&L drivers 2009A 2010A 2011A 2012A 2013E 2014E 2015E Loan growth 36% 19% 15% 15% 14% 13% 12% Deposit growth 29% 21% 14% 13% 14% 13% 12% LDR 69.1% 68.0% 68.4% 69.3% 69.2% 69.3% 69.5% NIM 2.45% 2.58% 2.80% 2.76% 2.66% 2.65% 2.67% NIM change (bp) (70) 14 21 (3) (11) (1) 2 NII growth -3% 31% 29% 16% 10% 12% 13% Non-II growth 60% 24% 55% 16% 26% 15% 11% Non-II / Income 19% 18% 20% 20% 22% 22% 22% Op income growth 3% 29% 31% 17% 13% 13% 13% Cost-income ratio 40% 37% 34% 34% 34% 34% 34% PPOP growth -2% 38% 38% 16% 13% 12% 13% NPL formation (bp) 24 (13) (5) 4 43 48 52 NPL ratio 1.7% 1.2% 1.0% 0.9% 1.1% 1.3% 1.6% LLR / NPL 157% 213% 281% 298% 251% 220% 197% Credit cost (bp) 51 46 56 51 55 58 61 Net profit growth 15% 40% 34% 18% 11% 12% 12% ROAE 19% 20% 21% 21% 19% 19% 18% Leverage 19x 17x 16x 16x 15x 15x 14x Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 129 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 131. China Insurance: Opportunities Arising Key Takeaway We are constructive on Chinese Life insurance space going into 2014. We expect agency business will deliver moderate growth; furthermore, the benefits of the broadening of investment channels will start to surface. Along with relatively low street expectations, rising bond yields, and potential policy upside, we believe it is time to revisit the industry. Ping An is our top pick in the sector. Agency business to deliver moderate growth: We believe agency distribution will continue to be the key growth driver for Chinese life insurance industry for the years to come. In 2013, while agency business remained challenging, there were visible improvements, with both Ping An and CPIC delivering 1H13 agency business NBV growth of 15%/7%. Going into 2014, with broadening product offerings and increasing critical illness protection awareness, we expect agency distribution to deliver stable growth in the range of 5-8%. We acknowledge that bancassurance will continue to be a drag, and hence recommend investors to stay with insurers with relatively less bancassurance exposure (e.g. Ping An and CPIC) or insurers in the process trying to reduce bancassurance impact (e.g. NCL). Benefits of broadening investment channels to surface: It has been over 12 months since CIRC deregulated insurance funds investment channels. In this period, we have noticed prudent and gradual allocation towards alternative investment assets, with small improvements in net yields and less reliance on the volatile A-share markets. In 1H13, the big three life insurers reported comprehensive investment yield in the range of 4.2%-4.6%, despite the 12.8% decline in CSI300. We see this as encouraging, and expect gradual and stable improvement in insurers’ investment capacities. In addition, we noticed that 10- year government bond yields rose by over 80bps in 2H13, which could also improve insurers’ re-investment yields. Policies likely to offer upside: Looking forward, stemming from the Third Plenum, we see potential regulatory changes more likely to be on the upside, in the following areas: 1) promotion of pension-related business and commercial health insurance business; 2) accelerating the development of enterprise annuity business; 3) further broadening of investment channels; 4) strengthening social pension investment management. At the same time, we believe the key downside risk lies in full-scale deregulation of life insurance product pricing (e.g. participating and universal policies), but we do not expect this to happen within the next 12-24 months. Top pick Ping An: With Street expectations relatively low, the Chinese life insurance sector on average is trading at the undemanding level of 1.1x 14E P/EV, with the top three insurers trading at 1.2x 14E P/EV. Among the listed insurers, we see Ping An (trading at 1.1x 14E P/EV) as a clear stand-out, on the back of its strong agency focus and early e-commerce platform attempts. Ping An remains our top pick in the sector. At the same time, we also like CPIC (trading at 1.36x 14E P/EV) for its stable life business operations and NCL (trading at 0.88x 14E P/EV) for improving agency business momentum and current depressed valuations. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 130 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 132. Expect moderate agency business expansion in 2014 In our view, agency distribution will continue to be the key growth driver for Chinese Life insurance going forward. For 1-9M2013, while growth in agency business continued to be challenging, there has been visible improvement compared to 2012. In 1H13, First Year Premium growth stabilized to 8% for the Big 3 insurers, from a 3% drop in 2012. Exhibit 204: Agency First Year Premium Growth stabilized in 1H13 Source: Jefferies, company data In terms of agency headcounts, it has been generally flat for the listed insurers so far in 2013 (except for China Taiping), indicating that most of agency FYP growth was generated from improving productivities, either through rising proportion of active agents, and/or improving productivity of individual agents. Exhibit 205: Key agency measures in China –1-9M2013 Agency headcount net growth YTD Rookie recruitments YTD Industry hires YTD All agents retention YTD <1 yr agent retention YTD Expiring license renewal (3Q13)* China Life 5% 23% 2% 77% 74% 34% Ping An 11% 66% 1% 58% 41% 63% CPIC -3% 38% 2% 61% 59% 38% NCL -12% 28% 3% 60% 68% 23% Taiping 75% 74% 9% 82% 84% 36% PICC Life 0% 14% 4% 74% 88% 22% Source: Pi Financial Service Note: Expiring license renewal could be considered as a proxy to measure proportion of active agents Going into 2014, we expect agency business to deliver NBV growth in the range of 5-8% in general, thanks to the following factors: Broadening product offerings as a result of non-par insurance de-regulations; Stabilizing agency headcounts; Gradual improvements in productivities thanks to on-going trainings; Increasing demand and acceptance of certain insurance product lines, especially on critical illness policies such as cancer protections. Among the listed insurers, Ping An has the strongest agency quality, based on license renewals rates and its stronger professional training. In addition, Over 93% of its New Business Value was generated from agency distributions, which is a key advantage against peers. 28% 11% -3% 8% (0.2) (0.1) 0.0 0.1 0.2 0.3 0.4 0.5 2010 2011 2012 1H13 China Life Ping An Life CPIC Life Average Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 131 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 133. Pricing deregulation – orderly competition and proper product design could be beneficial Since the pricing deregulation of non-participating insurance products on 5th Aug 2013, insurers have gradually introduced newly priced non-par products into the market, mostly with pricing interest rate of 3.5%, and Ping An introduced “Ping An Fu” via its agency distribution in Oct 2013, using pricing interest rate of 4.0%. Irrational pricing competition has been one of the key concerns for investors under the new competition landscape. In our view, at 3.5% pricing rate, profit margin of traditional products is comparable or slightly higher than most of the current participating offerings. In addition, adjustments in product design could also help to maintain or even improve product margins. Generally speaking, higher discount rate will lead to reduction in premium and squeeze in margins, but this may not always be true – it depends on the details of the product design and how the product is positioned. The standard life insurance product pricing formula is as follows: Premium = Guaranteed benefit discounted at pricing rate / (1–loading) With higher pricing interest rate, insurance companies can increase their loadings (up to the regulatory cap level) and use more conservative mortality/morbidity tables to offset the impact, and hence maintain relatively healthy margins. “Ping An Fu” is a good example of such adjustments. We compared “Ping An Fu” against China Life’s flagship “Kang Ning 2”, with similar benefits, “Ping An Fu” charges even higher premium, despite its 4% pricing discount rate. Exhibit 206: Pricing comparison for Ping An Fu vs. China Life Kang Ning 2 Source: Jefferies estimates, company data The key drawback of using 4% in pricing is the larger size of initial capital outflow, due to the reserve calculation cap of 3.5%. However, looking beyond such actuarial calculations, with similar benefits, higher premium implies healthier margins. With more of these products coming on-line going into 2014, we believe life insurance agents could broaden their offering to consumers, begin to realize some new demands and improve productivity. While we acknowledge that irrational pricing is dangerous, we have not noticed aggressive behaviour in the industry so far. In our view, as long as the top insurance companies remain rational, with solvency constraints, smaller insurers will find it difficult to start a price war, especially in the agency distribution channel. Product pricing comparison Insured details: Gender Male Payment (years) 20 Protection terms Whole Life Sum insured (RMB) 300,000 Product China Life - Kang Ning 2 Ping An - Ping An Fu Pricing interest rate 2.5% 4.0% Premium (RMB) 9,450 11,728* Key coverage and benefits: 1 Death Death 2 40 listed critical illness 29/30 listed critical illness 3 10 specified illness - 20% of sum insured Accident insurance (up to age 70)** 4 Disability Accident medical insurance (up to age 50)*** 5 Premium waiver**** Note: * Accident probability is generally low, and only requires RMB1,500-RMB2,000 premium for this coverage, so comparable premium is about RMB10,000 for Ping An * RMB500,000 protection (167% of sum insured), double if incurred during public transportation or driving ** RMB50,000 (17% of sum insured) *** Premium is waived in the case of policyholder death, critical illness, or disability Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 132 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 134. Broadening of investment channels will gradually start showing benefits In 2H12, CIRC broadened the investment channels for insurance funds, with increasing allocation allowance into alternative asset classes such as WMP, trusts and real estates. Exhibit 207: insurance funds de-regulation Asset allocation caps Unlisted equities 10% Direct equities and equity funds 20% Unsecured debt 50% Related parties debt 20% Real estate 15% Real estate and infrastructure bonds 20% Wealth management products, credit related assets, trusts 30% Overseas investments 15% Emerging markets 10% Source: CIRC One of the concerns the market had earlier was insurers aggressively chasing high yield assets, which could compromise asset quality. So far, we notice relatively conservative actions from insurance companies, with only gradual approach to tap into the new asset classes, except for PICC Group, who have been more aggressive compared to its peers. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 133 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 135. Exhibit 208: Change in investment allocations Dec12 - Jun13 Source: Jefferies, company data Partly thanks to the rising allocation towards other investments and shrinking exposure to equities, we realize that insurance funds’ comprehensive investment yields (including AFS mark-to-market impacts) are relying less on A-share performance. In 1H13, comprehensive yield for the big three insurers was recorded at 4.2-4.6%, which is relatively healthy given the 12.8% decline in CSI300. China Life Ping An Dec-12 Jun-13 Chg Dec-12 Jun-13 Chg Cash, cash equivalents and others 3.9% 2.8% -1.1% 6.8% 4.8% -2.1% Term deposits 35.8% 37.2% 1.4% 22.5% 20.7% -1.8% Bond investments 46.2% 46.0% -0.2% 52.1% 53.4% 1.2% Equity investment funds 3.3% 3.1% -0.2% 2.3% 2.5% 0.2% Equity securities 5.7% 4.5% -1.2% 7.1% 6.9% -0.2% Debt schemes investment n/a n/a 3.5% 6.1% 2.6% Infrastructure investments n/a n/a 0.8% 0.8% -0.1% Investment properties 0.0% 0.1% 0.1% 1.5% 1.6% 0.0% Investments in associates 1.6% 1.6% 0.0% n/a n/a Others 3.5% 4.8% 1.3% 3.3% 3.5% 0.2% Total 100.0% 100.0% 100.0% 100.0% Alternative investment allocations 5.1% 6.5% 1.4% 9.1% 11.9% 2.7% CPIC NCL Dec-12 Jun-13 Chg Dec-12 Jun-13 Chg Cash, cash equivalents and others 4.0% 4.3% 0.3% 5.2% 4.1% -1.1% Term deposits 26.2% 23.3% -2.9% 35.9% 33.5% -2.3% Bond investments 52.8% 54.5% 1.7% 48.9% 50.7% 1.8% Equity investment funds 4.5% 4.4% -0.1% 3.3% 3.0% -0.3% Equity securities 4.3% 4.3% 0.0% 3.4% 3.4% 0.1% Debt schemes investment 4.5% 4.9% 0.4% n/a n/a Infrastructure investments n/a n/a n/a n/a Investment properties 1.0% 1.0% 0.0% 0.3% 0.3% 0.0% Investments in associates n/a n/a 0.1% 1.8% 1.7% Others 2.7% 3.3% 0.6% 2.9% 3.1% 0.2% Total 100.0% 100.0% 100.0% 100.0% Alternative investment allocations 8.2% 9.2% 1.0% 3.4% 5.2% 1.9% CTIH PICC P&C PICCG Dec-12 Jun-13 Chg Dec-12 Jun-13 Chg Dec-12 Jun-13 Chg Cash, cash equivalents and others 7.9% 6.4% -1.5% 5.9% 11.8% 5.9% 12.4% 9.7% -2.7% Term deposits 17.7% 16.6% -1.1% 24.5% 22.7% -1.8% 20.2% 19.8% -0.3% Bond investments 55.5% 56.7% 1.2% 44.8% 44.1% -0.7% 36.5% 37.9% 1.4% Equity investment funds 4.2% 3.6% -0.6% 0.0% 0.0% 0.0% 7.5% 7.5% 0.0% Equity securities 3.5% 4.5% 0.9% 16.2% 12.7% -3.5% 8.2% 3.6% -4.6% Debt schemes investment 9.4% 10.4% 1.0% 3.7% 4.0% 0.3% 6.6% 9.4% 2.8% Infrastructure investments n/a n/a n/a n/a n/a n/a Investment properties 1.8% 1.8% 0.0% 2.1% 1.9% -0.2% 1.4% 1.4% 0.0% Investments in associates n/a n/a 1.2% 1.3% 0.1% n/a n/a Others n/a n/a 1.7% 1.6% -0.1% 7.3% 10.8% 3.5% Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Alternative investment allocations 11.2% 12.2% 1.0% 8.7% 8.7% 0.1% 15.3% 21.5% 6.3% Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 134 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 136. Exhibit 209: Comprehensive investment yield vs. A-shares Source: Jefferies, company data; Bloomberg Exhibit 210: Net investment yields Source: Jefferies, company data Going forward, with gradual addition to alternative investment classes to improve net yields, and more controlled allocation towards the volatile A-shares market, we expect investors to gradually improve their confidence in the insurers’ investment capability, and have more visibility in terms of comprehensive investment yield forecasts. Rising bond yield could also help Since Jun13, China 10-years bond yield has risen substantially, by over 80bps, to 4.4% as at Nov 2013, which is fundamentally positive for life insurance companies, especially for investments from newly derived premium and re-investments of matured bonds. The benefit is likely to be more visible for Chinese insurers due to their longer liability durations. As an example, China Life disclosed that the durations of its financial assets are significantly shorter vs. the duration of its contractual liabilities. Exhibit 212: China Life expected undiscounted cash-flows (RMB mn) Carrying Amount Without maturity Less than 1 year 1-3 years 3- 5 years > 5 years Financial assets 1,828,467 164,748 306,992 399,340 528,381 1,040,506 Financial and insurance liabilities 1,604,511 0 134,489 95,844 276,859 2,107,996 Net cash-flow 223,956 164,748 172,503 303,496 251,522 -1,067,490 Source: Jefferies, company data The mismatch between asset and liability durations leads to more timely re-investment of assets, which can be put into higher yielding bonds. At the same time, for the newly derived premium, higher yielding assets become available, which can help insurance companies improve their net investment yields. We understand that there could be mark-to-market losses on EV due to the movement in bond yields. However, assuming the insurance companies can hold the bonds to maturity, such an impact will be short-lived. (Note: Chinese life insurance statutory reserve calculation is prescribed by CIRC, as a result, its contractual guaranteed benefit statutory liability will not be impacted by bond yield movements; however, assets will need to be marked to market, which caused this potential mark-down in EV). 9.0% 14.2% 18.9% 18.1% -9.3% -5.5% 8.7% 6.0% 2.3% 1.5% 3.1% -0.4% 4.0% 5.5% 4.3% 51.0% 46.4% 84.4% 41.8% -47.7% -34.9% 74.2% 12.9% -28.3% 22.1% -2.7% -22.9% 4.9% 2.5% -12.8% -60.0% -40.0% -20.0% 0.0% 20.0% 40.0% 60.0% 80.0% 100.0% -15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 1H06 2H06 1H07 2H07 1H08 2H08 1H09 2H09 1H10 2H10 1H11 2H11 1H12 2H12 1H13 China Life Ping An CPIC CSI300 index performance (not annualized) (RHS) 3.84% 3.67% 4.37% 3.86% 4.36% 4.17% 4.58% 4.28% 4.66% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 1H09 2H09 1H10 2H10 1H11 2H11 1H12 2H12 1H13 Average China Life Ping An CPIC Exhibit 211: China 10-yrs government bond yield Source: Jefferies estimates 3.0% 3.2% 3.4% 3.6% 3.8% 4.0% 4.2% 4.4% 4.6% Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 135 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 137. Valuation and stock picks Exhibit 213: Valuation table (19th Nov 2013) Source: Jefferies estimates, company data Exhibit 214: Key NBV/EV growth assumptions Ticker 2013E NBV growth 2014E NBV growth 2013E EV growth 2014E EV growth China Life 2628 HK 1.2% 3.0% 14.2% 12.2% Ping An 2318 HK 10.0% 7.1% 18.1% 16.7% CPIC 2601 HK 5.6% 6.4% 9.8% 9.6% NCL 1336 HK -3.0% 2.8% 16.2% 13.9% Taiping 966 HK 25.9% 5.6% 29.5% 15.2% PICC Group 1339 HK 0.7% -0.5% 20.5% 14.1% Source: Jefferies estimates Pecking order in China Insurance: Ping An (2318 HK ; BUY) CPIC (2601 HK ; BUY) NCL (1336 HK ; BUY) China Life (2628 HK ; HOLD) PICC (2328 HK ; HOLD) CTIH (966 HK ; HOLD) PICC Group (1339 HK ; HOLD) Exhibit 215: 3 years historical P/EV Source: Bloomberg; Jefferies Exhibit 216: 1 year historical P/EV Source: Bloomberg; Jefferies Ticker P/EV NBVM P/E P/B Ratings 2012 2013E 2014E 2012 2013E 2014E 2012 2013E 2014E 2012 2013E 2014E 2628 HK China Life - H 24.20 1.60 x 1.40 x 1.25 x 9.7 x 7.3 x 5.0 x 48.9 x 20.0 x 16.0 x 2.44 x 2.21 x 1.95 x HOLD 2318 HK Ping An - H 69.90 1.53 x 1.30 x 1.11 x 9.5 x 5.7 x 2.3 x 21.8 x 15.5 x 12.9 x 2.74 x 2.39 x 2.03 x BUY 2601 HK CPIC - H 31.15 1.65 x 1.50 x 1.37 x 12.4 x 10.0 x 7.6 x 42.8 x 21.6 x 18.7 x 2.32 x 2.15 x 1.99 x BUY 1336 HK NCL - H 26.90 1.17 x 1.00 x 0.88 x 2.3 x 0.1 x -2.2 x 22.6 x 14.6 x 11.1 x 1.85 x 1.64 x 1.42 x BUY 966 HK CTIH 15.20 1.17 x 0.90 x 0.78 x 3.3 x -1.9 x -4.7 x 27.7 x 20.7 x 13.2 x 1.87 x 1.72 x 1.48 x HOLD 1339 HK PICC Group 3.80 1.69 x 1.40 x 1.23 x n/a n/a n/a 16.9 x 14.6 x 11.3 x 1.95 x 1.71 x 1.43 x HOLD Average 1.47 x 1.25 x 1.10 x 7.4 x 4.2 x 1.6 x 30.1 x 17.8 x 13.8 x 2.20 x 1.97 x 1.72 x 2328 HK PICC P&C 12.88 12.0 x 12.8 x 12.4 x 2.74 x 2.25 x 1.91 x HOLD *Implied PICC Life & Health 0.72 x 0.66 x 0.59 x -3.5 x -4.7 x -6.2 x 0.94 x 0.99 x 0.82 x 1299 HK AIA 39.35 1.94 x 1.81 x 1.64 x 24.9 x 18.4 x 13.7 x 20.2 x 19.5 x 17.1 x 2.27 x 2.10 x 1.92 x BUY Price (HK$) 0.6 1.1 1.6 2.1 2.6 3.1 3.6 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 China Life Ping An CPIC TP 3 yrs Avg 0.6 0.8 1.0 1.2 1.4 1.6 1.8 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 China Life Ping An CPIC TP NCL 1 yr Avg Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 136 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 138. China Brokers: Expect Another Harvest Year with IB Rebound Key takeaways With the Third-Plenum report planning to promote a register-based IPO system, develop & standardize the bond market, and increase the proportion of direct financing, we believe brokers will be the top beneficiaries of these capital market changes. In 2014, we expect the investment banking (IB) business to rebound strongly with the resumption of IPO approvals, and the asset management and credit related businesses to continue growing steadily, resulting in further improvement in China brokers’ profitability. We remain positive on the sector, and prefer brokers with strong IB franchise and capital position. Top pick CITICS. Investment banking – the laggard to rebound: Investment banking was a drag on brokers’ earnings growth in 2013 due to A-share IPO suspension and a weak bond market in 2H13. Since the trend of interest rate deregulation and disintermediation is unlikely to change, and the recent Third-Plenum report plans to promote a register- based IPO system, develop & standardize the bond market, and increase the proportion of direct financing, we are optimistic on brokers’ IB business. We expect the IB business to rebound strongly after the resumption of IPO approvals, and debt underwriting to recover when the bond market stabilizes. Credit related business – steady growth expected, capital is the key: Credit related businesses – margin lending and stock repo – may continue to deliver steady growth in 2014 after the strong take-off in 2013, and the interest margin is likely to remain high given tight liquidity, in our view. Big brokers with strong capital positions are likely to be the largest winners. With lower account opening requirements and more target securities, margin lending may become a relatively stable and meaningful profit contributor. Meanwhile, stock repo balance is likely to increase faster with the newly introduced pledge-based stock repo. Asset mgmt – pie is still growing: We believe the demand for asset management will continue to increase as the demand from wealth diversification grows with a rising middle class in China, and more investment choices have attracted fund flows from bank deposits to the capital market during disintermediation. Although competition with banks, insurers and fund mgmt companies is fierce, thanks to regulatory loosening on brokers’ asset management business, we believe brokers may win market share with their diversified product offering and strong product innovation. Brokerage – Lower commission rate likely, time to differentiate and charge for service: As online and witness-based securities account opening are widely implemented in late 2013, and brokers are aggressively opening low-cost “light” branches, we see fiercer commission rate competition in 2014 and further decline in commission rates for the whole industry. But big brokers with better facilities, products and services may hold up better and offset the negative impact of lower commission rate through market share expansion, in our view. Stay positive – prefer brokers with strong IB franchise and capital position, top pick CITICS: We remain positive on the sector as we believe further development of credit related and asset management businesses as well as a rebound of the investment banking business will drive further improvement of China brokers’ profitability. As brokerage commission rate challenge may be offset by market share expansion for the big brokers, we prefer big brokers with strong IB franchise and capital position. Top pick CITICS (6030 HK, Buy), given its strong IB franchise, diversified revenue drivers after its overseas expansion, and strong earnings growth in 2014. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 137 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 139. Investment banking – the laggard to rebound The drag in 2013 China brokers’ investment banking income was weak in 2013, as A-share IPO has been suspended for more than one year. Corporate bond underwriting was strong in 1H13, but became weak in 2H13 due to weak bond market performance. The industry’s 1H13 investment banking income was down 26% YoY, even though total revenue was up 11%. CITICS and HTS’ 9M13 investment banking revenue was down 52%/25% YoY resp., vs. 26%/21% growth in total revenue. Expect strong rebound after IPO resumes A-share IPO has been suspended for more than one year (the last A-share IPO was listed on 2 Nov 2012), the longest suspension since the market was established. Currently, 40 companies have already got all the approvals and are waiting for IPO to resume. The bond market was hurt by the tight liquidity and regulatory review in 2H13, and thus bond underwriting volume growth decelerated. We expect the bond market to stabilize after the meaningful decline in 2H13 and bond underwriting volume to recover a bit. In the long term, since the trend of interest rate deregulation and disintermediation is unlikely to change, and the recent Third-Plenum report plans to promote a register- based IPO system, develop & standardize the bond market, and increase the proportion of direct financing, we remain optimistic on brokers’ investment banking business. Expansion of OTC market and asset securitization to drive additional revenues According to news from Caixin on Oct 8, the new OTC market, which is only open to specific high-tech districts, may be expanded nationwide in 2014. And the approval of OTC listing may become much easier and faster. The expansion may increase the number of listed companies in the OTC market meaningfully, and drive brokers’ investment banking fee income growth. Furthermore, an OTC trading system (including pricing, market making and negotiated pricing mechanisms) may be launched in 2014 according to news from Yicai on Oct 15. We believe market making in the OTC market may be a meaningful revenue driver for brokers. We note that the development of an OTC market (market cap growth and liquidity improvement) may take some time, thus revenue from the OTC market may grow gradually. Asset securitization has become an important development in China and is likely to earn additional investment banking fees for brokers, though the earnings impact may be marginal in the near term given regulatory uncertainties (assets for securitization still need approval) and strong competitors (banks, trust companies), in our view. Credit related business – steady growth expected, capital is the key Margin lending – from a new driver to a stable and meaningful profit contributor Margin lending business may continue to expand with more target securities and lower entry barriers for investors, and become a stable and meaningful profit contributor for brokers, in our view. Margin lending balance was up by 307% in 10M13 despite weak A-share equity market performance (-4.5% in 9M13), and contributed 10% of total revenue for the whole industry in 1H13 vs. 3% one year ago. Shanghai and Shenzhen exchanges increased the number of target securities for margin trading to 700 from 494 in September 2013, which may support further growth of the margin lending balance. There are in total 2,532 listed companies in the A-share market, thus only 28% of listed stocks are now available for margin trading. The margin trading securities pool is likely to become larger as the market develops, in our view. Exhibit 217: Weakest investment banking income in past 3 years in 1H13; we expect a rebound when IPO resumes (Rmb mn) Source: SAC, Jefferies 6,000.0 7,000.0 8,000.0 9,000.0 10,000.0 11,000.0 12,000.0 13,000.0 14,000.0 1H2011 2H2011 1H2012 2H2012 1H2013 Exhibit 218: The long waiting list for A-share IPO Source: CSRC, Jefferies SH Exchange SZ Exchange Total Approved by IPO committee 10 30 40 In the process of review 69 166 235 In the process of pre-review 98 115 213 Total 177 311 488 Exhibit 219: Margin lending balance grew strongly Source: Wind, Jefferies 30 80 130 180 230 280 30 80 130 180 230 280 330 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Average daily turnover (RHS, Rmb bn) Margin financing balance (LHS, Rmn bn) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 138 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 140. After 3 years’ development of the margin trading business, brokers have started to lower the entry barriers for investors to open margin accounts, which may increase the margin trading business penetration and thus revenues, in our view. CSRC used to require 18 months’ account history and balance of Rmb500K for margin account opening, but cancelled the restrictions and let the brokers make their own decision in 2013. Most of the brokers have started to lower the threshold to Rmb200K and account history of 6 months since mid-2013. Stock repo – new business to take off, aided by tighter liquidity Pledge-style stock repo was introduced in May 2013, which has easier operating process, more funding sources and longer lending period. According to news from Shanghai Security Journal, the new pledge-style stock repo has amounted to Rmb30bn (equivalent to 12% of margin lending balance) in two months after it launched in June, pricing around 8-9% p.a. We expect this new business to grow strongly in 2014 with stable pricing given the tightening liquidity in the market, and contribute meaningful interest income. Brokers with strong capital position may benefit more Credit related business development needs strong funding support, thus large brokers with strong capital and cash position may benefit more. All of the three H-share China brokers have strong cash and capital position, and will be the winners in the credit related market, in our view. CITICS has aggressively issued corporate bonds and ST commercial papers, and raised its leverage to 2.55x as of end-Sep 2013; HTS also issued USD900mn corporate bonds in October and CGS (China Galaxy Securities, 6881 HK, NC) just transferred its HK IPO proceeds back to China in September. Thus we believe credit related business will contribute meaningfully to the three brokers’ revenues. Asset management – the pie is still growing A growing pie – deposit outflows growing AUM Disintermediation also manifests in deposit outflows, as more investment choices have attracted fund flows from bank deposits to the capital market. Deposit growth in banks has become more volatile, while the AUM of brokers, insurers, funds and trust companies has been growing steadily. Brokers’ AUM was up more than 6x YoY and revenue from asset management increased by 176% YoY in 1H13. Also, fund companies, trust companies and insurers’ AUM were up 6%, 36% and 9% in 9M13 respectively. Diversified product offering and strong product innovation may help brokers to stay steady amidst fiercer competition Since the regulatory loosening on brokers’ asset management business was implemented in late 2012 (a lot of restrictions on investment scope have been removed), brokers’ asset management products have become more diversified and product innovation has speeded up. Besides the traditional asset management products that invested in equity or debt markets, PE fund, industry fund and credit related products have grown strongly. Asset management products can also be used as a stock repo funding source since the new pledge-style stock repo was introduced. Looser regulation and active innovation are brokers’ key strengths in the asset management business, which will drive the development of their asset management business, in our view. Banks are strong competitors in this area, given their strong network and customer base. However, the strict regulations to ensure their stability may restrict the diversification and innovation of bank wealth management products, in our view. We see limited impact of the newly approved debt-related asset mgmt plans issued by banks, as the pilot volume is still small and there are still many regulatory uncertainties. Exhibit 220: Industry margin lending revenue up 210% YoY in 1H13, accounting for 9% of total revenue Source: SAC, Jefferies 0% 2% 4% 6% 8% 10% 0.0 1,000.0 2,000.0 3,000.0 4,000.0 5,000.0 6,000.0 7,000.0 8,000.0 1H20122H20121H2013 Margin lending revenue (LHS, Rmb mn) Margin lending revenue% total (RHS) Exhibit 221: Deposit growth has become more volatile… Source: PBOC, Jefferies (1,000) (500) 0 500 1,000 1,500 2,000 2,500 3,000 2008/02 2008/10 2009/06 2010/02 2010/10 2011/06 2012/02 2012/10 2013/06 New deposits (Rmb, bn) Exhibit 222: ... while AUM has been growing steadily (Rmb bn) Source: PBOC, CIRC, SAC, AMAC 0.0 2,000.0 4,000.0 6,000.0 8,000.0 10,000.0 12,000.0 2012 1H13 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 139 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 141. Brokerage – Lower commission rate likely, time to differentiate and charge for service Looser regulations may trigger another round of commission rate competition With looser regulations, lower cost on customer accounts and branches opening, it has become easier for brokers to expand in under-penetrated areas and thus may lead to fiercer commission rate competition and further decline in commission rates, in our view. Online and witness-based account opening was officially implemented in August 2013, which allowed brokers to solicit customers with very little cost in under-penetrated areas where they have limited number of branches. This also gives brokers the opportunities to break the local rules on commission rates (local industry associations or CSRC set up minimum commission rate of around 8-10bps), as customer accounts can be opened under branches located in cities without minimum commission rules via online or witness -based account opening. CSRC also allowed brokers to set up “light” branches (set-up cost only around 10-20% of traditional branches) since end-2012, and many brokers have made aggressive plans; HTS (6837 HK, Buy) plans to open 89 “light” branches in 2H13, and Founder Securities (601901 CH, NC)/ Dongwu Securities (601555 CH) / Everbright Securities (601788 CH, NC)/ Shanxi Securities (002500 CH, NC) plan to open 28/ 24/ 24/ 16 respectively. Big brokers’ market share expansion and service charges may offset the commission rate decline While looser regulations on customer accounts and branch opening may lead to lower commission rates, they also lowered geographic barriers and make it easier for big brokers with strong balance sheets and better products and services to expand market share. CITICS and HTS’ equity brokerage market share increased from 6.06%/4.70% in 2012 to 6.50%/4.98% in 9M13. Moreover, with more new services and products introduced into the capital market during regulation reform, big brokers with a comprehensive platform may be able to charge higher commission rates for more diversified services and products. Exhibit 224: Current broker branches’ geographic allocation - East still accounts for more than 60% Source: Wind, Jefferies East 62% Middle 18% West 20% Exhibit 223: Commission rate likely to decline further Source: SAC, Wind, Jefferies 0.06% 0.08% 0.10% 0.12% 0.14% 0.16% 0.18% Net Brokerage Commision Rate Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 140 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 142. 2014 Macau Gaming Solid Organic Growth Ahead Key takeaways As China kickstarts its historic reform, we expect policy risk to moderate for the Macau gaming sector. We expect 15% yoy growth in GGR on increased mainland visitors and continuous table yield optimization. Sands China should take the lead, benefiting from its huge room inventory. Strong momentum in Galaxy is likely to be supported by improving margins. We are positive on the sector; our Top Picks are Sands China and Galaxy. Industry outlook steady, organic growth to drive GGR: We expect Macau GGR to grow at 15% yoy in 2014, driven by strong mass momentum (27%) and steady VIP (10%), our number is within consensus range of 25%-30% in mass and 10%-15% in VIP. Given very limited tables addition, we believe the growth drivers are 1) more mainland visitations to Macau; 2) longer hours playing at the Casinos and 3) larger betting size. China’s HNWI the base for premium players: Macau GGR exceeded US GGR in 2012, driven by China’s High Net Worth Individuals (HNWI). Despite the rich only representing a small percentage of the population, the absolute asset base size provides a positive backdrop for continuous gaming growth. As long as wealth creation for the richest few is sustained, we believe GGR has the potential to maintain steady growth. More upside from mainland visitation: In the first three quarters, visitations from mainland were up 12%, ahead of 0.3% and 4.6% growth in 2012, respectively. Importantly, overnight visitors accounted for 50%, compared with 44% at end 2011. The first phase of the Chimelong International Ocean Tourist Resort is expected to open later this year, we expect more visitors to follow in 2014. Sector margin to expand on table yield optimization: EBITDA margin started to improve as mass growth outpaced VIP in 2012, we expect the positive trend to continue, on the back of continuous yield optimization (shifting tables from VIP to mass). Overall, we expect EBITDA margin to expand to 21% in 2014 from 20% in 2013. Sands China to gain market share: SJM dominated the market in the decades before the license reform in 2002 and remained No. 1 still 2013. We believe Sands China will take over SJM’s leading position in 2014 as growth in Cotai is much faster than in the peninsula. Galaxy should take third place while MGM and Wynn Macau the last two. Who will be the winners and losers? We believe Sands China will be the major beneficiary of the visitation growth in 2014, thanks to its large hotel room inventory and potential table yield improvement at Sands Cotai Central. Galaxy has the strongest mass growth momentum in 2013; we expect the trend to continue. MPEL should see more positive news flow in 2014, such as City of Dreams Manila and more initiatives in attracting premium players. Clarity on the land cooperation with Angela Leong in Cotai will reduce investor concerns on SJM. MGM China rallied significantly in 2013 but it has limited room to grow, given fully utilized property. Strong dividend is the only support for Wynn Macau’s stock price. Key risk: Empirically, there is a strong correlation between GGR growth and China’s nominal GDP growth as the majority of the players are from mainland China. We believe China’s slowdown is the primary risk for Macau’s growth. In addition, labor shortage may also put gaming industry under pressure as there may not be enough dealers (Macau PR only) after massive launch in the next 4 years. China’s anti-corruption is also an overhang that should be closely monitored. Leon Liao +852 3743 8021 lliao@jefferies.com Rong Li +852 3743 8014 rli@jefferies.com Eric Chen +852 3743 8016 eric.chen@jefferies.com Christie Ju, CFA +852 3743 8012 cju@jefferies.com Exhibit 225: GGR growth trend Source: DICJ, Jefferies 50,000 150,000 250,000 350,000 450,000 550,000 2009 2010 2011 2012 2013E 2014E 2015E Sands China Galaxy Wynn Macau SJM MPEL MGM China Jefferies recommendation Ticker Rating Target Price 1928 HK Buy HK$60.0 27 HK Buy HK$68.0 MPEL US Buy Us$41.8 2282 HK Hold HK$28.1 880 HK Hold HK$24.7 1128 HK UNPF US$23.7 Source: Jefferies Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 141 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 143. Organic growth in GGR expected We expect GGR growth in 2014/15 to be 15/16%, respectively. Per segment, we expect mass revenue to grow at 27%/26% in 2014/15 and VIP revenue to increase 10%/11%. In the absence of table addition, we believe the revenue will be mainly driven by 1) more visitors entering the casino; 2) longer table playing hours and 3) larger betting size. The latter two depends on how the company optimizes its tables or improves its property efficiency. Exhibit 226: GGR growth forecast Source: DICJ, Jefferies estimates Limited supply in 2014, more catalysts in 2015 According to guidance from Macau authorities, new table grants will only be based on the non-gaming facilities in new properties. All new properties in Cotai are yet to be launched in 2014. Macau Legend (1680 HK, NC) in the peninsula is likely the only one that will add tables (116 tables) after the Babylon Casino & Rock Hotel are completed. Supply should be huge in 2015, with Galaxy Macau Phase II, Studio City, and Parisian all scheduled to open in 2015, but the majority of the tables are likely be added by year end, thus the real impact on gaming revenue in 2015 should not be significant. Exhibit 227: Table supply in 2014-2017 Source: Company data, Jefferies, according to company disclosures A total of 12,600 luxury hotel rooms will be added to the market in the next 5 years, representing a 68% increase compared to Macau’s current luxury room supply. 0% 10% 20% 30% 40% 50% 60% 70% - 100 200 300 400 500 600 GGR (MOP bn) yoy % 753 21 511 183 264 116 1,467 1,183 700 4,000 5,000 6,000 7,000 8,000 9,000 10,000 2009 2010 2011 2012 2013E 2014E 2015E 2016E 2017E Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 142 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 144. Exhibit 228: Cotai new property opening schedule Planned open Property Total investment (USD mn) Gaming Tables Slots Hotel Rooms 2015 Studio City 4,800 500 1,500 1,600 2015 Galaxy Macau Phase II 2,500 500 1,000 1,350 2015 Parisian (site 3) 2,700 350-450 2,500 3,000 2016 Wynn Cotai 4,000 500 1,500 2,000 2016 COD Tower V 800 - - 850 2016 MGM Cotai 2,600 500 2,500 1,600 2016 Louis XIII 900 66 0 236 2017 SJM Cotai 2,800 700 2,000 2,000 Total 21,100 3,166-3,266 11,000 12,636 Source: Company data, Jefferies Visitations trending up, supporting mass growth In the first three quarters, total visitations increased 5% while mainland visitors were up 12%, compared with 0.3% and 4.6% growth in 2012, respectively. Overnight visitors have accounted for 49% of total visitations to Macau in the past 10 years. The number declined to around 44% by end of 2011; it started to pick up in early 2012 and has reached 50% in recent months. We expect more visitors will stay in Macau overnight as China’s railway is now connected with inner cities and more hotel rooms have been added. We believe visitation growth is mainly driven by 1) strong growth in package tours, which increased 12.9% yoy in 1H; 2) improving infrastructure, simplified cross boarding process and enlarged gate capacity; and 3) strengthening of RMB, in our view. Exhibit 229: Visitation growth Source: Wind, Jefferies Exhibit 230: Overnight visitors as % of total Source: Wind, Jefferies Development in Hengqin Island The first phase of the Chimelong International Ocean Tourist Resort is expected to open in November this year during the first Circus Festival in Hengqin. The resort will also include a hotel with 1,888 rooms and an aquarium about 23K cubic meters in size. According to the media, the resort can accommodate ~20mn visitors a year when fully ramped up. China’s HNWI are the base supporting GGR growth Macau GGR exceeded US GGR in 2012, driven, we believe, by China’s High Net Worth Individuals (HNWI). Although the rich only represent a small percentage of the population, the absolute asset base size provides a positive backdrop for continuous gaming growth. As long as wealth creation for the richest few is sustained, the betting size should continue to rise. -40.0% -20.0% 0.0% 20.0% 40.0% 60.0% Total visitation Mainland visitor 40% 42% 44% 46% 48% 50% 52% Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 143 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 145. Table reallocation drives margin expansion We expect EBITDA margin to gradually expand, as mass revenue is growing much faster than VIP. On average, EBITDA margin for mass is around ~40% while VIP is in the range of 10-15%. We expect the overall EBITDA margin to reach 21% in 2014 from 19%/20% in 2012/2013, mainly benefiting from continuous table optimization by shifting tables from VIP/mass to premium mass or from low yield location to high yield properties. Galaxy is the most successful on table optimization, its VIP ceased to grow in 2013 while mass surged 50% yoy (data up to end-Sep). It has now transformed to a mass focus player; mass contribution to total GGR reached 30% in 3Q13 from 20% in 1Q12. EBITDA margin also improved to 20% in 3Q13 from 16% in 1Q12. Exhibit 231: GGR growth vs. EBITDA margin expansion Source: Company data, DICJ, Jefferies Sands China will lead the market SJM dominated the market in the past decades before the license reform in 2002 and remained in the No. 1 position still 2013, mainly supported by third party operated casinos. We believe Sands China will start to lead the market in 2014 as growth in Cotai is much faster than that of peninsula. Galaxy should take third place while MGM and Wynn Macau take the last slots. Cotai growth is much faster than that of the peninsula. The contribution from Cotai is gradually trending up from 25% in 4Q10 to 44% in 3Q13. We expect the contribution to reach 50% at end of 2014. Exhibit 232: Sands China has started to lead the market Source: DICJ, Jefferies Exhibit 233: GGR in Cotai vs. peninsula Source: DICJ, Jefferies 6% 10% 14% 18% 22% 0 20,000 40,000 60,000 80,000 100,000 2008 2009 2010 2011 2012 2013E 2014E 2015E HK$m Sands China Wynn Macau SJM Galaxy MPEL MGM China EBITDA margin 25% 23% 19% 16% 19% 22% 24% 24% 7% 11% 11% 16% 19% 18% 18% 19% 17% 15% 15% 14% 12% 11% 10% 10% 27% 30% 32% 29% 27% 25% 24% 23% 15% 12% 14% 15% 14% 14% 15% 15% 8% 9% 9% 11% 10% 10% 10% 9% 0% 20% 40% 60% 80% 100% 2008 2009 2010 2011 2012 2013E 2014E 2015E Sands China Galaxy Wynn Macau SJM MPEL MGM China 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 Cotai Peninsula Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 144 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 146. China slowdown the primary risk for gaming GGR Empirically, there is a strong correlation between GGR growth and China’s nominal GDP growth. GDP growth began to decelerate in 4Q11 and bottomed in 3Q12, while GGR started to slow down and reached its slowest pace (9% yoy) during the same period. We believe a China’s slowdown is the primary risk to Macau’s growth. Exhibit 234: China’s GDP growth vs. Macau Gaming GGR growth Source: CEIC, DICJ, Jefferies Labor shortage and China’s anti-corruption campaign are risks to watch Macau’s unemployment rate has been consistently low at around 2% in the past two years. Eight resorts with a total GFA of 45mn sqm, and 12.6K hotel rooms are to be launched in the next 4 years. Not to mention the construction worker shortage before the properties are launched, demand for resort staff will put pressure on the labour market. The Macau government has “firmly” banned migrants from working as casino dealers. This could put the industry under pressure as there will be massive table additions in the next five years (one table needs at least 3 dealers). In addition, the Chief Executive is pushing casinos to promote more residents to management positions during the policy address at the Legislative Assembly. We believe the labour shortage would: 1) increase labour cost; 2) make it difficult to reach full capacity and 3) lower working/services quality. Corruption in China and its links to Macau gambling are widely acknowledged. So far there is no visible evidence that anti-corruption measures have hurt GGR. We believe if the Chinese government maintains or strengthens its corruption crackdown, GGR is likely to be negatively impacted down the road. Share price performance and valuation The Gaming sector has outperformed the market in the past two years. YTD, gaming stocks rose 74% vs. the index 4%. MPEL, MGM China and Galaxy outperformed their peers, while Wynn Macau and SJM lagged. Exhibit 235: Share price performance Company Ticker 1week 1mth 3mth 6mth 12mth YTD Sands China 1928 HK 0.5 -1.7 33.2 39.0 85.1 67.9 SJM 880 HK -0.2 -8.7 25.9 13.4 35.8 35.8 MGM China 2282 HK -0.6 -8.3 20.7 32.5 115.8 104.1 MPEL MPEL US -3.0 -7.3 24.7 40.9 133.4 101.0 Galaxy 27 HK 2.2 -0.3 39.0 49.1 116.5 96.5 Wynn Macau 1128 HK 0.9 -6.3 41.6 16.1 37.7 41.3 Average 0.0 -5.4 30.9 31.9 87.4 74.4 HSI index 2.7 1.4 7.7 0.7 11.4 4.4 Source: Bloomberg, priced as Nov 19, 2013 0% 5% 10% 15% 20% 25% 30% -20% 0% 20% 40% 60% 80% 100% GGR growth rate nominal GDP growth rate Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 145 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 147. Exhibit 236: 2013 YTD, avg. +74% vs. +4% HSI Source: Bloomberg Exhibit 237: 2012 avg. +55% vs. +23% HSI Source: Bloomberg We still see potential upside for Sands China (1928 HK, Buy) going forward, given the company will continue to deliver solid earnings, in our view. The table yield will gradually ramp up as Sands has the largest hotel room inventory among its peers which can keep players for longer hours on their property. Galaxy (27 HK, Buy) is now focusing more on the mass segment. The contribution from mass has increased to 30% from 20% at end of 2011 and we expect the trend to continue. Galaxy Phase II is the first new property launch in Cotai, and we believe the new tables will be granted in late 2014. The sector is highly driven by news flow and frequent data points. We expect MPEL (MPEL US, Buy) to gain more traction on the back of 1) strong premium mass momentum; 2) new project launch in Manila at mid-2014 and 3) likely dividend discussion in 2014. MGM (2282 HK, Hold) has outperformed peers ytd, mainly benefiting from continued table optimization on its property and the announcement of a regular dividend policy at the start of the year. We don’t expect more earnings surprise from the stock in 2014. SJM (880 HK, Hold) is trading at 13x EV/EBITDA and 17x PE (consensus), the lowest among peers. Dividend has been providing its share price with strong support. We see more upside when there is more clarity on the land co-operation with Angela Leong. Wynn Macau (2282 HK, UNPF) has lagged peers in the past two years mainly because the standalone property has reached its mature phase, and no longer enjoys a premium valuation. The aggressive dividend payout is the main support for the stock. 36% 41% 68% 97% 101% 104% 0% 20% 40% 60% 80% 100% 120% SJM Wynn Macau Sands China Galaxy MPEL MGM China 7% 38% 42% 55% 75% 113% 0% 20% 40% 60% 80% 100% 120% Wynn Macau MGM China SJM Sands China MPEL Galaxy Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 146 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 148. Exhibit 238: Macau Gaming – forward EV/EBITDA range Source: Bloomberg, Jefferies Exhibit 239: Macau Gaming – forward P/E range Source: Bloomberg, Jefferies Multiples should sustain in a new range The gaming sector has been volatile over the past four years. It traded at an average of ~11x EV/EBITDA or 13-16x PE during 2010-2011, when the topline grew at 40-50%, and EBITDA grew even higher (96/54%). The stocks have been vulnerable to news such as: visa restrictions, credit controls over Macau consumption and the anti-corruption campaign in the mainland, despite solid growth prospects. The stocks started to trade up after the GGR slowdown in early 2012, and have been trading at 12-13x EV/EITDA in 2013. We believe the re-rating is mainly driven by: 1) Decreasing policy concerns; 2) Strengthened balance sheets, removing credit risk and 3) More clarity on the growth outlook for the next 2-3 years, as all players have secured pieces of land in Cotai. We believe the current multiple can be maintained as long as GGR has steady growth and the companies continue to deliver solid earnings. In addition, frequent high data points also drive share price performance. Exhibit 240: Valuation Comparison Mkt Cap Price EV/EBITDA PE Dividend Yield Macau Ticker Rating US$ mn Trading 2012 2013E 2014E 2012 2013E 2014E 2012 2013E Sands China 1928 HK Buy 59,287 57.00 20.2 22.1 17.7 46.8 27.0 20.5 2.4% 3.5% Galaxy 27 HK Buy 32,460 59.65 13.2 20.1 16.4 33.6 25.3 20.1 0.0% 0.0% Melco Crown MPEL US Buy 18,749 33.84 12.4 14.6 12.1 42.9 32.1 23.6 0.0% 0.0% SJM 880 HK Hold 17,265 24.10 10.3 13.1 12.1 20.0 17.4 16.3 3.7% 4.2% MGM China 2282 HK Hold 13,285 27.10 9.5 15.9 13.4 22.6 19.5 16.2 3.8% 4.4% Wynn Macau 1128 HK UNPF 19,809 29.60 13.6 17.7 17.3 23.3 21.3 19.6 4.2% 4.7% Average 13.2 17.3 14.8 31.6 23.8 19.4 2.3% 2.8% US gaming Las Vegas Sands LVS US NC 56,836 69.35 14.1 14.1 12.4 31.6 23.2 19.1 5.4% 2.0% MGM Int'l MGM US NC 9,101 18.57 20.4 10.6 9.8 NM NM NM 0.0% 0.0% Wynn Resorts WYNN US NC 16,104 159.20 11.0 11.9 11.4 29.3 23.0 22.0 6.0% 2.7% Penn National PENN US NC 1,154 14.92 9.1 5.1 6.9 6.2 12.3 26.9 0.0% 0.0% Average 13.6 10.4 10.1 22.4 19.5 22.7 2.8% 1.2% Other region Genting SG GENS SP NC 14,205 1.45 12.9 13.6 11.7 27.3 28.9 22.6 0.6% 0.6% NagaCorp 3918 HK NC 2,111 7.17 8.6 11.5 9.4 17.1 14.9 12.3 3.7% 4.5% Crown CWN AU NC 11,381 16.42 10.0 17.8 16.4 28.6 26.0 18.9 2.3% 2.2% Sky City SKC NZ NC 1,870 3.86 8.7 9.1 9.0 15.6 16.3 16.1 4.4% 5.1% Average 7.3 11.6 10.3 18.2 18.2 15.1 2.2% 2.5% Overall Avg. 11.1 13.5 12.1 24.8 20.9 18.6 2.5% 2.1% Source: Jefferies estimates, Bloomberg, priced as Nov 19, 2013 Note – Estimates for NC companies are Bloomberg consensus 11.4 12.7 10.2 8 10 12 14 16 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 EV/EBITDA Avg +1 sd - 1sd 18.4 21.1 15.6 15.6 10 14 18 22 26 30 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 PE Average +1std -1std Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 147 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 149. 2014 China Healthcare Driving Sustainable Growth Key Takeaway We maintain a favourable view on the Chinese pharmaceutical sector, as we see sustainable mid-teens% growth until 2020. Attractive growth prospects, defensiveness and undemanding valuation support our positive view. We believe the impact of the increasing cost containment pressure is manageable. We favour leading pharma companies capable of outgrowing the industry by product differentiation, innovation, and M&A. Pharma distributors are less likely to substantially outperform, as M&A pace is slowing down, and near-term efficiency improvement is unlikely. Four key industry trends: 1) Robust demand growth to continue. 2) Mounting cost containment pressures for drugs but impact manageable. 3) Negative impact from anti- bribery crackdowns could be short-lived. 4) Increasing M&A activity to drive further consolidation. Favourable government policy to support sustainable industry growth. The CPC’s Third Plenum communiqué further strengthens our confidence in the growth prospects of the Chinese healthcare industry. The blueprint calls for deepening the ongoing reform in the healthcare sector and public hospitals. Rollout of critical illness insurance will be accelerated. Medical insurance coverage will be extended to private hospitals. Government reiterates support for private investment in the medical sector, and particularly, non-profit hospitals run by private investors. These efforts will drive the sustainable growth of the pharmaceutical industry in China. Favourable view on leading Chinese pharmaceutical companies. Despite price overhang, we believe leading pharmaceutical companies will achieve above-industry growth, driven by superior product portfolio, strong sales channel, R&D commitment and M&A. Going into 2014, we project that leading players will deliver mid-20s% sales growth, outpacing the industry average of mid-teens%. We advise investors to build positions on industry leaders. Fosun Pharma (12-month PT of HK$25) remains our top pick, standing out with the most impressive M&A track record and as a first-mover in healthcare services. Neutral view on the pharmaceutical distribution subsector. We expect pharmaceutical distributors to grow at a moderate pace for the next several years, pegging growth to the slowed-down pharmaceutical industry, shy of significant M&A and efficiency improvement. Nonetheless, leaders such as Sinopharm will still be able to outpace the overall market, given scale advantage, nationwide distribution network and upside from a rapidly expanding retail pharmacy business. Of the three HK-listed pharmaceutical distributors, Sinopharm is our top choice with Buy rating and 12-month PT of HK$26.5. Valuation We believe the current sector valuation at 16X 2014e P/E factors in the slowdown of the overall pharmaceutical market in the region. There should be valuation upside for those companies that are capable of delivering above industry-level growth. We believe Chinese pharmaceutical distributors are fairly valued at 15X 2014e P/E, as we see deterrents to substantial efficiency improvement near term. Jessica Li, Ph.D. +852 3743 8010 Jessica.li@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 148 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 150. Trend 1: Chinese pharmaceutical market keeps chugging along The growth prospects of the Chinese healthcare industry should remain healthy, as we see key growth drivers staying intact: rapidly expanding middle class, aging population, urbanization, and improving individual affordability with lowered pricing and higher medical insurance coverage. China’s new leadership continues to push forward bold health reforms, aiming to improve the nation’s health coverage, promote the private hospital sector, as well as promote innovation and industrial upgrading. Entering into 2014, we project that the Chinese healthcare industry will deliver sales growth of 15- 17% and demand growth of 13-15%, helped by continuously increasing government spending, the rollout of critical illness insurance, and the expansion of private hospitals. Exhibit 241: China pharmaceutical market’s growth remains solid Source: National Bureau of Statistics of China, Jefferies Exhibit 242: Government spending on healthcare remains robust Source: National Bureau of Statistics of China, Jefferies Third Plenum strengthens our confidence in growth prospects The Third Plenum of the 18th CPC Central Committee held on November 9-12 set course for the next decade of China’s development. The blueprint demonstrates the party’s determination to deepen the ongoing reform in the healthcare sector and public hospitals. Rollout of critical illness insurance will be accelerated. Medical insurance coverage will be extended to private hospitals. Government reiterated support for private investment in the medical sector, and particularly, non-profit hospitals run by private investors. The new policies will further boost the demand side of the healthcare market. Insurance for critical illnesses is expected to significantly supplement the coverage of existing basic medical insurance, raising the overall reimbursement level. As a crucial part in critical illness insurance, commercial insurance companies will protect patients from unaffordable medical expenses, in our view. We believe that critical illness insurance will eventually be implemented nationwide, although it may take time to overcome some obstacles. Successful implementation of critical illness insurance should be positive to related drug sales and medical services. We expect the private hospital sector to grow rapidly and estimate it will have a CAGR of ~20% over the next three years, fuelled by incentive policies and increasing medical demand from the growing middle class. Government aims to double the contribution from private hospitals by 2015. In the latest issued State Council statement, China aims to build an Rmb8 trillion health services industry by 2020, while relaxing the threshold for the private sector to enter. We believe the private hospital sector is especially lucrative when offering high-end and premium services. 0% 10% 20% 30% 40% 0 500 1,000 1,500 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12 Mar-13 May-13 Jul-13 Sep-13 Rmb bn Sales of pharmaceutical industry Total profit of pharmaceutical industry Sales YoY growth Total profit YoY growth 0% 5% 10% 15% 20% 25% 30% 35% 40% 0 100 200 300 400 500 600 700 800 2000 2005 2010 2011 2012 2013YTD Government healthcare spending YoY growth% Rmb bn (Jan.-Oct.) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 149 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 151. Exhibit 243: Patient traffic and beds of private hospitals only account for ~10% of total – more room for growth Source: MOH, Jefferies Trend 2: Mounting cost containment pressures for drugs; impact manageable With the expanding health coverage and further enhanced benefits for the insured, cost- containment pressures are becoming more pronounced. Currently, China’s effort to control medical costs focuses on drug expenditures: drug pricing and utilization. The Third Plenum aims to promote reform of the payment system, pricing mechanism and compensation structure in hospitals. However, payment and drug price reforms are two of the most complicated aspects of China’s healthcare reform, particularly because the system involves multiple stakeholders, and the compensation structure of China’s hospitals, the main market for drugs, is ill-formed. Given the degree of difficulty in reforming China’s healthcare system, we do not believe that the impact of the government’s cost containment initiatives on the Chinese pharmaceutical industry will be acute and entirely negative. While we expect the overall market growth to gradually decelerate to mid-teens%, we believe domestic industry leaders should be able to sustain strong growth, benefiting from scale advantage and innovation. We also see a trend towards more import substitution, and leading domestic drug manufacturers with a larger portfolio of innovative, exclusive and/or drugs with limited competition could benefit from the cost containment environment. Payment system reform – rollout of global budgeting to curb drug utilization We believe the reform of the provider payment system is critical to achieving the goal of expanding access to affordable health care. Among various pilot reform initiatives, global budgeting seems to be the winning tactic for now. Expensive drugs from MNCs could be affected more than inexpensive domestic alternatives, and therefore global budgeting could indirectly lower average drug pricing. This trend should benefit domestic companies with higher-end generic drugs. Stricter drug price controls – limited impact on overall market The NDRC is formulating new policies to reform drug pricing in China. However, it is still in a trial-and-error stage, with neither a solid timetable nor a set strategy to implement any new policies. Historically, each NDRC-led price cut has usually affected less than 5% of total drug sales while average drug prices in China keep rising. The influence was minor on the overall market. 0% 2% 4% 6% 8% 10% 12% 0 500 1,000 1,500 2,000 2,500 3,000 2010 2011 2012 Jan-Aug 2013 outpatients in private hospitals outpatients in public hospitals outpatients in private hospitals as % of total mn 0% 2% 4% 6% 8% 10% 12% 0 20 40 60 80 100 120 140 2010 2011 2012 Jan-Aug 2013 inpatients in private hospitals inpatients in public hospitals inpatients in private hospitals as % of total mn 0% 5% 10% 15% 20% 0.0 1.0 2.0 3.0 4.0 5.0 2005 2006 2007 2008 2009 2010 2011 2012 # of beds in private hospitals # of beds in public hospitals # of beds in private hospitals as % of total mn Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 150 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 152. Exhibit 244: Rising drug ASP in China Source: IMS (historical and forecasts); SU: standard unit Exhibit 245: NDRC led three rounds, 31 mandatory drug retail ceiling reductions Source: NDRC, Jefferies Expansion and increased utilization of essential drugs: trend towards moderating price cuts We expect essential drug utilization to continue to increase from about 10% of total drugs sales to 15% by 2014, given the recent expansion of the essential drug list (EDL) and higher utility requirements for larger hospitals. However, we also observe the trend of moderating price cuts while more emphasis is being laid on drug quality. Exhibit 246: Rolling out the tender process for new EDL Source: Province tender offices, Jefferies Non-EDL tendering: progress slower than expected We anticipate a new version of NDRL with limited revision to come out by yearend or early 2014. So far, only a minority of provinces have started the new round of non-EDL tenders. We expect more non-EDL tenders to occur in 2014 after the release of the new NDRL. As tender models are evolving over time, the implications for pricing pressure remain uncertain. Nevertheless, we expect moderate price cuts in future non-EDL tenders, as the more recent tender models have moved towards an emphasis on quality. Exhibit 247: Summary of 2013 non-EDL tendering progress Source: Province tender offices, Jefferies 0% 5% 10% 15% 20% 25% 30% 35% 0.0 0.5 1.0 1.5 2.0 2.5 3.0 Hospital drug average price GrowthRmb AaveragepriceperSU Year-over-yeargrowth 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 Est. total retail sales impact Average price reduction of drug effected Retailsalesimpact Averagepricereduction Rmb bn First Wave Second Wave Third Wave Beijing 2013 2014 Shandong Guangdong QInghai Zhejiang Shanghai Hunan New EDL releases Jiangxi Other provinces Shannxi Guangxi Shanxi Liaoning Jiangxi Guizhou Gansu Hunan Jilin 2013 2014 Jilin Xinjiang Jinan Military Yunnan Ningxia Inner Mongolia Hainan Zhejiang Tianjin Hebei Jiangsu Jiangxi Henan Shanghai Guangxi • • • Guangdong Shandong Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 151 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 153. Trend 3: Anti-bribery crackdowns: negative impact could be short-lived Price cuts on foreign brands could be more imminent We believe that one direct impact of the latest anti-bribery crackdown is price reduction in MNCs’ off-patent originator drugs, as MNCs have been repeatedly criticized for having privileges in drug pricing, particularly for off-patent originator drugs. Foreign companies have had strong influence on the implementation of drug pricing policies. The latest anti-bribery crackdown could give the Chinese government an opportunity to weaken the bargaining power of MNCs. As a result, price cuts on off-patent originator drugs could come earlier than expected. Exhibit 248: Companies involved in the latest round of anti-bribery investigations Source: Jefferies, 21st Century Business Herald, CCTV, BBC news, Reuters Sales model could change – more outsourcing likely MNCs outsource some of their drug products to third-party pharmaceutical marketing services companies to expand the coverage in China. In view of the anti-bribery enforcement by the government and possible more severe price cuts, MNCs will likely increase the use of third parties to promote their products to migrate the risks and lower operating costs. Leading pharmaceutical distributors: Negative impact short-lived The growth of leading pharmaceutical distributors is tied to that of the overall pharmaceutical market. Given the temporary market slowdown, companies such as Sinopharm and Shanghai Pharmaceuticals will likely see reduced organic growth in 2H2013. M&A could potentially offset such slowdown. Domestic pharmaceutical manufacturers: Neutral near-term; negative impact longer term Some domestic companies could possibly benefit from MNCs’ reduced promotional efforts in the short run. However, as we expect MNCs will be pressured to reduce prices of their off-patent originator drugs, domestic companies that predominantly produce generic drugs will eventually be forced to cut their drug prices to sustain market share. Pharmaceutical marketing service providers: Positive longer term The Anti-bribery act could prompt MNCs to outsource more of their drugs to third-party pharmaceutical marketing service providers such as China Medical System to reduce risk and operating costs. Leading pharmaceutical marketing service providers with strong academic promotional capability should be the largest beneficiary. Date Company involved Investigation details Amount estimated to be involved Information Sources 27-Jun GSK Alleged to have used travel agencies as intermediaries to make illegal payments to officials, associations, foundations, hospitals and doctors RMB 3 billion Chinese Police 26-Jul Sanofi Accused of paying 500+ doctors in 79 hospitals “research grant” to boost product sales. The incident dates back to 2007 RMB 1.7 million Whistleblower 1-Aug Novo Nordisk Visited by authorities, provided company’s operations information 8-Aug Lundbeck Visited by authorities during summer regarding the company’s marking practices 14-Aug Novartis Allegedly paid Rmb50,000 kickback to doctors to guarantee RMB640,000 cancer product sales at large BJ hospitals Former sales 22-Aug Eli Lilly Accused of providing kickbacks to doctors for prescribing Diabetic drugs RMB 30 million Former sales manager 11-Sep Gan & Lee Pharmaceutical Alleged to have bribed doctors to promote drugs in the past 5 years RMB800 million 12-Sep Jiangsu Chia Tai Tianqing Pharmaceutical Accused of offering bribes to doctors to attention drug information section. Sales teams offered doctors free trips to Thailand and Taiwan. Undercover footage captured sales staff paid RMB6500 per doctor for overseas trips CCTV 16-Sep Alcon Allegedly offered bribes to doctors, involved more than 200 hospitals to boost sales of lens implants. Provided “research grants” via CRO RMB 627,000 Whistleblower 11-Oct Edding Pharm Allegedly provided kickbacks to doctors for prescribing drugs. Functioning as the sales agent, the company help promote the drugs and bribe the doctors. Whistleblower 13-Sep Bayer Investigation into potential case of unfair competition State Administration for Industry and Commerce (SAIC) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 152 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 154. Trend 4: Increasing M&A activity We continue to see a trend towards gradual consolidation of the Chinese pharmaceutical industry, driven by stricter government policies to enforce higher standards and raise entry barriers, as well as an increasingly marketized hospital sector. As health reform continues, policies change, and so does the competitive landscape; the industry has to undergo restructuring in order to separate winners from losers. We believe leading Chinese pharmaceutical companies will achieve above-average growth through M&As and innovations, while smaller companies are to be consolidated or eliminated. Favourable government policies also support further industry consolidation, setting goals for developing 1-3 top pharmaceutical distributors with revenues exceeding Rmb100 billion, and top 100 pharmaceutical manufacturers to reach at least 50% market share by 2015. Exhibit 249: Chinese pharmaceutical M&A on the rise Source: Wind Exhibit 250: Rising concentration of top 3 Chinese pharmaceutical distributors Source: CAPC, MOFCOM, Jefferies Exhibit 251: Increasing concentration of China's top 100 pharmaceutical manufacturers Source: NFS, MOFCOM, CFDA, Jefferies We see that Chinese domestic companies are driving the consolidation of product capacities as well as sales and distribution channels via acquiring other domestic players. Rising industry standards and a temporary closure of the domestic financing window render smaller companies more willing to merge with leading players. MNCs are likely to gain immediate market access via joint ventures and/or acquisitions as organic product development could be too time-consuming due to lengthy approval timelines in China. MNCs are becoming more proactive in forming alliances/joint ventures with established domestic pharmaceutical manufacturers, to 1) leverage on their partners’ established sales network for penetration into county hospital/rural markets, and 2) explore the generic drug market in China. We believe Chinese companies will benefit from the alliances with MNCs to tap into higher-end local and international markets by leveraging MNCs’ global networks. 0 50 100 150 2006 2007 2008 2009 2010 2011 2012 2013YTD # of M&A transactions 0% 5% 10% 15% 20% 25% 30% 2005 2006 2007 2008 2009 2010 2011 2012 Market share of top 3 pharmaceutical distributors 25% 30% 35% 40% 45% 50% 55% 2005 2006 2007 2008 2009 2010 2011 2012 2015E Market share of top 100 pharmaceutical manufacturers >50% Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 153 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 155. 2014 China Industrials Autos: Passenger Vehicles and Heavy Duty Trucks Key takeaways Our bullish view on Passenger Vehicles in 2014 stems from our belief that Chinese income is at a conducive level for auto penetration to accelerate. This will support the outperformance of Compact vs. Luxury. Despite the continued momentum in SUV, we expect competition to intensify. Separately, HDT is expected to experience near-term weakness due to exhausted demand from pre-buying and high existing inventory. S-curve explains strong growth in 2013. Generally, a country’s car penetration is expected to rise steeply once its GDP per capita approaches the threshold of mobility, which we estimate to be around the US$10,000 mark. At the end of 2012, China’s income level was at US$9,000, and this suggests China’s car penetration may have reached the acceleration phase of the S-curve. This can explain the stronger-than- expected growth this year, and would imply volume may remain elevated in the near term, as this is not likely to be a 1-year phenomenon. We are projecting 12% Passenger Vehicle (PV) sales growth in 2014, significantly stronger than our GDP growth forecast of 7.5%. Still prefer Compact to Luxury in 2014. Not all players will benefit from the secular trend to the same extent. After the Luxury segment outperformed Compact for 2011-12, we saw a reversal in 10M13, whereby Luxury underperformed Compact by 8ppt. Next year, we believe the trend would continue, as middle-class grow their wealth faster than the rich. Not forgetting Chinese luxury penetration had reached 9% in 2012, having surpassed Japan at 4% and Korea at 6%. China’s luxury over-penetration has been driven by two factors: 1) astoundingly high income gap and 2) extremely high propensity to consume luxury. We think both factors have likely peaked. In contrast, we believe Compact segment is in the sweet spot and most appropriate for China’s emerging middle class, especially those in tier 3-4 provinces. SUV competition to intensify. In the SUV market which grew 5x in as many years, even though the near-term momentum still appears intact, we fully expect competition to intensify. A total of 67 SUV models will be launched between 2H13-14 by local and JV manufacturers, vs. 90 existing. This will no doubt help sustain growth momentum given the proliferation of new models; but competition will likely erode the market share and margin of the existing volume leaders. Heavy duty trucks. Subjected to similar drivers as machinery, we believe demand for heavy trucks is likely to remain lukewarm in 2014. We are expecting flattish volume y/y, following a huge bounce in 2013. In 10M13, HDT volume was up 17% y/y, and in the last 6 months it was up 40% y/y. We are way more negative than consensus considering: i) likely slowdown in FAI growth ii) high penetration iii) lacklustre utilization iv) demand exhausted due to pre-buying v) high inventory level. Be selective on PV & HDT names. We rank PV over HDT, as we prefer discretionary consumption vs. FAI related names. Dongfeng and Geely are rated Buy given their large exposure to compact cars and relatively cheap valuation. We rate Brilliance Underperform given our concern on the sustainability of luxury growth, weak product cycle and deteriorating mix. We rate Great Wall Hold, as we believe that while its share price has priced in continued growth, the risk of greater SUV competition eating into its market share and profitability are yet to be discounted. Meanwhile, we recommend Underperform for both Weichai and Sinotruk, but show relative preference for the former due to less exposure to low-margin HDT business. Johnson Leung +852 3743 8055 jleung@jefferies.com Julian Bu +852 3743 8058 jbu@jefferies.com Zhi Aik Yeo +852 3743 8075 zyeo@jefferies.com Charles Cheng +852 3743 8056 ccheng@Jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 154 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 156. Summary of PV segment view We remain bullish on the growth prospects of China’s passenger vehicle (PV) sector. There’s no doubt the country’s low car penetration will underpin its long-term growth. If Chinese income can continue to climb, car penetration will continue to increase, translating to volume growth. We are forecasting above 12% PV sales growth in 2014, significantly above GDP growth of 7.5%. This will be mainly driven by strong demand generated from Tier 3-4 provinces. With car penetration in Beijing and Tianjin already at 20% and 13%, growth will come from poorer regions and lower-tier markets, as overall penetration deepens. This is also on the back of government’s efforts to redistribute income and greater infrastructure spending in the inland areas. Separately, Chinese society will evolve and car-buying will increasingly be driven by practicality, rather than wealth display. We are negative on the luxury segment, take a cautious stance on SUV, and are most bullish on Compact car, which is a largely forgotten space, in our view. We believe the compact segment is in the sweet spot and the most appropriate for China’s emerging middle class, especially those in tier 3-4 cities. As such, we are more cautious than consensus on Brilliance and Great Wall, and more positive on Dongfeng and Geely. Exhibit 252: Key views for PV sector & stocks in 2014E JEF assumption Consensus expectation JEF vs. consensus expectation Industry volume growth 2014 PV (excluding cross) 12% 10% more positive Segment volume growth 2014E Compact 15% Industry growth more positive Luxury 10% 15%+ more negative SUV 20% 20%+ in-line Earnings growth 2014E Dongfeng 18% 6% more positive Geely 12% 17% more negative Brilliance 15% 27% more negative Great Wall 11% 23% more negative Source: Jefferies estimates, company data Looking back at 2013 During our recent visit to the largest automobile manufacturer in China – Shanghai Automotive (SAIC), the company commented they had started 2013 with some fears. SAIC was initially concerned sales growth would further slow from the mediocre pace last year, but was pleasantly surprised at how the year panned out. In 10M13, PV growth recorded 18% y/y, a marked acceleration from the pace of growth of 8% seen in 2012. This positive sentiment was similarly reflected by most OEMs, but few were able to detail why volume growth had surprised on the upside this year, contrary to many macro indicators, which pointed to a slowdown in growth from 2012. The most reasonable explanation came from SAIC, in our view, who attributed this to i) strong demand coming from first time car buyers in lower tier cities and provinces, and to a lesser extent, ii) replacement demand. The strong demand from poorer provinces indicated by SAIC provides support to our view that over the next couple of years, we would still continue to see strong demand growth coming from first-time car buyers in lower tiered areas, prompted by an emerging middle-class car purchase wave. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 155 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 157. Start of S-curve acceleration in 2013 During our auto sector initiation earlier in the year, we highlighted an S-curve theory, which we believe is playing out for China at the current phase of automobile development. At US$9,000 at end of 2012, Chinese GDP per capita (PPP 2010 Intl $) is expected to surpass US$10,000 in 2015. This suggests China’s car penetration (corresponding with its current income level) may have reached the acceleration phase of the S-curve. Generally speaking, a country’s car penetration is expected to rise more steeply as its GDP per capita approaches the US$10,000 mark. While many factors do impact car ownership, apart from income i.e. car prices and infrastructure, we are assuming income is the dominant driver and China will follow a similar path experienced by most developed nations. Read through for 2014 What this implies is sales growth would likely remain elevated in the short term, as this is unlikely a one-year phenomenon. We see the need to emphasize; this is seen for many other developed countries in their respective automobile development histories. Barring any unexpected slowdown in economic growth, coupled with stronger replacement demand, we believe volume growth should remain above 10% over the next few years, exceeding GDP growth. Auto OEMs track the R-value closely The R-value, defined by vehicle price/GDP per capita is one way to measure vehicle affordability, tracked closely by many different OEMs. The history of the auto industry in industrialised countries demonstrates that when R-value approaches 2-3, the car penetration rate improves dramatically and sales volume experiences a sustained exponential growth. According to SAIC, the R-values for tier 1/2/3/4 cities in China are 1.2/2.7/3.2/4.3, respectively. What the figures indicate is that tier 1 cities have almost reached saturation, reflecting the government’s need to introduce quota systems in places like Beijing, Shanghai and Guangzhou. Meanwhile, tier 2 cities are enjoying a golden period of auto sales, whereby car penetration is growing rapidly, and Tier 3 cities are fast approaching that phase. Tier 4 cities represent the potential over the next number of years for car demand to further prosper. According to SAIC, the majority of the country’s population resides in tier 3-4 cities. Environmental measures will be the support We would not be surprised to see more tier 1-2 cities apart from Beijing, Shanghai and Guangzhou implementing ownership quotas to fight congestion and pollution. As a part of clean air initiatives, we anticipate that the government will encourage ownership of new energy vehicles (NEVs), with greater subsidies. As a result, demand from large urban centers will increasingly be replacement demand, as opposed to new demand. Comparing theory with the facts As seen by SAIC, tier 1/2/3/4 cities have shown car sales growth of 7%/8%/10%/11% respectively, with stronger growth experienced in tier 3-4 cities. Although this is data collected based on a single company’s sales volume, but SAIC being the largest player with 27.5% market share in 1H13, it should be representative of the market. This corresponds with our data that shows tier 3-4 provinces saw industry sales grow significantly faster than the pace in tier 1-2 provinces. The limitation is that city-level data is not available for comparison. Exhibit 253: Provincial tier sales and y/y growth comparison Sep-13 Sep-12 y/y 9M13 9M12 y/y Tier 1 475,481 384,621 24% 3,783,465 3,343,597 13% Tier 2 298,107 235,325 27% 2,313,496 2,031,934 14% Tier 3 490,555 375,484 31% 3,875,403 3,180,184 22% Tier 4 123,591 94,008 31% 998,226 810,118 23% Source: Jefferies, Auto Market Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 156 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 158. Segmental preference Though we remain positive on volume in 2014, the expected on-going solid growth does not suggest all players will benefit to the same extent. Our Compact over Luxury view stays the same going into next year. In the SUV market which grew 5x in as many years, even though the near-term momentum still appears intact, we fully expect competition to finally intensify in 2014, potentially weakening the profitability of existing volume leaders. Having said that, we prefer the SUV segment over Luxury cars. From Luxury to Compact While the luxury segment had outperformed compact vehicles in 2011 and 2012, we are calling for a reversal in coming years, starting in 2013. Indeed, in 10M13, Compact volume growth has started to outperform Luxury by 8ppt, which we believe is a trend that will continue into 2014. The deciding factor is the overly high Chinese propensity to consume luxury cars, and the trigger is the slowing Chinese investment growth and the new administration’s unrelenting anti-corruption campaign. Income disparity and luxury propensity If the China PV bull case is underpinned by the overall low penetration, such a bull case simply does not exist for luxury cars in China. Chinese luxury penetration reached 9% in 2012, having surpassed Japan at 4% and Korea at 6% despite China’s much lower income. In our view, China’s relatively high luxury penetration is driven by two factors: 1) astoundingly high income disparity and 2) astoundingly high propensity to consume luxury cars. With Gini Coefficient already at 0.61 and luxury car buying propensity almost 6x the US level, we believe both factors have likely peaked. For 2014, we expect 10% growth in luxury (segment C) sales, well below consensus at about 15%. The Compact sweet spot We believe Compact is the segment to be in to ride the Chinese PV boom. Compact cars, already the largest segment, have continued to take share from the Sub-compact category (due to better quality) and larger size (due to value for money) in recent years. We believe Chinese income will inevitably be redistributed in coming years to favour the emerging middle class, especially those in tier 3-4 cities, for whom the Compact vehicles are the most appropriate. For 2014, we expect high-teens growth in Compact sales. Importance of a Compact strategy When we first initiated on the sector, we had met with pushback regarding our favoured segment, the Compact vehicles. Investors criticised the segment for being low on margins, and not a profitability driver. Yes it may be true that Compact in general has lower margins vs. SUVs and Large Sedans (segment B), but with large volume and scale, the gap is actually not wide. This is shown in our conversation with OEMs. In 1H13, The VW Lavida (Compact) is at gross margin of 27% vs. the VW Passat (Large Sedan) of 32%. The VW Lavida shipped 212,000 units in 1H13 vs. the 126,000 units of Passat. The Passat is the best seller within the Large Sedan segment, and we would think it offers one of the best margin vehicles in the segment. Similarly for Dongfeng, the Nissan Sylphy’s (Compact) estimated margin in 1H13 was above 20% and the Nissan Teana (Large Sedan) was at 23% plus, according to management. The point being, with operating leverage, we believe Compact can close the margin gap by a fair bit. And we would imagine it is much easier to achieve big volumes on Compact than any other segment, simply by virtue of the existing size. In 1H13, Compact sales at 3.4mn units were more than 3x the Large Sedan sales of 1.06mn units. And GAC reminded us the importance of a Compact strategy, even though the company had been predominantly a Large Sedan player. It is important to achieve scale in auto manufacturing, be it through different models, as the sharing of the fixed costs Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 157 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 159. would also enhance the margins of vehicles with a smaller volume. According to GAC, the company will launch more Compact models going forward. SUV competition will intensify SUV has been the best performing segment in the past 5 years, having grown at 45% CAGR. In 10M13, it has grown 49%. This is phenomenal growth, but with Chinese SUV penetration still below other countries and neighbors, it seems the segment will likely continue to do well. Competition - looks to worsen in 2014 There is no doubt that competition in the SUV market is already keen and it looks to get worse, as a wave of new models is launched by local brands and JVs in 2013-14. They are moving down the price curve towards the mid-low end segments and positioned as economy SUVs. We look for competition to intensify over the near term for GWM. As of June 13, there are about 90 SUV models with 720+ variants available on the Chinese market. According to our channel checks with dealers and online sources, we have tabulated the 2013-14 SUV launch pipeline; including new launch, new generation and facelifts, there are a total 103 models to be launched. (Note, this is only based on current existing information, and more new launches for next year would be announced later) Of the 103 models, 36 were launched within the first 7 months of 2013, which means 67 more are to be launched in 2H13 and 14. Also, in the next 1.5 years, more than 40 new SUV models at retail prices of Rmb150k and below will enter the market, representing 45% of existing SUV space, and 61% of less than Rmb150k SUVs. We anticipate increasing competition in the low and mid-end segments ahead, which will put pricing pressure on the existing models, and market share pressure on the incumbent, i.e. Great Wall. Where we are different from consensus While our sector view is only slightly more positive than the street, our unique segmental view differentiates us. We are negative on the luxury segment, take a cautious stance on SUV, and are most bullish on Compact car, which is a largely forgotten space, in our view. As such, we are more cautious than consensus on Brilliance and Great Wall, and more positive on Dongfeng and Geely. We rate Dongfeng (489 HK) with Buy on its recovery mode and low valuation. Geely (175 HK) is also a key player in the Compact segment and one of the most successful local brands in China. We rate Brilliance (1114 HK) Underperform given our concern that the best of China’s luxury car boom is likely behind us. We rate Great Wall (2333 HK) Hold given our view that the risks of greater SUV competition are yet to be discounted. Summary of HDT segment view After bouncing 17% in 10M13 and outperforming construction machinery significantly, the China heavy duty truck sector (HDT) is set to fall in 2014, in our view. We believe the bounce is largely driven by i) inventory restocking by dealers ii) pre-buying ahead of Euro 4 implementation in some areas and iii) the start of more infrastructure projects. We believe these reasons are unlikely sustainable going forward. We think HDT/engine producers are facing multiple persisting headwinds – i) structural slowdown in FAI ii) high penetration iii) falling utilization iv) overcapacity v) likelihood of share loss due to new entrants. While we may not see an abrupt slowdown in FAI growth, we expect generally sluggish demand in the next few years. In particular, we are forecasting flat volume growth in 2014. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 158 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 160. Exhibit 254: Top 5 players’ performance in Oct and 10M13 Oct 13 y/y 10M13 y/y Sinotruk (3808 HK, Unpf) 9,927 60% 99,934 9% Shaanxi/Weichai (2338 HK, Unpf) 6,186 11% 79,780 13% FAW 11,069 33% 106,718 20% Dongfeng (489 HK, Buy) 12,453 46% 131,380 17% Beiqi Foton (600166 CH, NC) 10,119 54% 94,259 32% Top 5 players 49,754 41% 512,071 18% Others 10,826 28% 117,039 17% Total HDT industry 60,580 39% 629,110 18% Source: Jefferies, CAAM Latest freight/cargo trends While HDT do not provide similar utilization data as per excavator operating hours, we find the Yiwu cargo price index and average daily highway freight tonnage growth useful proxies. In the month of May, the Yiwu price index recorded 103.55, up 0.7% y/y and down 0.4% m/m. While the general trend seems an improvement from last year’s low level, the most recent data points indicate a retreat from the high in Dec 12. Note the cargo price index is not solely influenced by utilization level of HDT, but also the operating expenses i.e. fuel, labor cost, etc. Meanwhile, the 11% y/y growth of average highway freight tonnage in Oct 13 also indicates the amount of goods carried by trucks is not picking up just yet. Euro 4 introduced in 19 cities Against wide expectation that Euro 4 would be postponed due to the lack of quality fuel and urea additives, it was ‘quietly’ and gradually introduced in limited number of cities. 19 to be exact, including Beijing, Shanghai, Shenzhen, Guangzhou and Hangzhou, were deemed as try-out areas. Under the new emission standard, Euro 3 trucks will not be able to obtain vehicle registration going forward. It had prompted some drivers to pre-buy in 2013; for fear that they must pay Rmb20–30k more for Euro 4 trucks. And pre-buying would mean exhausting future demand, causing 2014 to see unexpected weakness. Competition just went from intense to fuming Earlier, machinery makers XCMG and Zoomlion announced ambitious plans to enter the HDT segment. According to Zoomlion’s management, a portion of HDT production is meant for insourcing of chassis for its own construction machines, as they are currently the largest customer of Mercedes Benz. Along with chassis, Zoomlion aims to have capability in gearboxes and engines over the next few years. From our understanding, Zoomlion and XCMG are aggressive players and it would not make much sense if they are plainly seeking to have the HDT, gearbox and engine capability only for insourcing purposes. Their entry would signal heightened competition in a market where margins are already very thin. Note Sinotruk’s 2012 operating margin was only 3%. Less bad than construction machinery We think HDT compares slightly better than construction machinery in the next few years: i) All things equal, we prefer logistics exposure to FAI; ii) There appears less egregious vendor financing and promotional tactics in HDT; iii) HDT have much lower margins than machinery peers, which could mean less room to fall; iv) HDT sales likely better reflect underlying demand, due partly to the higher mobility of both the trucks and the owners, whereas machinery may show greater latent risk given aggressive financing and less efficient markets; v) HDT may have shorter replacement cycle and higher replacement demand. vi) beneficiary of implementation of more stringent emission standards. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 159 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 161. Rail Equipment & Construction Key takeaways It is no wonder the government has been promoting export of HSR. We figure the leadership believes the development of HSR in China may have gone ahead of demand. Hence there is a need to find orders for the manufacturing capacity that has been developed in anticipation of a prolonged rail FAI bull-run. Rail FAI may remain elevated but growth is unlikely in 2014 and 2015 as already guided in the revised 12-5 plan, which may keep rail construction an underperformer among the FAI segments. We remain convinced that China does not need more MU sets given the 43% utilization as per results from our latest Count the Train exercise. We pick China Communications Construction (CCC) as our upside risks cover in case FAI comes in stronger than expected. Else we remain cautious on this space. Flat FAI spending guided but consensus is hoping for growth for 2014. We expect the rail FAI to be quite flattish between Rmb680bn and Rmb700bn between 2013 and 2015 as per the revised guidance of Rmb3.3tn for 2011-2015 from MOR, assuming the Rail FAI reached Rmb690bn in 2013. The market, however, may have factored in some growth as Bloomberg consensus is suggesting Rmb100/bn or 9% YoY higher total revenue for the two main railway construction companies in 2014, after about 15% YoY growth in revenue in 2013. We believe the push for HSR construction toward less affluent areas in China is advancing the future construction demand to today. So a beat to the MOR guidance would carry bearish implication for the long term. Spending in rail construction may crowd out the same for equipment but underperform non-rail construction. Construction companies may continue to get the lion’s share (81-82%) of the rail FAI budget, although unlikely to see much YoY growth in 2014. Rail construction FAI may be about Rmb555bn and Rmb570bn between 2013 and 2015. Yet, we think the MOR might still miss its rail length target of 120,000km. We figure MOR may need Rmb1.4tr in rail construction alone to add the additional rail length of 14,500km, including 8,000km for HSR tracks, in the next two years. Then there will be no money left for purchase of equipment like MU sets. If total FAI continues to grow at 20% YoY in 2014 as it did in 2013, FAI growth for the non-rail segments in transport, water conservancy and properties may see substantial outperformance over the same for rail and mining industries. 400 MU sets may be tendered but the HSR utilization does not suggest 400 MU sets being delivered. Rail equipment makers are suggesting about 400MU sets will be tendered each year. Yet delivery schedule, which matters more to the companies’ earnings may be far below the 400 MU sets per year. First, we think the currently available 887 MU sets may be only 43% utilized. So there are sufficient MU sets to cover twice the current rail length. Second, the utilization could be even lower if MOR speeds up the existing MUs closer to their designed speed. We figure the current MU sets are running at 200km/hr as opposed to 250-350km/hr. Third, Rmb690bn rail FAI budget may be just sufficient for rail construction or purchase of 200-300 MU sets a year in the next two years. Anyway, if the existing MU sets are already enough to cover the planned expansion of rail length by 2015, more MU sets delivery would just be advancement of future demand, in our view. Cautious in the entire space but pick CCC. We remain cautious about the entire railway E&C space as HSR development, which is the emphasis of the railway E&C companies’ earnings, has gone ahead of the fundamental demand. We particularly feel the bullishness in the market about rail equipment makers is unwarranted. While the government may not always do what we think it should, we pick CCC as our upside risk cover because it relies more on non-railway construction, which could be an area where the government is still willing to spend as a way to maintain GDP growth and employment opportunities. Upside risk for the space is usually government’s reliance on rail spending to boost growth but we believe the leadership understands the economic hazards of such strategy. Exhibit 255: China railway FAI peaked in 2010 Source: MOR, Jefferies estimates 0 100 200 300 400 500 600 700 800 900 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E Rmb bn exponential growth trendline Exhibit 256: China's HSR passenger and capacity growth: capacity cannot outpace the passenger growth for too long Source: Wikipedia, company data 0% 20% 40% 60% 80% 100% 120% 2008 2009 2010 2011 2012 Passenger Growth Capacity Growth Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 160 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 162. Construction and Coal Machinery Key takeaways We believe the earnings power of machinery names will weaken over time. In the near term, operating hours are still not showing a meaningful recovery, despite the rally in stock price. We remain unconvinced that construction machine stocks have bottomed, as repercussions from previous aggressive tactics are still felt. We prefer coal machinery over construction machinery, though we remain cautious on both. Summary of our Machinery view: China’s FAI is expected to slow gradually and continuously near-term. It’s important to recognize the asymmetrical nature of the FAI growth – while the downside has the potential to be great, there is no upside to FAI growth, in our view. FAI growth ultimately drives new machinery demand. Machinery utilization remains weak. Therefore there is only limited demand for new machines until utilization has tightened materially. We are still many years away from replacement demand becoming significant. Meaningful excavator and concrete machinery replacement may only occur in 2016 and 2018, respectively. Although margins have fallen in recent quarters, they remain well above sustainable levels for best-in-class operators. We believe margins will need to fall at least to the global level. As long as receivables continue to grow in excess of revenue, investors need to be concerned about late payments and defaults, which may have the tendency to move suddenly. As Chinese liquidity tightens over time, machinery vendor financing could scale back further, limiting volume sales. Machine hours remained weak. In the shorter term, machine hours are the lead indicator and most recent data points indicate weakness in utilization across the industry. In Sep, excavator machine hours fell by 4% m/m and up 1% y/y to 152 hours, the lowest levels YTD excluding Jan/Feb. And as indicated by industry leader Zoomlion, the all-important truck pump hours were around 67 in Sep, below the May-Aug level. Truck cranes were running 172 hours, also below August. Zoomlion (1157 HK, Unpf) described the demand in 2H as steady, and suggested that while there has been some minor stimulus, the scale was limited, the banks have remained tight, and the customers are still cautious. Exhibit 257: Komatsu China excavator operating hours (Jan 09- Sep 13) Source: Jefferies, company data 40 60 80 100 120 140 160 180 200 220 Jan/09 Jul/09 Jan/10 Jul/10 Jan/11 Jul/11 Jan/12 Jul/12 Jan/13 Jul/13 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 161 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 163. Receivables and cash flow still an issue. From 2008-11, almost all industry growth came from selling machines on credit, we believe. This has caused cash flow to be short of profit growth, pulled future demand forward, and led to rising defaults, as zero down-payment attracted risky buyers. At present, the repercussions of these aggressive tactics are still being felt, and it’s hard to gauge how deep the hole is. In 1H13, after Zoomlion had gone through a year of cleaning up the risky buyers, receivables are still fast accumulating, despite the decline in revenue. Late payment rate rose to 14.6ppt in 1H, up from 9.2ppt last year. Although operating cash flow turned positive, it was only helped by receivable factoring of Rmb8.9bn; ex this amount, operating cash flow would be -Rmb8bn, hugely negative. We continue to stress the importance of being able to get paid by willing customers, and think if the cash flow before factoring figure remains a key indicator, we are approaching the bottom. Coal machinery only slightly better. While we are more positive on coal vs. construction machinery due to its relatively defensive nature, our coal analyst Laban Yu warns us of China’s falling energy intensity, shift to cleaner energy and efficiency gains. Meanwhile, we believe road header demand (core product of Sany with 55% contribution in 2012) is driven by 3 factors: i) increase in coal production, ii) the need to replace backward capacity, and iii) replacement demand. We surmise that replacement demand may have become the largest factor, but still expect the rising replacement demand to be insufficient to offset the falling machinery demand resulting from slowing coal production growth and decreasing need to replace backward capacity if mining activity slows. We are a Hold on Sany International (631 HK). Prefer Lonking over Zoomlion. Despite our UNPF recommendations for both companies, we show preference for Lonking (3339 HK, Unpf) over Zoomlion due to the former’s more comprehensible finances, better operating cash flow and lower expectation by the street. We think there’s big chance revenue will miss Zoomlion’s consensus expectation of 9% growth in 2014, due to Management’s flattish Concrete segment guidance, which accounts for 50% of 2012 top line. Having said that, we are forecasting 8% y/y decline in revenue. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 162 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 164. 2014 China Metals & Mining Cement, Steel, Coking Coal & Gold Takeaways We expect 2014 demand growth for both cement and steel to slow from 2013’s high base as the impact of the current “mini-stimulus” starts to fade. We, however, do not expect a government induced collapse in demand similar to 1H12. We are more positive on cement than steel. In Cement, we like cement companies with East & South China exposure, such as Conch and CR Cement, due to limited capacity growth in those regions. We expect steel companies’ margins to be squeezed in 2014 as demand growth slows. We remain bearish on gold companies and their expensive valuation. 2013 demand has benefited from the FAI mini-cycle that started in 4Q12: In 2013, both steel and cement demand grew by about 10%, showing a strong rebound from a moderate 4-6% growth in 2012. The strong rebound in demand growth in 2013 has been a surprise to many given demand growth for both cement and steel were almost zero in the middle of 2012 when the Chinese government withdrew investment on concerns on non-performing loans in its financial system. However, our data suggests that the government has re-ignited its investment engine. Tertiary industry FAI and cement and steel production growth have all picked up strongly since mid 2H12, resulting in strong demand growth in 2013. 2014 demand growth to slow, but won’t collapse like in 1H12: We believe we have just passed the peak of the current investment mini-cycle and demand growth should slow in 2014, because: 1) tertiary industry FAI growth has been coming down gradually for 4 straight months, mainly driven by the slowdown in railway FAI; 2) we are gradually entering into the territory of difficult comparison – cement demand picked up significantly in 4Q12. We expect demand growth in 2014 to slow down to roughly 6%-7% vs. about 10% in 2013. The growth slowdown shouldn’t be a surprise to the market. Cement capacity growth to slow down in 2014: Both top-down and bottom-up analyses suggest that China’s cement industry capacity addition will slow down in 2014E. East, South and Central China should see relatively slower growth, but Northwest and Southwest should continue to grow at a relatively fast pace. Regions practicing “price co-operation” attracted higher investments due to abnormally high profits. Industry consolidation could accelerate in 2014 (see detailed analysis in the report). Prefer cement over steel value chain: We believe the slowdown in cement capacity growth in East and South China will benefit cement companies such as Anhui Conch (Buy, TP HK$30.00) and CR Cement (Buy, TP HK$6.40). We are holding a more cautious view on steel as we believe the sequential improvement in profitability over the course of 2013 was mainly due to the strong demand growth and corporate action (Angang), not due to improvement in industry fundamentals (the industry still lacks bargaining power vs both suppliers and buyers). With the demand growth slowdown, we expect steel companies’ margins to worsen. Our most recent check with both Magang (Hold, TP HK$2.20) and Angang (Hold, TP HK$5.30) suggest the deterioration of profitability has started in 4Q13. Remain bearish on gold price and gold companies: We are staying bearish on gold and our long-term gold price forecast of US$1,250/oz (vs. the current spot price of US$1,288/oz) price is based on: (1) industry short-covering, one of the biggest fundamental drivers supporting gold price is now gone; (2) higher interest rates will inevitably dampen investment demand, which accounts for roughly 30% of the world’s annual gold procurement; and (3) increased interest rates will mean central banks are likely to become net sellers of gold as they used to be in the past few decades. We maintain our Underperform ratings on both Zhaojin (TP HK$5.00) and Zijin (TP HK$1.40), with a relative preference for Zhaojin over Zijin, given its proven track record in volume growth and cost control, and more importantly, it doesn’t have the resources depletion issue in its core mine that Zijin is facing. Po Wei +852 3743 8074 jfong@jefferies.com Laban Yu +8852 3743 8047 lyu@jefferies.com Brian Lam +852 3743 8083 blam@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 163 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 165. 2014 demand growth should slow from current high level but probably shouldn’t be a surprise to the market Construction activities in China account for about 60% of China’s demand for steel and all of the demand for cement. The main driver of demand for China’s construction activity is in term FAI. The most recent FAI mini-cycle started in 2H12 when the government restarted the investment projects. We believe there are three indications that we could have just passed the peak of current investment mini-cycle: (1) Tertiary industry FAI growth has been coming down gradually for 4 straight months, mainly driven by slowdown in railway FAI. As 3Q13 GDP growth exceeded its target 7.5%, the government now has more room to slow down investment; (2) manufacturing (secondary) industry FAI, which historically has had an inverse correlation with tertiary FAI, is picking up; (3) we are gradually entering into the territory of difficult comparison – cement demand started picking up strongly in 4Q last year. We expect demand growth in 2014 to slow down to roughly 6%-7% vs. about 10% in 2013. The slowdown in growth, however, shouldn’t be a surprise to the market. Exhibit 258: China’s 2013 steel production grew by ~9% yoy in 2013, recovering from only 4% growth in 2012 Source: Jefferies, Steelease Exhibit 259 : … and cement production in China also grew by ~10%, up from just 6% in 2012 Source: Jefferies, Steelease 151 182 220 273 353 419 489 500 568 627 684 709 455 19% 20% 21% 24% 30% 18% 17% 2% 14% 10% 9% 4% 8.8% 0% 5% 10% 15% 20% 25% 30% 35% 0 100 200 300 400 500 600 700 800 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013Jan-Jul YoY(%) mntons Crude steel production (mt) YoY (%) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 164 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 166. Exhibit 260: Breakdown of China’s steel demand: about 60% came from construction activities (real estate & infrastructure) Source: Jefferies estimates Exhibit 261: Breakdown of Cement demand: the key driver is FAI Source: Jefferies estimates Exhibit 262: China’s steel and cement production growth: both grew strongly starting in July/August 2012 Source: Jefferies, Steelease, Digital Cement Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 165 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 167. Exhibit 263: Breakdown of China’s FAI investment growth (YTD) Source: CEIC, Jefferies Exhibit 264: Breakdown of China’s FAI investment growth (3MMA) Source: CEIC, Jefferies Exhibit 265: Breakdown of China’s Tertiary Industry FAI growth (YTD) Source: CEIC, Jefferies Exhibit 266: Breakdown of China’s Tertiary Industry FAI growth (3MMA) Source: CEIC, Jefferies Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 166 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 168. Exhibit 267: Breakdown of China’s Transportation Industry FAI growth (YTD) Source: CEIC, Jefferies Exhibit 268: Breakdown of China’s Transportation Industry FAI growth (3MMA) Source: CEIC, Jefferies Cement capacity growth set to slow down quickly Top-down and bottom-up analysis both suggest new capacity addition will slow down in 2014 (East and South to be the most favorable) Historically, the correlation between the Chinese cement industry’s capex spending and the following year’s new capacity addition has been very strong. We believe this is due to the fact that it takes about 1-1.5 years to construct a cement plant in China. This year’s spending would normally show up the following year as a new capacity ramp-up. Hence, we believe the industry’s capex spending data to be a reasonable top-down leading indicator for the following year’s new capacity addition. To reconcile with our top-down analysis, we use Digital Cement’s bottom-up on-the- ground data to gauge the following year’s capacity addition. It, however, should be noted that due to the difficulty in gathering new capacity data in China, Digital Cement’s counting could be slow and tends to underestimate the following year’s new capacity addition. For instance, over the past year, Digital Cement has raised its 2013E new capacity addition forecasts from 77mt to 133mt, and the number is likely to be revised upwards further. While we believe there are still upside risks to Digital Cement’s 2014E new capacity estimate of only 53mt, the underlying trend of slower growth can be confirmed after three straight years of falling industry capex. After falling by 18%/3% in 2011/12, we expect the industry’s capex to fall by another >10% in 2013. On the other hand, the cost for building up new capacity has been increasing rapidly: our check with companies has indicated that the cost of building up new clinker capacity has risen to at least RMB450/ton from RMB400/ton a few years ago, and cost of cement is now about RMB100/ton, vs. only RMB80/ton earlier. The falling capex and the increasing costs for new capacity build up should lead to slower capacity growth going forward. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 167 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 169. Exhibit 269: Correlation between cement industry FAI and the following year’s capacity addition is strong (R square=0.83) Source: NBS, Digital Cement, Jefferies Exhibit 270: Capex spending in China’s cement industry Source: Digital Cement, Jefferies Exhibit 271: … and the resulting yearly new clinker capacity addition (the correlation between spending and new capacity built up is high) Source: Digital Cement, Jefferies y = 1.0476x + 57.258 R² = 0.8254 0 50 100 150 200 250 300 0 50 100 150 200 Newcapacityaddition(mt) Cement industry capex (RMB bn) 40% 101% 75% -5% -6% 31% 61% 62% 3% -18% -3% -11% -40% -20% 0% 20% 40% 60% 80% 100% 120% 0 20 40 60 80 100 120 140 160 180 200 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E yoy(%) RMBbn Cement industry capex spending yoy (%) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 168 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 170. Exhibit 272: NSP clinker capacity in China Source: Digital Cement, Jefferies East China: Region’s Practicing Price Cooperation Attracted the Highest Investment Cement companies’ capex investment continues its downward trend in most regions in East China. In Anhui, the largest clinker production base in East China, investment is expected to come down by 60% to RMB3.7bn in 2013E from its peak of over RMB9bn in 2009. Digital Cement’s on-the-ground research shows that there will be a total of 9 and 6 clinker lines ramping up in East China in 2013 and 2014, respectively. We believe these lines would be located in Jiangxi (2x), Jiangsu (1x), Fujian (2x), Anhui (2x) and Shandong (6x). It is worth noting that Shandong has received the highest investment in 2012/13E. We believe the so-called “price cooperation” has kept the province’s cement price and profitability at an abnormally high level, hence the province has attracted new investments and large capacity build up in the region in the past two years. We believe in 2013/14 there will be at least 6 new clinker lines ramping up in this province (vs a total of 15 lines in East China), of which 2x would belong to Shanshui Cement and 2x to CNBM. 22% 65% 63% 29% 19% 17% 25% 26% 27% 17% 11% 8% 3% 107 130 214 348 449 535 626 784 984 1,249 1,457 1,623 1,756 1,810 0% 10% 20% 30% 40% 50% 60% 70% 0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E Total NSP capacity (mt) yoy (%) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 169 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 171. Exhibit 273: East China cement industry FAI by province: Investment fell in most provinces except for Shandong. Invt in Anhui is expected to fall the most Source: NBS, Jefferies Exhibit 274: East China clinker production capacity: Growth rate is likely to slow down going forward Source: Digital Cement, Jefferies Exhibit 275: In 2013/14, there could be another 9/6 clinker lines ramping up in East China Source: Digital Cement, Jefferies South & Central China: Investment Below 2009/10 Peak in Every Province Investment in South and central China are mostly below their 2009/10 peak. After adding 4 clinker lines in 2013, Guangdong could have another 2x lines in 2014 (one of which would belong to Conch, if the project proceeds as planned). In Guangxi, CR Cement will ramp up another line in 2014. 11% 12% 9% 3% 2% 339.8 375.8 421.5 460.0 474.3 483.6 0% 2% 4% 6% 8% 10% 12% 14% 0 100 200 300 400 500 600 2009 2010 2011 2012 2013E 2014E Total clinker capacity (mt) yoy (%) 28.61 35.99 45.73 38.5 14.26 9.3 20 24 28 24 9 6 0 5 10 15 20 25 30 0 10 20 30 40 50 60 70 80 2009 2010 2011 2012 2013E 2014E New clinker capacity addtion (mt) # of new clinker lines (RHS) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 170 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 172. Exhibit 276: South & Central China cement industry FAI by province: most provinces’ investments are now well below their 2009/10 peak Source: NBS, Jefferies Exhibit 277: After growing by 10% in 2012, South & Central China’s clinker capacities are likely to grow by less than 6% per annum going forward Source: Digital Cement, Jefferies Exhibit 278: According to Digital Cement’s survey, there will be about 23 new clinker lines ramping up in 2013/14 in South and Central China Source: Digital Cement, Jefferies Southwest China: Still Adding Capacity at a Relatively Fast Pace After the major earthquake in 2008, Sichuan’s cement industry capex shot up dramatically in 2009, resulting in massive additions to clinker capacity in 2010 and 2011. Both Conch and CR Cement have aggressive expansion plans in southwest China. CR Cement is expected to ramp up 2 lines in Guizhou and 1 line in Yunnan in 2014. According to Digital Cement, there are about 16 clinker lines that will ramp up in Southwest in 2014, making it the region with highest capacity ramp up, together with the Northwest. 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 Henan Hubei Hunan Guangdong Guangxi Hainan RMBmn 2007 2008 2009 2010 2011 2012 2013E 257.61 310.59 343.05 375.66 398.91 407.12 21% 10% 10% 6% 2% 0% 5% 10% 15% 20% 25% 0 50 100 150 200 250 300 350 400 450 2009 2010 2011 2012 2013E 2014E Total clinker capacity (mt) yoy (%) 62.12 52.98 32.46 32.61 23.25 8.22 49 39 22 23 16 7 0 10 20 30 40 50 0 10 20 30 40 50 60 70 80 2009 2010 2011 2012 2013E 2014E New clinker capacity addtion (mt) # of new clinker lines (RHS) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 171 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 173. Exhibit 279: Southwest China cement industry FAI by province: After the earthquake in 2008, Sichuan’s capex jumped significantly, leading to many years of depressed cement pricing in the region Source: NBS, Jefferies Exhibit 280: Southwest cement capacity will continue to grow at 10% in 2013E and then potentially slow down to roughly 5% in 2014 Source: Digital Cement, Jefferies Exhibit 281: After adding 30 clinker lines in 2012, another 27 clinker lines will be added in 2013E Source: Digital Cement, Jefferies 134.54 211.39 261.95 293.23 323.86 341.37 57% 24% 12% 10% 5% 0% 10% 20% 30% 40% 50% 60% 0 50 100 150 200 250 300 350 400 2009 2010 2011 2012 2013E 2014E Total clinker capacity (mt) yoy (%) 57.13 76.85 50.56 31.28 30.63 17.52 65 73 51 30 27 16 0 10 20 30 40 50 60 70 80 0 10 20 30 40 50 60 70 80 2009 2010 2011 2012 2013E 2014E New clinker capacity addtion (mt) # of new clinker lines (RHS) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 172 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 174. Northeast China: Could Lose its Edge as One of the Most Profitable Markets in China The North East China market could be another case of a highly profitable market attracting more investment and building up capacity, eventually leading to deteriorating industry profitability. In 2011/12, the North East China cement market was the most profitable in China as a result of very little new capacity addition in during those two years. However, the high profitability has resulted in an addition of 8x new lines in the region in 2013E. Shanshui Cement is one of the most active players in the region, adding 4x new clinker lines in Liaoning (3x near East Inner Mongolia), and the company expects in total there are about 5 lines ramping up in this province in 2013/14E. Exhibit 282: Northeast China cement industry FAI by province Source: NBS, Jefferies Exhibit 283: Northeast clinker capacity estimates: 2013E has been an year of strong capacity addition Source: Digital Cement, Jefferies Exhibit 284: North East China yearly new clinker capacity addition: 2013 has 8 new lines compared to only 1 line in 2012E Source: Digital Cement, Jefferies 70.56 81.87 83.42 84.97 95.51 98.98 16% 2% 2% 12% 4% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 0 20 40 60 80 100 120 2009 2010 2011 2012 2013E 2014E Total clinker capacity (mt) yoy (%) 12.4 11.32 1.55 1.55 10.54 3.47 9 9 5 1 8 2 0 2 4 6 8 10 0 5 10 15 20 2009 2010 2011 2012 2013E 2014E New clinker capacity addtion (mt) # of new clinker lines (RHS) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 173 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 175. Northwest China: Still has the Highest Capacity Ramp Up After growing by 20% CAGR in 2009-12, 2013E was another year of strong capacity addition for Northwest China cement market. In total, another 28 lines are expected to come online, making it the region with the highest new capacity additions. While demand growth in Northwest China has also been strong as a result of the government’s policy to speed up the infrastructure construction in Northwest China, it was not growing as fast as supply. Hence, cement prices in North West China are now about RMB30-100/ton below the same period last year, except for in Gansu. Exhibit 285: Northwest China cement industry FAI by province Source: NBS, Jefferies Exhibit 286: Northwest China Clinker Capacity Source: Digital Cement, Jefferies Exhibit 287: Northwest China Annual Clinker Capacity Addition Source: Digital Cement, Jefferies 85.3 127.46 159.6 195.41 228.73 249.549% 25% 22% 17% 9% 0% 10% 20% 30% 40% 50% 60% 0 50 100 150 200 250 300 2009 2010 2011 2012 2013E 2014-15 Total clinker capacity (mt) yoy (%) 20.12 42.16 32.15 35.81 33.33 20.77 23 43 34 30 28 19 0 10 20 30 40 50 0 10 20 30 40 50 2009 2010 2011 2012 2013E 2014-15 New clinker capacity addtion (mt) # of new clinker lines (RHS) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 174 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 176. North China Cement Industry: Shanxi is the Key Battleground While both Hebei and Inner Mongolia have been seeing industry FAI falling quickly, Shanxi’s cement industry capex still remains high at close to the 2009/10 peak level. Both CR Cement and Shanshui Cement have aggressive strategies to enter into the Shanxi market. Shanshui plans to build 5 clinker lines in Shanxi in 2013/141 . CR Cement now has about 2x 5,000 tons/day clinker lines in Shanxi and one additional line to ramp up by 2013 end. In 2014, the company will have 2x 1,200 tons/day line ramping up. Exhibit 288: North China cement industry FAI by province Source: NBS, Jefferies Exhibit 289: North China Clinker Capacity Addition Source: Digital Cement, Jefferies Exhibit 290: North China New Clinker Capacity addition Source: Digital Cement, Jefferies 1 Three out of the five lines are now in production, the other 2 are under construction 95.72 141.57 187.48 213.8 234.88 245.1148% 32% 14% 10% 4% 0% 10% 20% 30% 40% 50% 60% 0 50 100 150 200 250 300 2009 2010 2011 2012 2013E 2014E Total clinker capacity (mt) yoy (%) 19.5 45.85 45.91 26.32 21.08 10.23 18 39 41 22 16 8 0 5 10 15 20 25 30 35 40 45 0 10 20 30 40 50 60 70 2009 2010 2011 2012 2013E 2014E New clinker capacity addtion (mt) # of new clinker lines (RHS) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 175 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 177. Steel industry’s margin likely to worsen in 2014 Most steel companies saw their margins expand sequentially in 2013. We believe the improvement in margins is mainly driven by the strong growth in construction demand. As demand growth slows going forward, we expect margins will start to decline, especially in the early part of 2014. Our most recent checks with both Magang and Angang have indicated the decline in sequential profitability has started in 4Q13. Exhibit 291: Evolution of Baosteel’s GP/ton (HoH since 1H12) Source: Company data, Jefferies Exhibit 292: Evolution of Angang’s GP/ton (HoH since 1H12) Source: Company data, Jefferies Exhibit 293: Evolution of Magang’s GP/ton (HoH since 1H12) Source: Company data, Jefferies Exhibit 294: Number of steel mills in China – fell slightly again in 2013 Source: WIND, Jefferies 315 873 365 577 922 194 18 (800) (600) (400) (200) 0 200 400 600 800 1H12 Decrease in ASP Decrease in costs 2H12 Increase in ASP Decrease in costs 1H13 RMB/ton 117 459 108 493 451 146 239 (400) (300) (200) (100) 0 100 200 300 400 500 600 1H12 Decrease in ASP Decrease in costs 2H12 Increase in ASP Decrease in costs 1H13 RMB/ton (54) 85 109 49 91 335 311 (100) 0 100 200 300 400 500 1H12 Increase in ASP Decrease in costs 2H12 Decrease in costs Decrease in ASP 1H13 RMB/ton 200 250 300 350 400 450 1999-02 1999-08 2000-02 2000-08 2001-02 2001-08 2002-02 2002-08 2003-02 2003-08 2004-02 2004-08 2005-02 2005-08 2006-02 2006-08 2007-02 2007-08 2008-02 2008-08 2009-02 2009-08 2010-02 2010-08 2011-02 2011-08 2012-02 2012-08 2013-02 2013-08 266 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 176 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 178. Gold: Remain bearish on long-term gold price, maintain Underperform on Zhaojin and Zijin We maintain our bearish view on long-term gold prices. Our view is underpinned by three underlying trends: (1) industry short-covering, one of the biggest fundamental drivers supporting gold price is now gone; (2) higher interest rates will inevitably dampen investment demand, which accounts for roughly 30% of the world’s annual gold procurement; and (3) increased interest rates will mean central banks are likely to become net sellers of gold as they used to be in the past few decades. We have a long-term (LT) gold price forecast of US$1,250/oz vs. the current spot price of US$1,288/oz. Expensive valuation: Even if we assume a bull case LT gold price of US$1,400/oz (an unlikely scenario, in our view), Zhaojin/Zijin would trade at about 9x/11x 2014E earnings, which are not very attractive valuations in the Metals & Mining space given the stagnant mined production growth and surging cost inflation (especially for Zijin). Our scenario analysis on the two companies' 2014E earnings is based on different 2014 average gold price assumptions of US$1,400/1,250/1,175/1,100 per oz. In the worst case scenario, Zhaojin and Zijin’s 2014E EPS could be as much as 25% and 20% below current consensus, respectively. Prefer Zhaojin over Zijin: We have a relative preference for Zhaojin over Zijin, given its proven track record in volume growth and cost control. Zijin’s gold production cost will continue to increase going forward, while we expect Zhaojin’s to be more stable. More importantly, it doesn’t have the resources depletion issue in its core mine that Zijin is facing. We believe the depletion of Zijin’s Zijinshan mine, the largest and lowest cost mine, will lead to both stagnant mined production growth and surging production costs in the coming years. We forecast Zijin's mine gold production to grow <5% CAGR going forward with further downside risk vs. Zhaojin's c.10%. Exhibit 295: Three potential scenarios for gold price outlook Source: Company data, Jefferies estimates 1,418 1,250 1,250 1,250 1,2501,411 1,175 1,125 1,100 1,075 1,404 1,100 1,000 950 900 1,572 1,669 1,418 1,400 1,400 1,400 1,400 800 900 1,000 1,100 1,200 1,300 1,400 1,500 1,600 1,700 1,800 2011A 2012A 2013E 2014E 2015E 2016E 2017E US$/oz Base case Bear case #1 Bear case #2 Bull case Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 177 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 179. Exhibit 296: Zijin’s gold production cost will continue to rise going forward whereas Zhaojin’s will stay relatively stable Source: Company data, Jefferies estimates Exhibit 297: Average cost of Zijin’s production by mines: the depleting Zijinshan has the lowest costs (2012) Source: Company data, Jefferies estimates Exhibit 298: After growing by 5% CAGR in the past 5 years, Zijin’s mined gold production is likely to grow by around 5% in an optimistic scenario… Source: Company data, Jefferies estimates Exhibit 299: … whereas Zhaojin will maintain double digit growth for the next few years Source: Company data, Jefferies estimates Take profits on both names or pair trade: We believe the risks for both companies' earnings are heavily skewed to the downside and at 12-13x our 2014 PE, the valuations for both companies are extremely expensive. We advise investors to take profits on both names. Our global team has been a long-time advocate of a "long gold, short gold equities" trade. Historically this trade worked better on Zijin and we continue to recommend this pair trade. 454 509 472 490 510 531 364 427 596 731 780 835 50 150 250 350 450 550 650 750 850 950 2010 2011 2012 2013E 2014E 2015E US$/oz Zhaojin Zijin 69 120 338 0 50 100 150 200 250 300 350 400 Zijinshan Company average Norton (acquired in 2012) RMB/g 17.4 18.0 16.2 16.2 16.4 11.5 10.0 8.0 7.7 6.4 8.0 7.8 7.5 9.3 10.0 0 5 10 15 20 25 30 35 40 tons Others Zuoan Norton Gansu Yate Tajikistan ZGC Congli Dong ping Shuiyindong Huichun Shuguang Zijinshan 32.1 24.8 36.8 5% CAGR 5% CAGR 1.6 2.4 3.0 3.6 3.9 4.1 4.1 4.1 2.5 2.5 1.9 1.6 1.8 2.0 2.0 2.00.4 0.5 0.7 0.6 0.8 1.0 1.1 1.11.4 2.1 2.6 3.5 4.4 5.8 7.5 9.0 0 2 4 6 8 10 12 14 16 18 20 tons Mines outside Zhaoyuan Daqinjia Canzhuang Hedong Jintingling Dayinggezhuang Xiadian Jinchiling 15% CAGR 11% CAGR Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 178 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 180. 2014 China Property The Era of Reform, Outlook Bearish Key takeaways China’s Residential Property sector is facing tough headwinds, with softening demand and rising policy concerns. We expect increasing affordable housing to curb demand, and expect property tax in Tier 1/2 to be implemented in the next 12 months. On the back of declining margin and tightening financing, we expect sector de-rating ahead. We prefer China retail plays on resilience: Top Picks are CMA, HLP and CR Land. The era of bold reform: The Third Plenum highlighted a broad spectrum of economic reform, with profound impact on China property sector. While no specific measure was revealed at the meeting, property rights protection and legislation property tax set the stage for long-term urbanisation & consumption trend. Property tax and rising affordable supply curb demand: We expect China to launch property tax in Tier 1/2 cities in the next 12-18 months and increase affordable housing supply, including social/self-use housing. Property tax levied annually on asset value could trigger a potential sell-off. Beijing set a 50k units target as supply of self-use housing for 2014, over 40% of the total volume in 2012. In addition, YTD land sales for self-use accounted for 16k units, on track to meet the target. Presale growth to decelerate: We forecast national transaction volume and home price to grow by 5% yoy, below the 18% and 9% yoy, respectively, in 2013E. We expect Tier 1/2 cities to underperform due to property tax and affordable supply. Almost all major developers we follow will boost saleable resources to drive presales performance, in our view. In our base case scenario, we forecast average contracted sales to grow at only 11% yoy (vs. 26% in 2013E). Volume may decline 2% in our bear case scenario, should increased supply on affordable housing and property tax hurt sell-through rate. Margins to decline, financing at risk: In the past two years, the ratio of land price/ASP jumped from 22% to 35% for Tier 1 cities, compared with 23% to 28% increase for Tier 2 cities. We reckon aggressive land is fuelled by accommodating environment for offshore financing. YTD, bond issuance by Chinese developers surged 120% from that of 2012. Tightening liquidity is a potential risk for those rely heavily on offshore bond market. We expect developers’ gearing to be on the rise, as increasing capex is needed to boost saleable resources. Sector de-rating likely, we prefer retail plays: YTD, China property sector has outperformed MSCI China slightly, supported by robust contracted sales. In 2014, the sector may see more downside pressure, and it may test new lows before hitting new highs. Lacklustre presales and tighter liquidity could lead to a sector de-rating, in our view. COLI, CR Land and COGO are better positioned among residential players. We prefer retail stocks on visible income streams and limited policy impact. Our Top Picks are CMA, Hang Lung Prop. and CR Land. Christie Ju +852 3743 8012 cju@Jefferies.com Venant Chiang +852 3743 8013 venant.chiang@jefferies.com Parvani Zheng +853 3743 8019 pzheng@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 179 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 181. Bearish 2014 Outlook We are bearish on the China property sector for its outlook in 2014. Property sales growth is likely to decline, financing risks may intensify and new policies following tax reform and increase in affordable supply would change the market dynamic in the housing market. During 2008 to 2013, this sector witnessed different market cycles, from the global financial crisis and administrative tightening to China’s credit crunch. Based on our 2025 China property forecast, we reckon the highest growth phase has already passed. Exhibit 1 illustrates our forecast for total housing demand till 2025. On our base case, the average housing demand amounts to about 1.1bn sqm per year, roughly just 10% higher than the total transaction volume recorded in 2012. Exhibit 300: Jefferies housing demand forecast Source: Jefferies estimates As a matter of fact, between 2010 and 3Q13, the top 30 players measured by property sales acquired a larger market share from 20% to 27% at a rising rate. If market reform happens, industry consolidation is likely to accelerate. Property tax is now on its way The government will speed up property tax legislation in the Third Plenum, indicating the determination to implement property tax at the national level. Moreover, a housing data platform will be set up, which will lay the foundation for property tax, especially for levy of existing housing. As the critical part of the long-term mechanism, we believe the property tax will impact the market profoundly. Considering legislation is a time consuming process, we expect a pilot expansion to occur first at a tax rate higher than that in Shanghai & Chongqing. When it is executed, we expect investment demand to decline substantially and some existing properties could also come under sell-off pressure. Affordable supply increase a threat to commodity housing Based on latest China Audit Report, urban social housing development was under smooth progress with 7.7m units starting construction and 4.5m units completed in 2012, achieving 106% and 110%, respectively of the government target. This endeavor has been enhancing the housing market structure, witnessing 20% coverage of total housing by 2016 compared to less than 7% in 2010. We believe boosting social supply will become one of the key agendas to refine the China housing market as part of the urbanization process. The proportion of this supply can only go higher, threatening the commodity housing market, in our view. Beijing also shows a red flag with 50k units target (c40% of 2012 overall transacted volume) for the provision of self-use housing at 30% below the market price. Based on current land sale progress, it is on track to the target, and expectedly more Tier 1 cities may follow Beijing to introduce this type of supply program, which would help absorb more demand. Bear case Base case Bull case Newly added urban population (mn) 210 215 298 Average GFA per person (sqm) 28 30 32 Urbanization demand (sqm bn) 5.87 6.45 9.54 Existing urban population (mn) 707 707 707 Newly added GFA per person (sqm) 5.4 6.4 8.9 Upgrade demand (sqm bn) 3.83 4.53 6.28 Residential GFA built before 2000 (sqm bn) 7.5 7.5 7.5 Relocation rate x 12 years 0.25 0.33 0.36 Relocation and Redevelopment (sqm bn) 1.85 2.43 2.72 Total housing demand (sqm bn) 11.55 13.41 18.53 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 180 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 182. 2014 national property sales to grow slower For 2014 physical market, we expect the national transaction volume to grow moderately at 5% yoy vs. an average of 8% for the past 3 years, as we believe 1) demand would soften following double-digit growth for 16 consecutive months. Purchasing demand that was suppressed during 2H11-1H12 has largely been released; 2) potentially a wider and deeper property tax implementation would alter the public home price expectation. Thus, potential buyers would wait and see; 3) the increase in mortgage down payment and interest rate will dampen buyers’ affordability and 4) the enhancing return from other wealth management products may impact the attractiveness of property investment. In terms of commodity housing supply, we expect 2014 supply to remain relatively flat on a nationwide basis. New starts declined 11% in 2012 and have merely grown 5% YTD. Driven by increasing cost of land & construction, we expect national home price to grow 5% yoy to Rmb6.2k/sqm at the end of 2014. Although demand in Tier-1/2 cities remains strong driven by population inflow, we forecast its ASP growth to edge down to 7% next year (vs.15% YTD), mainly due to: 1) rebound in land transaction in 2013, especially for Beijing (+ 112% yoy ) and Shanghai (+57% yoy); 2) the focus of asset turnover by developers given the policy uncertainty. In a bear case scenario, which assumes the expansion of property tax and increase in affordable supply, we believe the impact would be much more severe in Tier 1/2 cities. We forecast a -15% yoy drop in volume and -15% ASP decline. Exhibit 301: National transaction volume YTD yoy growth Source: NBS, Jefferies estimates Exhibit 302: 2014 national transaction forecast Source: NBS, Jefferies estimates Exhibit 303: National transaction volume estimates Source: NBS, Jefferies estimates Exhibit 304: National ASP estimates Source: NBS, Jefferies estimates -40% -20% 0% 20% 40% 60% 80% 100% Jan08 Apr08 Jul08 Oct08 Jan09 Apr09 Jul09 Oct09 Jan10 Apr10 Jul10 Oct10 Jan11 Apr11 Jul11 Oct11 Jan12 Apr12 Jul12 Oct12 Jan13 Apr13 Jul13 Oct13 National Tier 1/2 cities Tier 3 cities Volume Bull Case 17% 20% 15% Base Case 5% 7% 5% Bear Case -10% -15% -6% ASP Bull Case 8% 9% 8% Base Case 5% 7% 4% Bear Case -10% -15% -5% 27% 22%20% 29% 19% 47% 9% 27% -19% 54% 8% 4% 2% 18% 5% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60% 0.0 200.0 400.0 600.0 800.0 1,000.0 1,200.0 1,400.0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E GFA sold Yoy growth mn sqm 1,843 1,952 2,068 2,130 2,212 2,549 3,0103,132 3,6653,655 4,427 4,724 5011 5,428 5,900 6,195 1,500 2,500 3,500 4,500 5,500 6,500 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 201… 201… Rmb/sqmRmb/sqmRmb/sqmRmb/sqmRmb/sqmRmb/sqm Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 181 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 183. 2014 developers’ sales growth to slow down Although national supply is expected to be flat in 2014, we forecast major developers under our coverage will have a larger amount of saleable resources, since new starts and development under construction have accelerated during 2013, underpinned by strong presales, aggressive land acquisition, and expanded financing throughout the year. Based on our analysis, 2014 saleable resource may grow 22% on average compared to c16% for 2013E. After a strong 2013, we expect developers’ sales growth to decline owing to lower sell-through rate on demand moderation. In our base case, average sell-through rate may drop from 60% to 54% in 2014 due to 1) strong absorption of first-time home buyers in 2013 and 2) transaction held back by upgraders and investors due to property tax concerns. Taking into account a slower run-rate and high base, we forecast a mere 11% contracted sales growth on average for developers in 2014, the lowest level in history. In a worst case scenario, their contracted sales may decline 2% if measures on increasing affordable supply and property tax are implemented. Exhibit 305: Developers’ presales yoy change Source: Jefferies estimates Exhibit 306: 2014 presales forecast (Rmb bn) 2013 2014E Saleable resource Sell-through rate Growth in saleable resource Saleable resource Presales in base case Presales in bull case Presales in bear case Agile 75 53% 26% 94 45 50 40 Country Garden 131 70% 30% 171 108 120 96 COGO 19 70% 25% 23 15 16 13 COLI 150 70% 20% 180 113 126 101 CR Land 98 65% 22% 120 70 78 62 CMP 65 62% 18% 77 44 49 39 Evergrande 200 55% 20% 240 119 132 106 Franshion 18 80% 25% 22 16 18 14 Greentown 120 50% 15% 138 65 72 58 Hopson 30 42% 5% 31 12 13 11 KWG 25 65% 30% 32 19 21 17 Longfor 85 55% 23% 105 51 57 45 Poly Property 42 64% 15% 48 28 31 25 Powerlong 15 47% 20% 18 9 10 7 R&F 75 56% 25% 94 47 53 42 Shimao 100 70% 38% 138 88 98 78 Sino Ocean 68 53% 10% 75 36 40 32 SZ Investment 23 42% 40% 32 12 14 11 Vanke 258 66% 20% 309 184 204 163 Average 60% 22% Source: Jefferies estimates, 2014 base case on assumption of 90% sell-through rate of 2013, bull case on sell-through rate of 2013, and bear case on 80% sell-through rate of 2013 34% 16% 23% 26% Base case :11% -10% 0% 10% 20% 30% 40% 2010 2011 2012 2013 2014E Bull case: 23% Bear case:-2% Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 182 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 184. Margin pressure persists on rising land price Land price is soaring across the board sparked by developers’ strong appetite in land supplementation. Tier-1 cities register the strongest growth as land price jumped 44% as of Oct to Rmb7.2k/sqm, followed by 17% growth in Tier-3 cities and 13% growth in Tier-2 cities. In our view, development margin is unlikely to improve as land price appreciation significantly outpaces that of ASP. This is evidenced by the fact that land price % of ASP jumped from 23% to 35% for Tier 1 cities and from 26% to 28% for Tier 2 cities during 2011 to 2013. Although land price in Tier-3 cities grew modestly during the same period, margin would also be difficult to improve as we are concerned about a large amount of inventory and only a stable demand support. Exhibit 307:Average land price in GFA (Rmb/sqm) Source: Local land bureau in 40 key cities,* include 4 tier-1 cities,24 tier-2 cities and 12 tier-3 cities Exhibit 308: Average land price/ ASP Source: Local land bureau in 40 key cities,* include 4 tier-1 cities,24 tier-2 cities and 12 tier-3 cities Exhibit 309: Net Margin for major developers FY09 FY10 FY11 FY12 1H13 COLI 17% 22% 27% 24% 25% KWG 17% 17% 21% 20% 22% SZI 13% 13% 16% 21% 17% Shimao 13% 13% 14% 15% 17% Longfor 14% 17% 18% 19% 17% COGO na 15% 27% 22% 17% Country Garden 11% 16% 17% 16% 16% Powerlong 30% 27% 16% 16% 16% Greentown 10% 12% 11% 12% 14% Hopson 16% 16% 17% 11% 14% CR Land 19% 17% 15% 16% 13% R&F 13% 14% 16% 16% 11% Agile 14% 18% 17% 16% 11% Poly Property 8% 14% 12% 11% 11% Sino Ocean 12% 14% 11% 9% 10% Evergrande 4% 12% 14% 10% 10% Average 15% 16% 17% 16% 15% Source: Company data 2940 5864 5608 3885 4958 7155 1783 2539 2390 2285 2318 2627 871 1404 1651 1559 1555 1822 0 1000 2000 3000 4000 5000 6000 7000 8000 2008 2009 2010 2011 2012 2013 Tier-1 Tier-2 Tier-3 21% 37% 34% 23% 29% 35% 24% 32% 28% 26% 27% 28% 14% 22% 24% 22% 22% 24% 10% 15% 20% 25% 30% 35% 40% 2008 2009 2010 2011 2012 2013 Tier-1 Tier-2 Tier-3 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 183 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 185. Gearing on the rise, financing support may weaken In 2013, developers accelerated land acquisition on strong market sentiment and developers’ bullish outlook. Based on our estimate, developers on average have allocated 41% of their presales on land purchase as of end-Oct vs. 22% in 2012. With mortgage tightening unlikely to change and development cost continuing to rise, we thus expect gearing to escalate from 55% in 1H13 to 58% at end of 2013. In 2014, it will further rise to 61% in 2014, subject to contracted sales performance and land banking activity. Based on Moody’s, bond issuance by Chinese developers as of Oct is US$17.9bn, equivalent to 2.2x the size recorded in 2012. When US tapering became a concern, shift in HK liquidity situation may be a risk for those heavily relying on the offshore bond market. Compared to 1H13, bond raising by Chinese developers has dropped by over 40% so far. As such, when HK bond issuance market weakens, developers will confront a higher cost of borrowing. The risk is higher for developers facing rising capex pressure due to large land bank and development pipeline. Exhibit 310:2012 Land acquisition consideration vs. presales Source: Company data, Jefferies Exhibit 311: Land acquisition consideration vs. presales as of Oct Source: Company data, Jefferies Exhibit 312: Gearing forecast 1H13 2013E 2014E COGO 11% 16% 22% COLI 15% 30% 32% CMP 25% 30% 35% Vanke A 41% 42% 45% CR Land 44% 52% 57% Sino Ocean 49% 50% 55% Greentown 49% 50% 52% Evergrande 54% 70% 77% Agile 58% 65% 70% CGH 58% 70% 70% Powerlong 61% 70% 75% Shimao 61% 65% 68% Longfor 64% 68% 68% Hopson 69% 70% 72% KWG 72% 68% 68% SZI 76% 76% 76% Poly Property 83% 80% 83% R&F 99% 89% 80% Average 55% 58% 61% Source: Jefferies estimates , Company data 8% 10% 10% 11% 11% 14% 14% 15% 15% 21% 21% 24% 36% 38% 42% 55% 0% 10% 20% 30% 40% 50% 60% Agile Poly property Shenzhen Investment Powerlong R&F Greentown Sino Ocean CR Land KWG Country Garden Evergrande Shimao COGO COLI Vanke Longfor avg: 22% 11% 17% 18% 29% 34% 41% 41% 42% 45% 45% 47% 47% 49% 50% 57% 58% 65% 0% 10% 20% 30% 40% 50% 60% 70% Greentown Poly Property Country Garden COLI Longfor KWG CR Land CMP Evergrande Shimao Franshion Agile R&F Vanke Gemdale COGO Powerlong avg: 41% Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 184 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 186. Valuation downside on sector de-rating With change in market context expected due to reforms, the sector may see another dip (47% disc at 1SD below mean vs. 37% currently) as during 2011 when HPR was introduced and mid-13 when credit crunch intensified. Also, weakened property sales and liquidity support (onshore and offshore) would hinder the sector from performing better than in a strong year. That being said, the China property sector is likely to de- rate on concerns of slower growth, funding risk and new policy throughout the reform. Measured by PE or PB, trading at the current level which is near the top range during the year should not be compelling to investors. At best, the upside is capped by the mean valuation. However, similar to the historical NAV discount metric, both of the perspective sector PE and PB will see the risk trending down to -1SD below mean or lower when Central government unveils more new policies. Exhibit 313: Weighted sector NAV discount chart Source: Jefferies estimates, Bloomberg as of Nov 19, 2013 Exhibit 314: Weighted sector PE band Source: Jefferies estimates, Bloomberg as of Nov 19, 2013 Exhibit 315: Weighted sector PB band Source: Jefferies estimates, Bloomberg as of Nov 19, 2013 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 185 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 187. YTD, China’s property sector has outperformed with MSCI China slightly as supported by robust contracted sales despite economic challenges. However, if we look into the performance deeper, stock return is mixed among different group of developers YTD; COLI & CR Land are in line with overall sector, large non-SOE developers (including Agile, Country Garden, Evergrande, Longfor, R&F and Shimao) outperformed while other developers lagged. Without significant change in company fundamentals, we expect the sector polarisation to widen in 2014. Exhibit 316: Stock performance comparison Source: Bloomberg as of Nov 18, 2013 Exhibit 317: Valuation table Company Ticker Price Mkt Cap Rating Target Upside NAV* Disc PE PB DY * US$ mn Price* /Down /prem. 12 13E 14E 12 13E 14E 12 13E 14E CGH 2007 HK 5.32 12,666 Buy 5.5 3% 7.3 -27% 11.1 9.1 7.9 2.0 1.7 1.5 3.3 3.3 3.3 CMA CMA SP 2.02 6,319 Buy 2.4 19% 2.7 -25% 40.4 33.7 28.9 1.2 1.2 1.1 1.5 1.5 1.5 CMP A 000024 CH 23.31 6,207 Buy 34.0 46% 43.5 -46% 12.1 8.1 6.4 1.7 1.4 1.2 1.3 1.3 1.3 CMP B 200024 CH 21.37 6,207 Buy 37.9 77% 55.1 -61% 8.7 5.9 4.6 1.2 1.0 0.9 1.8 1.8 1.8 COGO 81 HK 9.00 2,650 Buy 14.1 57% 14.8 -39% 10.5 8.0 6.3 2.6 1.9 1.4 1.2 1.3 1.6 COLI 688 HK 24.05 25,354 Buy 28.0 16% 28.0 -14% 12.5 9.5 7.6 2.3 1.9 1.6 1.7 1.8 2.2 CR Land 1109 HK 21.45 16,133 Buy 30.0 40% 30.0 -29% 17.2 13.2 10.3 1.8 1.6 1.5 1.6 1.8 1.9 Evergrande 3333 HK 3.26 6,748 Buy 4.1 26% 9.0 -64% 6.2 5.1 4.3 1.0 0.9 0.7 0.0 3.9 4.7 Franshion 817 HK 2.61 3,084 Buy 3.7 42% 5.6 -53% 13.1 8.7 7.1 0.8 0.8 0.7 2.7 2.7 2.7 Greentown 3900 HK 13.70 3,814 Buy 18.5 35% 26.5 -48% 4.6 4.3 3.6 1.0 0.9 0.8 4.6 4.6 4.6 KWG 1813 HK 4.69 1,750 Buy 6.5 39% 12.9 -64% 5.5 4.4 3.4 0.7 0.6 0.5 4.1 5.2 6.5 Powerlong 1238 HK 1.62 846 Buy 2.0 23% 4.0 -60% 5.3 4.3 3.2 0.3 0.3 0.3 6.3 6.3 6.3 Shimao 813 HK 19.48 8,726 Buy 22.8 17% 32.6 -40% 12.5 7.6 5.2 1.5 1.3 1.1 2.9 3.3 4.8 SZI 604 HK 3.08 2,137 Buy 4.3 40% 7.2 -57% 6.2 6.0 6.4 0.6 0.5 0.7 5.8 5.8 5.8 Vanke A 000002 CH 9.08 16,787 Buy 17.6 94% 19.5 -53% 8.0 6.8 5.0 1.6 1.3 1.1 2.0 2.0 2.0 Vanke B 200002 CH 13.76 16,787 Buy 22.5 64% 25.0 -45% 9.5 8.1 6.0 1.9 1.6 1.3 1.7 1.7 1.7 Gemdale 600383 CH 6.21 4,557 Hold 7.1 14% 11.8 -47% 9.1 13.8 8.2 1.2 1.1 1.0 1.3 1.3 1.3 Hopson 754 HK 9.54 2,768 Hold 11.3 18% 32.0 -70% 14.6 10.4 9.4 0.4 0.4 0.3 0.0 0.0 0.0 Poly Property 119 HK 4.61 2,167 Hold 5.5 19% 11.0 -58% 7.2 5.8 4.4 0.6 0.6 0.5 4.7 4.7 4.7 R&F 2777 HK 12.94 5,379 Hold 13.8 7% 25.1 -49% 6.5 5.9 5.3 1.2 1.1 0.9 5.9 5.9 5.9 Sino Ocean 3377 HK 4.95 3,803 Hold 5.2 5% 10.3 -52% 8.8 8.3 6.8 0.6 0.6 0.5 4.8 4.8 4.8 SOHO 410 HK 6.75 4,226 Hold 6.5 -4% 10.8 -38% 9.0 9.1 13.6 0.9 0.8 0.8 4.7 4.7 4.7 Agile 3383 HK 9.15 4,069 U/P 7.8 -15% 19.4 -53% 5.4 5.8 5.1 1.0 0.9 0.8 4.3 4.3 4.3 Glorious 845 HK 1.24 1,246 U/P 1.3 5% 3.8 -67% 10.8 6.1 4.4 0.4 0.4 0.4 0.0 0.0 0.0 Longfor 960 HK 12.14 8,521 U/P 11.0 -9% 20.0 -39% 9.3 8.3 6.6 1.7 1.5 1.2 2.1 2.1 2.4 Renhe 1387 HK 0.42 1,146 U/P 0.4 -5% 0.7 -40% N/A N/A N/A 0.3 0.3 0.3 0.0 0.0 0.0 Yanlord YLLG SP 1.23 1,926 U/P 1.2 -7% 2.6 -52% 11.6 12.0 9.7 0.7 0.7 0.6 1.5 1.5 1.5 Average 28% -51% 9.0 7.9 6.8 1.1 1.0 0.8 3.0 3.1 3.4 Source: Jefferies estimates, Bloomberg as of Nov 18, 2013, *trading currency Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 186 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 188. 2014 China TMT China Internet: Building a Mobile Ecosystem Key Takeaway As affordable smartphones proliferate, favourable data usage offers emerge as the telecom operators compete for 3G users and rush to deploy 4G LTE. We expect to see multiple connected devices, multi-screens working on mobile and PC platforms driving Chinese Internet user behaviour and preference for applications and products in 2014. As we predicted at the beginning of 2013, this year saw large Internet players continue to expand into new segments of the Internet economy with a slew of M&A announcements. We expect the trend to continue into 2014, as companies position themselves strategically as Internet users’ time-spent increasingly transitions to mobile from PC. We recommend four Internet segments to watch in 2014: (1) e-Commerce; (2) Mobile games; (3) Search and performance-based ads; (4) Online travel. We are overweight on China Internet, and our top picks for 2014 are Baidu and Tencent. Internet user growth benefits from increasing mix shift to mature population In our January 8th , 2013 note “China Internet: Long Term Demographic Changes Bear Far Reaching Implications”, we discussed that Chinese Internet user mix will be more balanced, matching the demographics of the general Chinese population. In 2014, 44% of total Internet users aged between 30-59 in 2014. In the longer term, we expect that 66% of total Internet users will be older than 30 by 2025, compared to 44% in 2012, given the aging population trend in China and increasing Internet penetration in the older generations. Exhibit 318: China Internet Users by Age Group (2008A- 2025E) Source: CNNIC, US Census Bureau, Jefferies estimate Exhibit 319: Chinese Mobile Internet Users (2007A-2016E) Source: CNNIC, National Bureau of Statistics, Jefferies estimate 3G and mobile devices drive mobile Internet penetration Chinese Internet users grew to 591mn (44% penetration rate) in 1H13, driven by rapid growth of mobile Internet users. 70% of newly added Internet users adopt mobile devices. We estimate 89% of Chinese Internet users will be mobile Internet users in 2014E, mainly due to 3G/4G LTE wireless and rising smartphone penetration given Cynthia Meng +852 3743 8033 cmeng@jefferies.com Ken Hui +852 3743 8061 khui@jefferies.com Clara Fan +852 3743 8069 cfan@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 187 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 189. increasing availability of lower-end handset and enhancement in mobile device capability. Exhibit 320: China Smartphone Users and Penetration (2011A-2025E) Source: Company data, MIIT, Jefferies estimate Positive for e-Commerce, mobile games and mobile search As Internet users shift to more mature population with generally higher disposable income, we believe the e-Commerce sector will directly benefit from rising number of online shoppers and average spending per head. Accelerating 3G migration and mass market smartphone commoditization allows people to be always “online”, and therefore gives rise to huge market potential in mobile games and mobile search, in our view. E-Commerce: B2C growth to accelerate; m-Commerce growth ramps up The total online shopping market reached RMB437.1bn in 3Q13, +42.4% YoY. We estimate that China’s online sales penetration as a % of total consumer goods retail sales will reach 9.7% in FY14, driven by both increasing number of online shoppers and rising ARPU. In our view, the current relatively low penetration of online shoppers (46% of Internet users, according to CNNIC), increasing urbanization and consumption power in China, as well as the changing user behaviour on mobility are the main drivers for e- Commerce growth in China. Exhibit 321: China’s Online Retail Sales Market (2007A-2016E) Source: iResearch as of Jun 2013, Jefferies We estimate that China’s online sales penetration as a % of total consumer goods retail sales will reach 9.7% in FY14, driven by both increasing number of online shoppers and rising ARPU. We estimate that China’s Smartphone users as a % of total mobile subs and that of population to both reach 46% in FY14, driven by both increasing availability of low- end handset and enhancement in mobile device capability. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 188 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 190. Exhibit 322: Historical Trend of Alibaba’s GMV on Singles’ Day (Nov 11th ) Source: Company data, iResearch, Jefferies Note: Alibaba's annual GMV includes Taobao and Tmall's total transactions. Alibaba's 2012 annual GMV is estimated according to market data and public media news. Alibaba, the leading Chinese e-Commerce player, achieved RMB35bn in GMV on Singles’ Day (Nov 11th) in 2013 with 83.3% YoY growth rate. If we assume the GMV of Cyber Monday in the US grows at 20% YoY this year, the implied GMV of Alibaba’s Singles’ Day would be 3X that of the US Cyber Monday in FY13. Exhibit 323: GMV Comparison: Alibaba Singles’ Day vs. US Cyber Monday Source: Company data, comScore as of Nov 2012, Jefferies The number of orders placed on Alibaba’s Tmall was 18.7x that of its daily average. The November 11th Singles’ Day promotion at Alibaba also helped to generate huge sales at other eCommerce players. According to Egou.com’s survey on shopper’s behaviour: 1. 63% of Tmall shoppers also purchased goods on JD (Jingdong or 360Buy). JD saw its no. of orders on Singles’ Day up 8.7x compared to its daily average no. of orders; and JD’s GMV on Singles’ Day was 6.67x compared to its daily average GMV; 2. 45.8% of Tmall shoppers also bought from Tencent’ 51Buy (Yixun), and 51Buy’s GMV on the Singles’ Day this year was 4.32x that of its daily average GMV. 3. Lastly, 41% of Tmall shoppers placed orders at Dangdang on Singles’ Day. 2009A 2010A 2011A 2012A 2013A Alibaba's Annual GMV (RMB bn) 208.3 400.0 632.1 1,090.0 n.a. YoY % change 108.4% 92.0% 58.0% 72.4% n.a. Alibaba Singles' Day GMV (RMB bn) 0.1 0.9 5.3 19.1 35.0 YoY % change 1772.0% 466.2% 260.4% 83.3% % of Annual GMV 0.0% 0.2% 0.8% 1.8% n.a. 2009A 2010A 2011A 2012A 2013A Alibaba Singles' Day GMV (USD mn) 7 142 820 3,027 5,666 YoY % change 1801.9% 477.7% 269.2% 87.2% US Cyber Monday's GMV (USD mn) 887 1,028 1,251 1,465 - YoY % change 15.9% 21.7% 17.1% % difference -99.2% -86.2% -34.5% 106.6% Alibaba, the leading Chinese e- Commerce player, achieved RMB35bn in GMV on Singles’ Day (Nov 11th ) in 2013. If we assume the GMV of Cyber Monday in the US grows at 20% YoY this year, the implied GMV of Alibaba’s Singles’ Day would be 3X that of the US Cyber Monday in FY13. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 189 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 191. Exhibit 324: Number of Orders Placed on Singles’ Day vs. Daily Average Source: Egou.com as of Nov 2013 Exhibit 325: Singles’ Day GMV vs. Daily Average GMV Source: Egou.com as of Nov 2013 We believe that product diversification into high-margin, non-standardized goods and leverage on larger economies of scale will provide upside to margins for the principal B2C eCommerce players. WeChat payment was launched by Tencent in 2H13. We believe that Tenpay, integrated with WeChat payment, bridges the gap between online and offline, simplifies the shopping process on 51buy and offers O2O revenue opportunities. As of Oct 2013, the number of orders completed through WeChat payment on 51buy reached 350K with transaction amount accounting for over 5% of 51buy’s total transaction amount, according to management. Exhibit 326: China’s 3Q13 B2C Market Share by Players (Including Platform) Source: iResearch as of Oct 2013, Jefferies M-Commerce accounted for 9.5% of total online sales in 3Q13, up from 5.6% in 3Q12, according to iResearch. In our view, m-Commerce growth continues to accelerate as it provides consumers a convenient shopping experience through easy-to-use features such as QR code scanning. We currently estimate m-Commerce penetration of online sales to reach 13.2% in FY14, up from 9.7% in FY13. Baidu is beefing up its location-based services (LBS) offering [over 140mn Monthly Active Users (MAU) in 3Q13, up from 120mn in 2Q13] with the integration of Nuomi and Baidu Map, an important mobile gateway of local search that enables transactions to be completed within the Baidu ecosystem, such as hotel bookings, movie ticket purchases, group buying and taxi booking. Baidu also indirectly benefits from the Tmall, Jingdong and Tencent were ranked top 3 in China’s B2C market in 3Q13, with 51.1%, 17.5% and 6% market share respectively. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 190 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 192. growing e-Commerce market as e-Commerce companies or the eCommerce business units of large brands increasingly place ads on Baidu’s Hao123 and Brand Zone. Exhibit 327: China’s M-Commerce Market Size by GMV (2009A-2016E) Source: iResearch as of Jun 2013, Jefferies Mobile Games: Explosive growth driven by WeChat FY13 marks an inflection point for explosive mobile game market growth with an estimated market size of RMB13.7bn, +73.3% YoY, revised up by 18% from iResearch’s previous estimate. Looking into FY14, we believe the explosive market growth is largely driven by WeChat’s mobile game platform, which greatly enhances Tencent’s distribution capability based on its social circle. Exhibit 328: Monthly Time Spent on Mobile Game Apps (Sept 2012-Sept 2013) Source: iResearch as of Oct 2013, Jefferies iResearch recently revised up FY14 mobile game market forecast by 32% to reach RMB20.9bn, +53.3% YoY, in which smartphone games account for RMB17.9bn, +371.3% YoY. Total mobile game market is expected to reach RMB33.2bn by FY16 with a 2012-2016 CAGR of 43.3%, supported by strong growth in mobile games. This may We estimate m-Commerce penetration of online sales to reach 13.2% in FY14, up from 9.7% in FY13. Monthly time spent on mobile game apps more than tripled YoY to 761mn hours in Sept 2013. WeChat launched its first mobile game on Aug 5th , driving rapid increase on monthly time spent on mobile game apps. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 191 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 193. prove conservative in our view and we believe in further potential upside as mobile device increasingly captures fragmented user time. Exhibit 329: China Mobile Game Market Size (2011A-2017E) Source: iResearch as of Oct 2013, Jefferies We reiterate Tencent as our top pick as we consider Tencent the best positioned among Chinese Internet companies, with its strong coverage of multiple mobile Internet entry points. Tencent owns three out of the top 10 apps ranked by monthly time spent, including WeChat, mobile QQ and QQ mobile browser, according to iResearch. WeChat and mobile QQ in aggregate accounted for 20.7% of total time spent on mobile apps in Sept 2013, up from 15.2% in Oct 2012, with WeChat leading other social networking apps by a wide margin in both monthly active users and time spent. Exhibit 330: Monthly Active Users of Top 5 Social Networking Apps (Aug 2012-Aug 2013) Source: iResearch as of Sept 2013, Jefferies iResearch recently revised up FY14 mobile game market forecast by 32% to reach RMB20.9bn, +53.3% YoY, in which smartphone games account for RMB17.9bn, +371.3% YoY. WeChat and mobile QQ in aggregate accounted for 20.7% of total time spent on mobile apps in Sept 2013, up from 15.2% in Oct 2012. WeChat leads other social networking apps by a wide margin in both monthly active users and time spent. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 192 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 194. Exhibit 331: 10 Mobile Apps (Non-Game) by Monthly Time Spent (Sept 2013) Source: iResearch as of Oct 2013, Jefferies Note: This table contains mobile apps excluding games. Exhibit 332: WeChat and Mobile QQ Monthly Time Spent and Market Share (Sept 2013) Source: iResearch as of Oct 2013, Jefferies Tencent has rolled out 5 self-developed games, since the launch of WeChat’s mobile game platform in Aug 2013. “Timi Run Everyday” has reportedly achieved monthly gross revenue of over RMB100mn and Daily Active Users (DAU) of “Rhythm Master” surged to 16mn one month after its launch on WeChat. Among WeChat’s mobile games, four topped both MAU and monthly time spent rankings in Sept 2013, according to iResearch. Games distributed on WeChat platform are able to aggregate huge user activity as social features such as top player ranking among friends, gifts to friends, etc. generate high user stickiness. We believe WeChat’s launch of a mobile game platform will greatly enhance Tencent’s distribution capability, leveraging on its 600mn user base. Exhibit 333: Top 10 Mobile Games in China by Monthly Active Users (Sept 2013) Source: iResearch as of Oct 2013, Jefferies Exhibit 334: Top 10 Mobile Games in China by Monthly Time Spent (Sept 2013) Source: iResearch as of Oct 2013, Jefferies We recently revised up Tencent mobile game revenue by 6.4% and 15% to reach RMB2bn and RMB6bn in FY13 and FY14, respectively. In our view, the market share gain of Tencent’s mobile gaming platforms, including WeChat and QQ, will accelerate and potentially account for 35% and 48% of China’s mobile game market in FY14/FY15, respectively. No. App Type Monthly Time Spent (in mn hours) 1 WeChat IM 734.9 2 Mobile QQ IM 586.5 3 UC Browser Browser 410.2 4 Youku Online Video 217.4 5 QQ Mobile Browser Browser 175.7 6 Sina Weibo Microblog 148.5 7 iQiyi Online Video 140.7 8 PPS Online Video 130.6 9 360 Battery Manager System tools 98.0 10 PPTV Online Video 91.5 No. Game MAU (mn) Developer 1 Timi Match Everyday (Tian Tian Ai Xiao Chu) 55.0 Tencent 2 Rhythm Master (Jie Zou Da Shi) 38.5 Tencent 3 Timi Link Everyday (Tian Tian Lian Meng) 36.1 Tencent 4 Timi Run Everyday (Tian Tian Ku Pao) 28.7 Tencent 5 Plant vs. Zombie 2 (Zhi Wu Da Zhan Jiang Shi 2) 25.1 PopCap 6 Temple Run (Shen Miao Tao Wang) 18.3 Imangi Studios 7 Carrot Fantasy (Bao Wei Luo Bo) 14.3 Beijing Kai Luo Tian Xia 8 Fruit Ninja (Shui Guo Ren Zhe) 12.1 Halfbrick Studios 9 Pop Star (Xiao Mie Xing Xing) 9.8 Lei Zeng 10 JJ Dou De Zhu 5.9 JJWorld(Beijing) Network No. Game Monthly Time Spent (mn hours) Developer 1 Timi Match Everyday (Tian Tian Ai Xiao Chu) 106.4 Tencent 2 Rhythm Master (Jie Zou Da Shi) 65.1 Tencent 3 Plant vs. Zombie 2 (Zhi Wu Da Zhan Jiang Shi 2) 64.8 PopCap 4 Timi Run Everyday (Tian Tian Ku Pao) 54.2 Tencent 5 JJ Dou Di Zhu 28.1 JJWorld(Beijing) Network 6 Timi Link Everyday (Tian Tian Lian Meng) 27.8 Tencent 7 Pop Star (Xiao Mie Xing Xing) 27.6 Lei Zeng 8 Carrot Fantasy (Bao Wei Luo Bo) 26.0 Beijing Kai Luo Tian Xia 9 MT (Wo Jiao MT) 20.8 Loco Joy 10 Bo Ke Dou De Zhu 13.6 Poker City Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 193 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 195. Exhibit 335: Tencent’s Mobile Game Revenue Estimates and Market Share Source: iResearch as of Oct 2013, Jefferies estimate We view Qihoo as another beneficiary in this blossoming mobile game market. The strong distribution capability of its app store (ranked no.1 with 21.7% market share by number of times used in Sept, 2013, according to iResearch) gives rise to Qihoo’s large traffic and vendor neutral mobile game platform. We believe Qihoo’s mobile game upside will mainly come from increasing paying user conversion, which is currently at a high single-digit. Mobile Search: Nascent market with increasing adoption Based on channel checks with search ads agents, advertisers are increasingly allocating at least 10-15% incremental ad budget to mobile search as traffic shifts to mobile. According to our checks, mobile queries already account for 40% of total queries at Baidu. The mass adoption of mobile devices given availability of lower-end handsets and accelerating 3G migration, allows people to be always “online” to search for not only information, but also services such as movie ticket purchases, hotel reservations, taxi booking, etc. Exhibit 336: China’s Search Market Size (2008A-2015E) Source: iResearch as of Jun 2013, Jefferies In our view, the market is still nascent and mobile search has a more diversified market landscape vs. PC given its various entry points, including app store, vertical apps and maps on top of the traditional search box in mobile browsers. We view Baidu as the best positioned in mobile search ramp-up and monetization with a 62% share in mobile search, according to Research Sootoo. We believe its strong app distribution capability, narrowing of CPC gap between PC and mobile, map-supported LBS offerings and iQiyi- PPS’s leading online video position on mobile will strengthen Baidu’s mobile search ads positioning. in RMB mn 2013E 2014E 2015E 2016E Mobile games market size 13,650 20,920 28,420 33,170 YoY % change 73% 53% 36% 17% Tencent's market share % 16% 35% 48% 60% Total Tencent's mobile game net revenue 2,014 6,041 10,402 14,180 YoY % change 106% 200% 72% 36% FY14 Search market is forecast to reach RMB45.2bn with 30.1% YoY growth. In our view, the market share gain of Tencent’s mobile gaming platforms, including WeChat and QQ, will accelerate and potentially account for 35% and 48% of China’s mobile game market in FY14/FY15, respectively. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 194 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 196. Looking across global search engines, mobile constituted 21.2% of Google’s ad revenue as estimated by Jefferies U.S. Internet team and est. 20% of Yandex in 3Q13, compared to over 10% of Baidu, underpinning its large upside in mobile search revenue. According to our industry checks, Baidu has required all mobile search ad customers to have mandatory mobile landing page starting from Dec. 1st , which we believe will be positive in accelerating customers’ mobile search adoption in the long term, in our view. Exhibit 337: Mobile Search Revenue as % of Total Ads Revenue Source: Company data, Jefferies estimate; Note: Google’s mobile revenue contribution refers to Jefferies U.S. Internet team’s estimate in FY13. Yandex’s mobile revenue contribution refers to estimate in 3Q13 according to its Mgmt. Baidu’s mobile revenue contribution was based on 2Q13 results. Baidu dominated the mobile search market with 61.7% share in 3Q13, according to Sootoo Research. We expect Baidu to continue as the no.1 search engine despite some potential PC search market share loss to Qihoo and stronger Sogou with Tencent’s traffic support. Benefitting from a dominant position in both PC browser and security products, we expect Qihoo to deliver PC search traffic gain and the monetization gap between revenue share and traffic market share to close as the bidding process intensified with larger number of advertisers and its system intelligence improves in terms of both keyword coverage and search result relevancy. Top Picks: Tencent (700 HK), Baidu (BIDU US) Our top picks are Tencent (700 HK) and Baidu (BIDU US) within the Chinese Internet space Company Mobile search revenue as % of total ads revenue Google 21.2% Yandex 20.0% Baidu 10.0% Looking across global search engines, mobile constituted 21.2% of Google’s ad revenue as estimated by Jefferies U.S. Internet team and est. 20% of Yandex in 3Q13, compared to over 10% of Baidu, underpinning its large upside in mobile search revenue Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 195 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 197. Baidu (BIDU US, BUY, TP USD 222) Key Takeaway Our positive outlook on Baidu is built upon its faster-than-expected mobile search ramp-up and monetization potential, driven by increasing mobile search demand and incremental mobile ad budget from Baidu’s customers. Newly launched “Zhixin” interim landing page may see more upside on both PC and mobile platforms. Increasing mobile search demand Our checks with search ad agents reveal that advertisers are increasingly allocating at least 10-15% incremental ad budget to mobile search. We estimate that mobile queries already account for 40% of total queries at Baidu, and the cost per click (CPC) gap between mobile and PC has narrowed over the past few months. Starting from Dec 1st , all Baidu mobile search customers are required to have a mobile landing page. New product helps drive monetization Baidu launched “Zhixin” search on four verticals including education, finance, travel and medical in July, presenting search results in an easy to use format on an interim landing page. Our channel checks indicate that Zhixin has improved click-through rate (CTR) and conversion rate for Baidu’s search. According to management, iwan.baidu.com, Baidu’s PC-based online gaming portal, has delivered 50% increase in ROI since its integration with “Zhixin”. We hold the view that further upside exists if Zhixin is expanded successfully to other verticals, , and onto mobile search. Laying out a mobile ecosystem with strong app distribution capability Baidu has enhanced its mobile apps distribution capability with the acquisition of 91Wireless, making it a close #2 with 20.5% in aggregate market share. Baidu is beefing up its LBS offering (over 140mn MAU, up from 120mn last quarter) with the integration of Nuomi and Baidu Map, an important mobile gateway of local search which enables transactions to be completed within Baidu ecosystem, such as hotel booking, movie ticket purchase, group buy and taxi booking. Valuation Maintain Buy with PT at USD222, based on 25x FY15 PE, 7% above peer average, with an implied 35x FY14 P/E. We believe investors will look through given mobile search upside and expected margin expansion in FY15. Risks include execution in the transition to and potential monetization of mobile, and stronger than expected competition. Exhibit 338: Mobile search traffic market share (3Q13) Source: Sootoo Research, Jefferies Exhibit 339: App distribution platform market share by number of times used in Sept 2013 Source: iResearch Oct 2013, Jefferies App Distripution Platfrom Market Share % 360 Mobile Assistant (Qihoo) 21.7% Wandoujia 15.3% Tao App Store (Alibaba) 10.6% 91 Mobile Assistant (Baidu) 9.2% HiMarket (Baidu) 6.5% Baidu Mobile Assistant (Baidu) 4.9% MIUI App Store (Xiaomi) 6.0% Anzhi Market 3.4% PP Mobile Assistant 4.7% Tencent Myapp 1.8% Others 15.9% Total 100.0% 20.5% Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 196 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 198. Tencent (700 HK): Green light for mobile game take-off Key Takeaway Tencent’s online game revenue growth will continue to be driven by stable user base, increasing ARPU and rich game pipeline. We expect WeChat mobile games to take off in 2014 and see further monetization potential in stickers and corporate accounts. We see solid e-Commerce growth with improving margin to be driven by product category expansion. Performance-based and video ads will provide support to robust online ads growth. Online games see strong growth; mobile games to take off. Online games continue to grow with increasing game user base, higher ARPU on major titles and rich pipeline. We expect games growth to remain strong as more pipeline games will move onto commercial launch in 2014. CrossFire has benefitted from new game items and anniversary activities. Legend of Yulong exceeded 800K PCU with an expansion pack released in July. Asura entered unlimited closed beta testing in mid Sep and will move onto commercial launch in the near future. Blade & Soul entered limited closed beta testing in late Oct. Games distributed on WeChat platform are able to aggregate huge user activity as social features such as top player ranking among friends, gift to friends, etc. generate high user stickiness. Mobile games will see significant growth leveraging on WeChat and mobile QQ’s large user base and the viral social network effect generated from players’ interaction. We recently revised up our mobile game revenue estimates by 6.4% and 15% to reach RMB2bn and RMB6bn in FY13 and FY14, respectively. In our view, market share gain of Tencent’s mobile gaming platform, including WeChat and QQ, will accelerate and potentially account for 48% of China’s mobile game market by YE15. WeChat monetization to focus on mobile game, stickers, and enterprise a/c. Wechat is leading all other mobile social networking applications by a wide margin in both monthly active users and time spent. Tencent owns three out of the top 10 mobile apps ranked by monthly time spent, including WeChat, mobile QQ and QQ mobile browser, according to iResearch. Wechat and mobile QQ in aggregate account for 21.2% of total time spent on mobile apps in Aug. 2013, up from 15.2% in Oct. 2012. Combined Weixin/WeChat MAU reached 272mn in 3Q13, +124% YoY and +15% QoQ. The 5 mobile games launched on WeChat reached 570mn total registrations within 3 months, while “Timi Run Everyday” secured a top 3 position in gross revenue ranking on iOS store, demonstrating the strong monetization capability of WeChat games. Of the five self-developed WeChat mobile games, four topped both MAU and monthly time spent rankings in Sept 2013, according to iResearch. We believe there are further revenue opportunities to explore on WeChat, including stickers and corporate accounts, as validated by LINE (a leading Japanese messaging app). Solid growth in e-Commerce with improving GPM E-Commerce demonstrated solid growth benefiting from both user expansion and increasing total number of orders placed. We believe that Tenpay, integrated with WeChat, simplifies the shopping process on 51Buy and offers O2O revenue opportunities. Online ads strength was contributed by robust performance-based and video ads. Valuation Tencent (700 HK): Reiterate Buy with PT at HKD492, based on 33.4x FY14 PE. Tencent is currently trading at 28.5x FY14 PE and our PT implies 17% upside from current levels. Risks include execution in e-Commerce development and integration of multiple business lines. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 197 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 199. China Telecom: The beginning of the 4G battle; FDD-LTE Licensing MIIT has reconfirmed throughout the year that 4G licenses will be issued before YE2013. In our view, all three operators are likely to receive TDD-LTE licenses with FDD-LTE license to follow within 12 months after TDD. While China Mobile (CM) has a head start on TDD-LTE, where CM has recently launched commercial trials in multiple cities, including Beijing, Shanghai, Hangzhou and Guangzhou, China Unicom (CU) and China Telecom (CT) are rapidly catching up on 4G LTE deployment. CU and CT are both adopting a combined FDD/TDD-LTE network structure, with a focus on FDD-LTE. Initially, 4G LTE will focus on hot spot areas and major cities for both CU and CT given their more comprehensive 3G network, in our view. We believe CM will continue to be the most active operator in pushing 4G TDD-LTE services in 2014 prior to the issuance of FDD-LTE licensing. CT will leverage on TDD-LTE to absorb high data usage from data card users, and for wireless broadband in rural areas. Upon issuance of FDD-LTE licenses, we expect CU and CT to rapidly deploy FDD-LTE and to focus on FDD-LTE handsets to ramp up 4G subscribers given the more mature FDD-LTE handset value chain compared to TDD-LTE. Availability of affordable 4G smartphones will be critical to the ramp up of 4G subscribers. Our checks indicate leading vendors plan to offer high-end TDD-LTE models for most of FY14. 4G LTE capex drives industry capex growth We forecast total Chinese telcos capex to grow 4.4% YoY to RMB418bn in FY14, mainly driven by 95% YoY growth in LTE capex to RMB100.6bn, offset by capex decline in other areas. We believe that FDD-LTE deployment will most likely be skewed towards 2H14, as our view of FDD-LTE license to come within 12 months after TDD-LTE license (before YE2013) implies uncertainty in the timing of CT and CU’s FDD-LTE capex deployment. We see potential upside to CU’s LTE capex (FY14E/FY15E of RMB7.5bn each year). CU’s 52K 4G LTE base stations (80% FDD 20% TDD) that started bidding in Oct 2013 are expected to start shipping in 1Q14. Total value is estimated to be RMB8-9bn. In our view, CU is likely to hold another 4G LTE network bidding next year, exceeding the RMB5-10bn LTE capex for FY14 guided by the management. Telecom equipment vendors are direct beneficiaries of the potential increase in capex from CU. ZTE in our view, will become a dominant player in the 4G equipment space given its current 25% market share in CU’s 3G WCDMA installed base. Exhibit 340: 4G LTE Capex Forecast (Rmb bn) Source: Jefferies estimates, company data 2013E 2014E 2015E 2016E China Mobile 41.7 45.0 40.0 40.4 YoY% 7.9% -11.2% 1.1% China Telecom 10.0 48.1 54.8 54.9 YoY% 381.2% 14.0% 0.2% China Unicom - 7.5 7.5 7.5 YoY% 0.0% 0.0% Total 4G LTECapex 51.7 100.6 102.3 102.8 YoY% 94.6% 1.7% 0.5% We believe 4G license awards to all telcos may come in 4Q13 at the earliest. We are estimating 8.7% YoY telecom industry service revenue growth in 2013. We estimated total telecom industry capex of RMB358bn in 2013, slightly up 1.8% YoY, including total TD-LTE capex of RMB55bn, up 18x YoY. 2013: Industry experts expect 320mn handset units to be sold in China (up 45% YoY), of which 90- 95% would be smartphones (288mn-304mn, up 75%-77% YoY). Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 198 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 200. Exhibit 341: Chinese Telcos Capex Forecast by Company (Rmb bn) Source: Jefferies estimates, company data Telecom service revenue growth remains moderate We forecast Chinese telcos total service revenue to grow 8.7% YoY to RMB1,209bn, mainly driven by 10.2% YoY growth in mobile service revenue. 3G services revenue will still be the revenue driver for FY14 as 2G migration to 3G is expected to accelerate in 2014. We estimate 2G net loss will reach 75.6mn in 2014E, up from 65.6mn in 2013E. Although all three Chinese telcos are expected to launch 4G services in 2014, revenue contribution will be insignificant given (1) 4G services will not ramp up quickly until affordable handsets are available. Our checks indicate leading vendors plan to offer high-end TDD-LTE models for most of FY14; (2) FDD-LTE licenses are expected to be issued in 2H14 at the earliest, potentially delaying CU/CT in promoting 4G services, leveraging on the more mature handset value chain of FDD-LTE. Before affordable 4G handsets become available, CM will continue to be in a defending position against CU/CT, leading to higher handset subsidies, especially after iPhone launch (which handset subsidies are approx. 45%-50% of service revenue at CU/CT). CM is forecast to grow at the slowest pace at 6% YoY growth out of the three operators. In addition, CM has the largest 2G subs base as a percentage of total mobile subs base, and therefore is the most vulnerable to Over-The-Top (OTT) service providers providing “free” SMS and voice services (users only have to pay for data used). China Mobile Capex - Total Listco + Parentco 0 0 0 2010A 2011A 2012A 2013E 2014E 2015E 2016E China Mobile Capex - Total Listco + Parentco 149.3 166.5 184.3 242.4 236.9 202.0 186.9 YoY -7.5% 11.5% 10.7% 31.5% -2.2% -14.7% -7.5% 0 0 0 0 - 0 0 0 China Mobile Capex - Listco - 2G+4G from 2013, only 2G before 0 0 0.0 0.0 0 0 0 0 2010A 2011A 2012A 2013E 2014E 2015E 2016E Total Capex (RMB bn) 124.3 128.5 127.4 190.2 193.1 167.9 166.3 YoY% -3.9% 3.4% -0.9% 49.3% 1.5% -13.0% -1.0% 0 - 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% China Mobile Capex - Parentco - TD (3G) 0 0 0 0 0 0 0 0 2010A 2011A 2012A 2013E 2014E 2015E 2016E TD-SCDMA Capex (RMB bn) 23.0 13.0 23.9 22.2 18.9 14.2 10.6 YoY% -23.3% -43.5% 83.8% -7.1% -15.0% -25.0% -25.0% 0 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% China Mobile Capex - Parentco - Railcom (Wireline) 0 0 0 0 0 0 0 0 2010A 2011E 2012A 2013E 2014E 2015E 2016E Total Capex (Railcom) (RMB bn) 2.0 25.0 33.0 30.0 25.0 20.0 10.0 YoY% 0% 1150% 32% -9% -17% -20% -50% 0 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% China Unicom Capex - Listco - Wireless +Wireline 0 0 0 0 0 0 0 0 2010A 2011A 2012A 2013E 2014E 2015E 2016E China Unicom Capex (RMB bn) 70.2 76.7 99.8 78.1 96.0 96.7 95.4 YoY% -37.6% 9.2% 30.2% -21.8% 23.0% 0.7% -1.3% 0 - - - - - - - China Telecom Capex summary 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 China Telecom Capex - Total Listco + Parentco 0 0 0 0 0 0 0 0 2010A 2011A 2012A 2013E 2014E 2015E 2016E China Telecom Capex - Total Listco + Parentco 70.0 71.6 72.5 80.0 85.0 92.6 90.9 YoY -23.5% 2.1% 1.4% 10.3% 6.3% 9.0% -1.9% 0 0 0 0 0 0 0 0 China Telecom Capex - Listco - Wireline 0 0 0 0 0 0 0 0 2010A 2011A 2012A 2013E 2014E 2015E 2016E Total wireline Capex (RMB bn) 43.0 49.6 53.7 50.0 34.4 34.9 35.9 YoY% 13.2% 15.1% 8.4% -6.9% -31.2% 1.6% 2.9% 0 - - - - - - - China Telecom Capex - Listco (from 2013) - Wireless 0 0 0 0 0 0 0 0 2010A 2011E 2012A 2013E 2014E 2015E 2016E Total wireless Capex (RMB bn) 27.0 22.0 18.8 30.0 50.6 57.7 54.9 YoY% -49.5% -18.5% -14.6% 59.6% 68.8% 14.0% -4.9% Total Industry Capex 2010A 2011A 2012A 2013E 2014E 2015E 2016E Total Capex (Industry) (RMB bn) 289.5 314.7 356.6 400.5 418.0 391.4 373.2 YoY% -20.8% 8.7% 13.3% 12.3% 4.4% -6.4% -4.6% Exhibit 342: 1: Telecom Services Revenue Growth (YoY%) Source: Jefferies, company data 2012 2013E 2014E CM 6.1% 6.2% 6.0% CT 11.8% 10.1% 9.0% CU 13.1% 13.6% 12.6% Total 8.9% 8.7% 8.2% Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 199 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 201. Exhibit 343: Chinese Telcos Total Service Revenue and YoY% Source: Jefferies estimates, company data Margins of operators diverge In FY14, we expect CU to (1) maintain a relatively stable ratio of handset subsidies to 3G service revenue, even with the launch of 4G services in FY14; and (2) continue to expand 3G revenue base prior to the ramp up of mass market 4G services and enjoy 3G operating leverage. Prior to the issuance of FDD-LTE license in FY14, we believe CU will only promote 4G LTE on a smaller scale, limiting the cost impact from LTE. We forecast CU’s EBITDA margin expansion to carry onto FY14E to 36.1%, +0.2pcpt YoY. Coupled with lower depreciation from lower capex in FY13, we estimate CU’s margin to reach 5.9%, +1.2pcpt YoY. For CT, with less leverage on 3G than CU, we forecast EBITDA margin to slightly decline to 33.4%, -0.6pcpt YoY, while net margin is forecast to increase slightly to 6.9%, +0.7pcpt YoY. On the other hand, CM faces multiple challenges in FY14, including (1) OTT services eating into CM’s most profitable SMS and voice services; (2) increasing leasing cost pressure from higher utilization of 3G TD-SCDMA network and increased usage of CT/CU’s Internet access gateway triggered by rapid increase in data usage; (3) higher handset subsidies to sales ratio, especially after introduction of iPhone; and (4) 4G related expenses will start kicking in in FY14. We forecast CM’s EBITDA margin to decline 2.1pcpt YoY to 39.4% in FY14. Higher depreciation expenses from LTE deployment in FY13E/14E adds to pressure on net margins. We expect net margin to decline 3.1pcpt YoY to 17.5%. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 200 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 202. Exhibit 344: Chinese Telcos EBITDA Margin Comparison (on Service Revenue) Source: Jefferies estimates, company data Exhibit 345: Chinese Telcos Net Margin Comparison (on Service Revenue) Source: Jefferies estimates, company data Potential regulatory changes may impact industry’s competitive landscape In 2014, there are a few potential policy changes that could potentially change the industry landscape. Cut in interconnection fee for CU/CT; issuance of broadband license to CM MIIT may consider reducing interconnection settlement fee when CU and CT mobile calls terminate on CM’s network, while CM will continue to pay RMB0.06/min (the current rate for all three operators) for calls terminating on CU/CT’s network. At the same time, CM may receive a broadband license as a “compensation”. According to our sensitivity analysis, a 10% cut in interconnection settlement fee at CU/CT, will translate into 7%/4% profit upside to our FY14 estimate and a 1% downside to CM’s FY14E net profit. The issuance of a broadband license to CM will create three integrated service providers in the industry, intensifying both the fixed-line and mobile competition in the telecom industry. MVNO licenses: introducing new mobile competitors According to the “Trial Proposal” announced by MIIT in May 2013, qualified applicants can apply for the trial of mobile-network-virtual-operators (MVNO); the trial period will end on Dec 31, 2015. The Chinese media recently reported that CU has a list of 14 potential MVNO partners and CT has 16, with 9 companies on both lists. The potential MVNO partners include handset distributors and Internet players, such as D-Phone, Funtalk, Suning, JingDong, Gome, etc. We expect MIIT to announce the successful applicants sometime in 2014. MVNO will bring opportunities and threat to the operators. Although MVNOs will further promote mobile usage in China, they will also increase competition in the market. However, we do not expect meaningful impact from MVNO in 2014 as even after successful applicants are announced by MIIT, service launch may involve a certain amount of preparation time, including software upgrades. VAT looks inevitable for all telecom operators The telecom services and railway industries have been included by the government as the second batch to trial value-added tax (VAT), increasing the tax burden on the operators. However, its timing and magnitude are uncertain. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 201 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 203. Top pick: China Unicom, ZTE China Unicom (Buy) and ZTE (Buy) are our top picks in the space, followed by China Telecom (Buy) and CCS (Buy), lastly China Mobile (Hold) and Comba (Hold). ZTE will benefit from 4G capex plans in FY14/15 as a dominant equipment vendor in China (4G market share of 32% at CM, 26% at CT and expected 25% at CU). CU to (1) maintain a relatively stable handset subsidies to 3G service revenue ratio even with the launch of 4G services in FY14; and (2) continue to expand 3G revenue base prior to the ramp up of mass market 4G services and enjoy 3G operating leverage. CM remains Hold-rated with pressure on capex, subsidies and top line growth, supported by stable dividend payout ratio with its cash rich position. Comba continues to face strong competition from ZTE and Huawei in the long run. Valuations ZTE: Reiterate Buy and PT of HK$23, implying 23.6x FY14E and 21.5x FY15 PE, higher- end of historical range of 13x - 26x PE. ZTE is trading at 17.3x FY14E and 15.7x FY15E PE, 2%/8% premium to peers, respectively. Risk is mgmt. execution as ZTE increases global expansion & builds its handset brand, worse than expected handset mkt competition due to low-end smartphone commoditization. China Unicom: Reiterate Buy and DCF-based price of HK$15.5, implying FY14 4.5x EV/EBITDA and 17.9x PE. At current price, CU is trading at FY14E 14.1x PE, and 3.9x EV/EBITDA, a 23% discount compared to emerging Asia peer group average FY14 EV/EBITDA. Risks include deeper integration of wireless and fixed line, and the threat from OTT players from Internet industry. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 202 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 204. China Technology: Cautious on 2014 Key takeaways We believe consumer PC slowdown is secular in China, although we see possible recovery in corporate PC demand in 2014 on better corporate earnings in 2013. We expect China smartphone growth to slow in 2014, thus negatively impacting both smartphone markers and component suppliers. As a beneficiary of stronger smartphone growth in other emerging markets, FIH is the only Buy under our coverage. Secular downtrend in China consumer PC demand We believe consumer PC demand in China is on a secular downtrend. Therefore, although we believe it is bottoming out, we do expect meaningful recovery in 2014. PC penetrations in urban households reached 82% in 2011, already on par with developed markets. While rural households saw PC penetration remain low at 18% in 2011, with low affordability and available alternatives, they are skipping a US$400 PC to a RMB400 smartphone or tablet for Internet connections. Exhibit 346: % of households with a PC Source: International Telecommunication Union, National Bureau of Statistics Possible recovery in China corporate PC demand in 2014 On the corporate front, as expected in our 2013 tech outlook, we are seeing slower IT spending growth this year due to prior year’s weak corporate earnings. However, corporate profit recovery in 2013 suggests better IT spending and therefore PC demand in 2014. For example, SOEs saw 10.5% y/y earnings growth for the first three quarters in 2013. On the other hand, the Chinese government’s efforts in tackling corruption may continue to inhibit corporate IT spending growth, in our view. 86.9 84.6 83.9 83.4 82.6 81.9 78.2 75.5 57.1 45.4 35.4 18.0 6.1 0 10 20 30 40 50 60 70 80 90 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 203 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 205. Exhibit 347: Changes in China SOE profits vs. IT spending Source: Jefferies estimates E-commerce is destroying traditional PC distributors We believe proliferation of e-commerce in China is destroying the traditional distribution network. E-commerce penetration in China at 6.3% in 2012 has already surpassed the US. Enfodesk forecasts online shopping penetration for electronics products in China to increase from 15.5% in 2012 to 29.4% in 2017, thus making the traditional distribution channels less relevant. We have already begun to see brick-and-mortar PC stores close in tier-one cities. Exhibit 348: Online penetration of retail sales for consumer electronics Source: Enfodesk 14.6% 40.2% 6.4% -5.8% 10.5%11.9% 15.2% 19.3% 13.9% 7.3% -10% 0% 10% 20% 30% 40% 50% 2009 2010 2011 2012 2013E SOE Profit Growth (1-3Q for 2013) China IT Spending Growth 7.0% 15.5% 29.4% 0% 5% 10% 15% 20% 25% 30% 2009 2012 2017E Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 204 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 206. Exhibit 349: A Lenovo PC store in Shanghai closed four months ago Source: Jefferies Slower China smartphone growth in 2014 Smartphone shipment penetration, that is, smartphone as a percentage of total handset shipments, in China was 72% in 2Q13, getting very close to developed markets at 78%. This suggests slower China smartphone growth in 2014. IHS expects China smartphone shipment growth to slow down from over 50% in 2013 to 16% in 2014, with most of the incremental 50mn units being LTE. Exhibit 350: Smartphone shipment penetrations Source: Jefferies estimates, Gartner 65% 66% 72% 77% 78% Developed Markets 78% 33% 40% 48% 53% 65% China 72% 23% 24% 24% 26% 31% Other Emerging Markets 32% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 205 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 207. Exhibit 351: China smartphone shipments Source: IHS TD-SCDMA no longer a smartphone growth driver in China Aggressive TD net adds by China Mobile is boosting the smartphone market to a high base in 2013. TD accounted for 48% of 3G handset shipments in 1H13, compared to 24% in 1H12. We expect TD handset shipment growth to slow down from 127% in 2013 to 4% in 2014, coming off a high base exiting 2013. Exhibit 352: TD handset forecast model Source: Jefferies estimates, CATR Stronger, but unlikely explosive, smartphone growth in emerging markets We view other emerging markets as a wildcard to worldwide smartphone growth in 2014, but unlikely to see explosive growth like China, given lower affordability, fewer local vendors and poorer 3G networks. Negative impact on Chinese smartphone makers We expect China’s smartphone market to face several negative impacts in addition to a slowing market in 2014. China’s smartphone market has started to show seasonal patterns instead of continuous q/q growth, but expectations remain overly optimistic, in our view. Therefore, we expect channel inventory levels to remain volatile in near term, leading to challenges in timing product launch and production planning. Performance gaps between Chinese smartphone makers have begun to widen, and vendors without competitive products or good channels are under stronger pressure. With the pie no longer growing fast, Chinese smartphone makers have to move up their price points in order to sustain profitability, which however requires higher spending on R&D and marketing in the near term. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 206 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 208. Negative impact on smartphone component suppliers With a slowing smartphone market, as component makers have been massively expanding capacities, they will likely see oversupply, thus suffering from stronger pricing and margin pressure in 2014, in our view. Top Sell: Digital China (861 HK) Our top sell within our China Tech coverage is Digital China (861 HK) as we see ongoing structural challenges in the Distribution and Systems, the two most profitable businesses at Digital China, despite management’s best efforts. Digital China (861 HK): Structural Challenges in Core Businesses Structural headwinds to Distribution We see a secular downtrend in consumer PC demand in China and increasing threats from e-commerce. PC stores are being closed in tier-one cities. While Digital China is providing e-commerce operators with logistics services, the growth opportunity is unable to offset the shortfall in the highly profitable Distribution business. Long-term threats to Systems Foreign vendors have been losing tenders to domestic competitors such as Huawei (NC), particularly in information-sensitive telcos and public sectors. We also expect persistent weakness in corporate IT demand in the near term. While we expect the overall demand to improve in CY14 to partly offset the structural headwinds, it is unlikely to return to the level in CY12. Positive on spinning off Services, but smart city remains distant We are encouraged by spinning off Services into A-share Shenzhen Techo Telecom. However, with its current sub-optimal scale, Services requires capital investments in near term. Contributions from smart city remain distant before a viable business model can be devised. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 207 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 209. 2014 China Transportation Key takeaways A global cyclical recovery does not benefit all cyclicals. We favor airlines and ports for 2014 vs. shipping in general. Airlines, with least capacity issues, are set for a cyclical rebound from their trough valuation. Crude tankers may struggle some more but we pick it for long-term investors seeking contrarian investment in a depressed cyclical sector. Freight rates for dry bulk shipping should go higher amid continuous huge seasonal volatility. Container shipping could continue to suffer, even with a moderate pick-up in demand, which should benefit ports more. Exhibit 353: Subsector Valuation vs. our projected ROEs Source: Jefferies estimates Aviation: Bullish on aviation sector, particularly Cathay Pacific, exposed as it is to premium travel, where demand is on a clear recovery path. We also recently turned positive on Chinese domestic airlines on their cyclical trough valuation, but their earnings are likely to recover in 2014 on prudent supply and improving cost efficiencies. Cathay Pacific is our top pick; we also rate Air China and China Eastern as Buy. Ports: Our relative preference in the Transport space. We expect the sector will be supported by improving export growth to US and Europe, and lack of the capacity issues present in shipping. CMHI is our top pick for the sector, both in light of improving industrial fundamentals, but also on its undervalued land reserve in Qianhai. Crude tankers: May still struggle to turn around in 2014, but we think the sector may be interesting for long-term investors because (1) the sector is between despondency and depression in terms of market sentiment; (2) energy shipping has the most growth potential in the long run among shipping sub-segments; and (3) capacity growth may come to a halt after 3 years of very low investment. We play the theme through CSD and MOL. Dry Bulk Shipping: We are getting more constructive because capacity growth may track below demand growth in 2014 to allow for higher full year average freight rates. PBS is our pick in the dry bulk space as the company could grow earnings even if BDI only shows marginal improvement. Container Shipping: Remain cautious because container shipping may again struggle to stay profitable in 2014 as surplus capacity would depress freight rates that outweigh the benefit from potential cost cut. -1.2 -0.8 -0.4 0 0.4 0.8 1.2 -20% -15% -10% -5% 0% 5% 10% 15% 20% Container Shp Bulk Shp Ports PRC Airlines 2013 ROE 2014 ROE 2014 PB Johnson Leung +852 3743 8055 jleung@jefferies.com Boyong Liu, CFA +852 3743 8015 bliu@jefferies.com Benjamin Wang +852 3743 8035 bwang@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 208 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 210. Aviation We are bullish on the aviation sector, particularly Cathay Pacific, exposed as it is to premium travel, where demand is on a clear recovery path. We also recently turned positive on Chinese domestic airlines on their cyclical trough valuation, but their earnings are likely to recover in 2014 on prudent supply and improving cost efficiencies. Cathay Pacific is our top pick; we also rate Air China and China Eastern as Buy. Long haul premium travel is on a clear recovery path The recent pick-up in leading indicators of premium class travel such as JP Morgan/Markit Global PMI, which tends to lead premium travel by 2-3 months, and positive outlook guidance on corporate travel from premium carriers have reaffirmed our view that premium class demand has started on a recovery path after remaining rather subdued since 1Q11. With 40% passenger revenue from premium travel, Cathay should be a direct beneficiary from this demand uptrend, in our view, and expect its blended passenger yield growth to further accelerate in 2H13. Cargo finally finds some support Air cargo is finally showing some signs of stabilization in the past 2 months, with spot freight rate registering 2% growth in 3Q13, after a 7% decline in 1H13. Demand has recovered somewhat, as our recent channel checks suggest a strong pick-up in air cargo volume in 4Q13, driven by the launch of new Apple and Surface products. We believe Cathay should benefit the most from cargo recovery, given its 25% revenue exposure to the segment, while airlines including Air China and China Eastern will also retire or replace their cargo fleet with more fuel-efficient aircraft, which should help them to further narrow the loss on the cargo front Chinese domestic market to see a rebound on easing supply, lower cost inflation and lower base The Big 3 Chinese carriers (Air China, China Southern, and China Easter) suffered 45% yoy EBIT decline in 1-3Q13 collectively, weighed down by a sharp 7% yoy decline in passenger yield. We expect their earnings to bottom out in 4Q13 and into 2014, on the back of 1) rebounding passenger on the back of prudent supply and low base , and 2) easing cost pressure, both fuel and non-fuel. Slow supply growth after high yielding demand dampened Our checks suggest that the Big 3 airlines are now turning cautious on 2014 capacity deployment in the domestic market, following a sharp 7% yoy ticket price drop in domestic market. While we believe overall ASK growth should accelerate to 10.7% yoy in 2014 from 10.2% in 2013, we expect their domestic ASK growth to slow further to 8.9% yoy from 9.4% yoy in 2013, slightly below our forecast demand growth (measured in RPK) of 10.1%. Exhibit 355: ASK growth for Big 3 airlines has slowed since Aug Source: Company data, Jefferies Exhibit 356: Expect demand to slightly outgrow supply in domestic market for 2014-15 Source: Company data, WIND, Jefferies estimates 0% 2% 4% 6% 8% 10% 12% 14% 1 2 3 4 5 6 7 8 9 10 11 12 2012 2011 2013 9.4% 8.9% 8.8% 9.0% 10.1% 10.0% 0% 10% 20% 30% 40% 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E ASK growth RPK growth Exhibit 354: Global PMI has historically led premium travels by 2-3 months with 82% positive correlation, and bodes well for premium travel demand in coming months Source: Drewry, Bloomberg 30 35 40 45 50 55 60 65 70 -30 -20 -10 0 10 20 30 06 07 08 09 10 11 12 Global Premium class YoY (3 month lag) JPM Global Composite PMI SA Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 209 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 211. …but further tightening of travel budget is a risk that we cannot ignore The tough pricing, in our view, was mainly driven by 1) austerity measures taken by the government and SOEs, 2) sluggish economy in 1H13 and 3) several one-off events, such as the Bird Flu in 2Q13, and tensions between China and Japan. For 2014, if there a significant shrinking of the travel budget at the government and SOEs from an already very low base in 2013, it can be a downside risk to our call. We estimate that if high-end travelers (premium class and high-end economy class passengers who buy tickets at 20% discount or below) are 10% below our estimates, it could potentially bring our domestic yield down 2%, and pose a 10-30% downside risk for Air China and China Eastern. Cost pressure to ease going forward Operating costs for 3 Chinese airlines are better than our expectation, and helped their margins to contract only 3 ppt yoy in 1Q-3Q13, on the back of a 7% decline in passenger yield and flattish load factor. Our checks suggest that improved cost efficiencies may come from 1) the airlines’ tight control on labor cost, 2) increasing use of direct sales to reduce commissions, and 3) air fleet optimization, which lowers maintenance cost and fuel consumption per ATK. We expect all those favourable factors to continue into 2014 and onward, and expect non-fuel cost to grow slower than ASK for the 2014-15. Exhibit 357: Op. margin for all 3 airlines registered a smaller decline than ticket price decline in 1Q-3Q13 Source: Company data, Jefferies Exhibit 358: Jet fuel price (Singapore spot) is down 3.4% yoy in 4Q13. We expect another 3% yoy drop in 2014 Source: Company data, WIND, Jefferies estimates LCC threat remains well contained within Great China areas Market concerns on Hong Kong Express and potential opening of Jetstar HK in 2014 could weigh on short haul for Cathay, and CAAC’s deregulation of the price floor could fuel price war in the domestic market. However, we expect limited impact for the next 2-3 years, given: Lack of landing slots. Hong Kong Int’l Airport will reach its maximum aircraft movements in 1-3 years, and is already close to maximum capacity in peak hours. Landing slots are also a scarce resource in China’s Top 8 airports, and very difficult for LCC to penetrate. While CAAC has de-regulated the lower price limit of Rmb0.41/km (a 56% discount to the higher price limit), its impact has not been formally applied in the past. We have seen prices at 80-90% discount, particularly on short-haul routes that compete head-on with HSR. Current obstacles such as aircraft import quota, shortage of qualified pilots, in China market should all continue to cap the development of low-cost carriers. -8% -6% -7% -4% -3% -3% -10% -8% -6% -4% -2% 0% CEA CA CSA Ticket price decline (yoy) Op margin contraction (%) -20.0% -10.0% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 105 110 115 120 125 130 135 140 1Q112Q113Q114Q111Q122Q123Q124Q121Q132Q133Q134Q13 Jet fuel price YoY $/barrel Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 210 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 212. Ports Ports remain our relative long in the transport space. We expect the sector will be supported by improving export growth to US and Europe, and lack of capacity issues as in shipping. CMHI is our top pick for the sector, both in light of improving industrial fundamentals, and its undervalued land reserve in Qianhai. Throughput growth to steadily improve in 2014, pricing remains stable We expect China’s foreign trade container throughput growth to accelerate moderately to 5.5% from 4.9% in 2013, as demand from US continues to recover, and Europe may potentially start a small restocking cycle. Handling tariff should continue a steady 1-2% yoy increase, similar to 2013, as port operators provide more value-added services, but our checks suggest they are unlikely to raise their base fares in 2014, given the difficult situation of their customers. M&As will increasingly become a growth driver We expect large container port operators will increasingly rely on M&As to drive their growth, with organic volume growth in China moderate. While earnings contribution from overseas port remains low at below 10% for China Merchants Holdings (CMHI) and Cosco Pacific (ex-Cosco HIT) in 2013, we expect a quick rise to 15-20% in the next 2-3 years. Recent newsflow on CMHI’s negotiation with Australian ports, Cosco Pacific’s announcement on increasing investment in Piraeus, and Hutchison Port Holdings Trust (HPHT)’s potential acquisition of YRD ports could all happen in 2014, though each should be evaluated based on their individual valuation, whether the acquisition leads to immediate EPS enhancement, and/or initial cash outlay. Rolling out new FTZs could bring positive sentiment Details from the 3rd Plenum reveal that based on the success of Shanghai FTZ, the Free Trade Zone (Port) will be expanded to other areas. We expect Tianjin and Shenzhen/ Guangzhou to be in the second batch for Free Trade Zone, and benefit companies with large revenue exposure from those areas, such as Tianjin Port Development (3382 HK, Buy), CMHI (144 HK, Buy) and HPHT (HPHT SP, Buy). Company-specific factors will dominate share price performance While we believe industry fundamentals are supportive, we expect a meaningful alpha to be made by stock picking for 2014. China Merchants is our top pick, given that we believe its land in Qianhai is significantly valued, and there should be more clarity on the land in 1H14 that can catalyse its share price. We also rated HPHT Buy given its dividend per unit (DPU) recovery in 2014 from a very low base in 2013, and potential DPU accretive acquisition in Yangtze River Delta. We are less bullish on Cosco Pacific (Hold), given the uncertainty related to its potential equation after CIMC disposal. Potential acquisition of PPA (Piraeus Port Authority) can be an overhang to its share price given labor union issues and the large outlay for the facility upgrade. For smaller ports, we rate Tianjin Port Development Buy, as a potential beneficiary of potential Free Trade Zone. Exhibit 359: Foreign trade container growth to continue to moderate in 2014E Source: China Ministry of Transport, Chineseport.cn -10% 0% 10% 20% 30% 40% 50% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E2014E2015E Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 211 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 213. Crude tanker shipping Crude tankers may still struggle to turnaround in 2014 but we think the sector may be interesting for long-term investors because (1) the sector is between despondency and depression in terms of market sentiment; (2) energy shipping has the highest growth potential in the long run among shipping sub-segments; and (3) capacity growth may come to a halt after 3 years of very low investment. We play the theme through CSD and MOL. Expectation is low for 2014 but marginal improvement is highly likely. We may not see the crude tanker segment turn around in 2014 but marginal improvement is possible because (1) crude tanker rates cannot go lower than the average of negative $6,000/day recorded in 2013; (2) crude imports to Europe and China may experience some cyclical although modest recovery; and (3) crude tanker capacity growth may slow to below 3%. Everyone knows the bear case for crude tankers. Consensus has very low expectation for crude tanker segment, which is surviving its third consecutive year of negative return to investment. Equities analysts expect crude tanker operators to continue to make losses as per the Bloomberg consensus. Ship owners have been almost as busy scrapping crude tankers as they have been ordering them. The bear case are well known in the market: too much capacity ordered before 2010 for the required switch from single hulled to double hulled at the time; and US shale gas/oil discovery has set US crude import on a permanent decline. We believe investors’ sentiment is between despondency and depression, which is fully reflected in the share prices. Crude tanker may have even slower capacity growth than dry bulk. For crude tankers at Aframax class or above, 20mn DWT have been scrapped vs. 23mn DWT ordered over the past three years. Crude tankers’ order book stands at just 8% of the operating fleet, which is the lowest among the main shipping sub-segments. We estimated that crude tanker’s capacity growth will come to a halt in 2015. Investors have bought dry bulk on the idea of sharply slower capacity growth in dry bulk. We think they may even prefer crude tankers when they saw crude tanker’s order book. Shale gas story is not entirely bearish for crude tanker. Decline in crude oil imports to US, we believe, is the biggest obstacle for investors to overcome mentally. But we see a bull case hidden in this apparently very bearish situation. All the oil exploration facilities in Atlantic Basin will not stop producing because the US has stopped buying. Crude oil output from the Atlantic Basin will find its way to the Far East, which will become one of the longest shipping routes. In fact, China has been ramping up its imports from Latin America since 2004. Based on data compiled by our Asian Energy team, half of China’s oil investments made since 2009 focuses on crude oil originated from Latin Americas. Longer term, we believe the day China reaches a tipping point for private car ownership, its fuel demand will sky rocket, making crude tankers one of the few shipping segments that could see much stronger growth ahead. Exhibit 360: Demand/Supply for tanker shipping Source: Jefferies estimates, Clarksons -2,000 -1,000 0 1,000 2,000 -10.0% -5.0% 0.0% 5.0% 10.0% 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13E 14E 15E Crude tanker demand growth Crude tanker supply growth RHS: Baltic Dirty Tanker Index Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 212 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 214. Dry bulk shipping We are relatively more constructive about the dry bulk shipping stocks because we believe capacity growth may track below demand growth in 2014 to allow for higher full year average freight rates. PBS is our pick in the dry bulk space as the company could grow earnings even if BDI only shows marginal improvement, in our view. First, dry bulk capacity growth may slow sharply to 4% YoY in 2014, from 8% YoY in 2013 and over 10% over the previous few years. Second, ramp-up in iron ore output by the international miners and replacement demand from China may avoid any deterioration of demand although we remain unconvinced about the investment driven growth model in China. The net result would be 200bps improvement in utilization, which could lift freight rates closer to but not consistently over the overall breakeven level of 1,600 amid high volatility. Nevertheless, marginal improvement may suffice to keep us constructive and not good enough to attract speculative order of new ships, which may allow this up cycle to stretch into 2015. The upside to our base case could be a much stronger rally in freight rates stimulated by continuous fixed asset investments in China, for which we would still hold onto our dry bulk stocks for 1 year of strong earnings but would have to expect influx of new building orders that could shorten this up cycle. Our base case is for returns for dry bulk shipping to eventually return to a normalized level after a couple of years of value erosion. We do not hold high hopes of very robust demand for dry bulk shipping because we think long-term property construction in China may have peaked and in the short term there is unlikely to be a large scale re-stocking of residential property inventory among developers. Seasonal patterns, such as weather at loading ports, grain harvests and mining production schedules, and vessel speed would be near term swing factors driving freight rates. Size of order book relative to operating fleet will dictate investors’ willingness to stay in dry bulk equities. We would stay constructive until order to fleet ratio rises to 25%. The counter is currently at 18%. Exhibit 361: Demand/Supply for dry bulk shipping. Demand growth may exceed supply for the first time since 2008 Source: Jefferies estimates, Clarksons 0 20 40 60 80 100 120 140 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13E 14E 15E Demand growth Supply growth Cape 4 T/C 1,000$/daydemand/supply growth Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 213 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 215. Container shipping We remain cautious about container shipping stocks because we believe container shipping may again struggle to stay profitable in 2014 as surplus capacity would depress freight rates, outweighing the benefit from potential cost cut. We have only one Buy, OOIL. Over-capacity to continue. Global volume growth may accelerate just about 50- 100bps despite continuous recovery in Europe and US. Growth of westbound volume in AE could accelerate to approach 5% YoY as European retailers’ inventory to sales have fallen close to post-Lehman lows. Growth of eastbound volume to US may remain about 3%. However, tapering in US could depress currencies in the emerging market, which in turn may slow down emerging markets’ purchasing power of Chinese exports. Container shipping’s capacity growth will accelerate to 7% in 2014, from 6% in 2013. The mix of new capacity would be heavy on the larger ships. 57 vessels of 10,000TEU or above will be delivered in 2014 compared to just 36 delivered in 2013. Cost cuts may again help avoid losses expansion. We could continue to see both lower freight rates and lower unit costs among container liners. The annual global contracts, currently being negotiated, could be settled at lower freight rates because the YoY lower spot rates give a lower benchmark for the new contracts. Container liners may continue to focus on cost cutting through network optimization and introduction of newer vessels. However, much of the network optimization may have been performed over the past two years. We expect the fuel consumption cut will be less steep in 2014 than in 2013. P3 adds one more challenge for the Asian liners. The formation of P3, if finally approved by the regulators, could offer further cost cuts for the three European container liners but widen the margin between the P3 operators and the rest of the field. Although previously deemed impossible, Asian operators may have to take action to catch up with the P3’s scale advantage. Further alliance formation may not be a solution as involving too many operators in one alliance with overlapping route coverage would just complicate the coordination. So the industry may finally see its first major merger since 2005. Valuation, volume indicators and new building orders will continue to be the key fundamental indicators to follow for trading the container liner stocks. An entry point could be 30-40% discount to book value while an exit point would be 1x book, in our view, for the sector usually struggles to deliver at costs of equity. Spot freight rates are no longer the indicators for even short-term trades. Retailers’ inventory levels and PMI indicators will be relied on for more sustainable trade ideas. Inflow of new building orders will keep us from switching to a total buyer for the space. Exhibit 362: Demand/Supply for container shipping Source: Jefferies estimates, Alphaliner, SSE -15% -10% -5% 0% 5% 10% 15% 20% -10 10 30 50 70 90 110 130 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13E 14E 15E Demand Growth (RHS) Supply Growth (RHS) Freight Rate Index (LHS) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 214 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 216. 2014 China Utilities Key takeaways Heading into 2014 we are positive on the utilities space. We believe China is increasingly serious about tackling its environmental challenges head on and it needs more investment in natural gas, wind and solar infrastructure, necessitating firm policy support. As a result, we’re positive on natural gas distributors and wind farm operators. We believe the IPPs are simply too cheap to ignore, especially as coal prices are set to fall further and concerns over a possible tariff cut overdone, in our view. Our top picks are Huaneng Renewable (958, Buy) and China Resources Power (836 HK, Buy). Power Outlook: Don’t Be Scared of the Bogeyman In 2013, the power industry saw profits continue to improve on the back of falling coal prices and a pickup in power demand growth in the middle of the year, forcing analysts to play a game of catch. Despite this, IPP shares have been listless after concerns about a possible tariff cut let the steam out of the rally. However, the recent round of tariff adjustments has proved to be more bark than bite. In 2014, we expect earnings to be buttressed by lacklustre coal prices as China’s economy rebalances. More importantly, we expect the tariff adjustment to continue to surprise on the lower end as we expect the NDRC allow the IPPs to delever, and exercise risk management. Our top picks among the IPPs are China Resources Power (836 HK, Buy) and Huaneng Power Int’l (902 HK, Buy). Power demand growth set to slow again as China’s economy rebalances 2013 saw power demand growth start out weak before picking up in the middle of the year thanks to the mini-stimulus. However, we believe power demand growth should start to decelerate to ~4% in 2014 as the effects of the stimulus wear off and as we believe China’s economic rebalancing will cause investment growth to decelerate. Given the slowdown in power demand growth, we expect just ~2-9% revenue growth across the sector in 2014. Margins should expand as coal prices continue to fall We believe the recent bounce in coal prices is driven by restocking rather than actual demand and will be ephemeral. Coal prices should resume trending down in 2014 as we believe there is more downside risk for coal prices; cost-cutting measures, local government support (lower levies) and new railways will further flatten out the cost curve. The expected slowdown in power demand growth will be another negative catalyst. We believe benchmark 2014 QHD coal prices will be 7% lower YoY. The fall in coal prices should continue to be a boon to IPP margins. Exhibit 363: Huaneng Power Int’l – Forward ROE vs. P/B Source: Bloomberg, Jefferies 0.0 0.5 1.0 1.5 2.0 2.5 3.0 0 4 8 12 16 20 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 P/B (x)ROE (%) Forward ROE Current P/B Joseph Fong, CFA Equity Analyst +852 3743 8074 jfung@jefferies.com Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 215 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 217. Shares trading sideways despite consensus upgrades On the back of an improved 2014 outlook, the street has raised numbers throughout 2013, but the share price reaction has been more muted. For Huaneng, consensus expects a 2014 ROE of 16%, but shares are trading at just 1.3x consensus 2013 P/B; we’re expecting 2014 ROE to reach 19%. Fears of a Tariff Cut Continue to Linger Fears or speculation of a possible tariff cut have kept investors on the sidelines. In September, the NDRC reduced on-grid thermal power tariffs by 3% on average as part of recent measures to improve the financing of the renewable energy surcharge fund, within our expectation and lower than many had feared. In comparison to the 3% tariff cut, the price of 5,500 kcal coal at QHD has fallen by ~40% over the past two years (or when on-grid power tariffs were last adjusted). However, the rally in share prices was limited as investors next began to worry about whether there would be another tariff cut in December or the first quarter of 2014. Government will be slow to rein in returns The looming policy risk is the risk of government reining in returns. We believe an immediate, broad-scale adjustment in tariffs is unlikely, for several reasons: 1) the IPPs are unsustainably levered and need to de-lever; 2) improved profitability could be used to fund environmental upgrades; 3) externalities need to be priced in; and 4) the NDRC does not know the direction of the coal price. If the NDRC cuts power tariffs aggressively and coal prices actually rebound, they run the risk of having to reverse the decision immediately and appear indecisive, or they wait too long and the IPPs suffer massive losses. We believe the tariff cut will be in the middle of 2014 and it will, once again, be a moderate cut. The true cut will be followed by real reform We believe the NDRC will wait until we reach the flat part of the cost curve to more aggressively cut on-grid power tariffs. It is exactly when we reach the flat part of the cost curve that we may finally start to see policy reform. We believe the NDRC would do best to enforce the fuel cost pass-through mechanism when we reach the flat part of the cost curve as coal prices should be less volatile. If enforced, the pass-through mechanism may lower the return, but share prices should benefit as the sector effectively de-risks and multiples expand. Valuation attractive; China Resources Power an even bigger bargain Shares of the IPPs, now trading at 6-8x 2014 P/E, are trading at the lower end of their historical trading range. Huaneng is trading at just 1.3x 2013 P/B despite a forecast 19% 2014 ROE. China Resources Power, which has historically traded at a P/B premium, is trading at 1.4x 2014 P/B as accusations of mishandling of the Jinye projects acquisition are still an overhang. Stock recommendations. Our top picks within the sector are China Resources Power and Huaneng Power Int’l. We believe the IPP shares are attractively valued and should benefit from falling coal prices as tariff cuts continue to underwhelm. Our top pick is China Resources Power as shares should re-rate when the Jinye overhang dissipates; the company has better quality assets, a more commercial management team and growing exposure to wind power. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 216 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 218. Gas Utility Outlook: Demand growth visibility set to improve as prices rise Natural gas distributors stand out within the China Utility space given their earnings growth visibility, strong policy support and commercial management team. In 2014, we expect shares to continue to trend higher as the sector delivers on earnings growth. Natural gas sales volume growth is poised to actually benefit from the natural gas price reform as it should improve supply visibility, the true bottleneck of the sector; we are forecasting overall natural gas demand to increase by 15% YoY in 2014. Cash margins could see incremental expansion as we expect fuel costs to be passed on in full, and the faster growth in higher margin C&I and CNG gas sales should improve the volume mix. We are positive on the whole sector and we would look to accumulate shares of ENN Energy (2688 HK, Buy), China Gas (384 HK, Buy), and Towngas China (1083 HK, Buy). Energy substitution driving natural gas sales volume We believe natural gas demand growth is driven by energy substitution. In the near-to- medium term, natural gas demand is driven by residential users switching from LPG and coal to natural gas and industrial users switching from oil and, to a lesser extent, coal to natural gas. The switch from LPG and oil to natural gas is simple economics, as natural gas is cheaper than either fuel. Coal to natural gas substitution is in part driven by policy. Supply, not demand, is the bottleneck We believe there is a long line of industrial customers queuing for their allotment of natural gas; the potential substitution from fuel oil being used in industrial applications should drive 3-5 years of double digit growth alone. The problem is that there is not enough gas to go around. Exhibit 364: Natural Gas Supply and Demand in China with Price Controls Source: Jefferies estimates Higher natural gas prices all for the best Counterintuitive as it sounds, the ongoing higher natural gas price reform is actually a positive for the distributors. The natural gas price has historically been set on cost-plus basis and artificially low, resulting in ongoing supply shortages and rationing. Higher natural gas prices will provide PetroChina the cash flow it needs to invest into new fields, helping to increase domestic production. As there is excess demand in China for natural gas, the higher production can be easily absorbed by China. S D P Q P1 P2 Q1 Q2 Cost plus pricing leads to supply shortages Price reform will encourage production Excess demand Market equilibrium Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 217 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 219. Smooth sailing so far as higher prices typically passed through The higher natural gas prices have been passed through in the majority of impact projects and natural gas distributors as of yet have NOT reported natural gas sales nose- diving in the face of higher prices. In fact, there have been reports of an improvement in natural gas sales volume growth in recent months due to better supply and an improvement in the macro-environment (more demand). Natural gas vehicle adoption could pick up in 2014 We believe we could see the adoption of natural gas vehicles pick up in 2014, especially if supply surprises on the upside. We believe CNG for buses and taxis is encouraged by the government and adoption faces limited hurdles. On LNG adoption, even at incremental volume gas prices, LNG will still be at ~30% discount to diesel. Adoption will be driven by track record of consistent LNG supply, truck reliability and operational safety; expansion of fuelling infrastructure; superior economics to diesel; as well as other factors. The other hurdles, we believe, will be resolved with time. In addition, we believe the government could potentially introduce more subsidies to encourage LNG adoption in late 2013 or 2014. Natural gas a beneficiary of stricter environmental regulations Natural gas demand growth is driven by energy substitution and the switch from LPG and oil to natural gas is simple economics. On the other hand, coal to natural gas substitution is in part driven by policy. In addition to large sweeping national policies to phase out and outright ban new industrial coal-fired steam boilers, individual cities are proactively coming up with plans to improve air quality as well. Taiyuan is looking to replace coal-fired boilers with cleaner alternatives and encouraging the adoption of natural gas vehicles. More and more, industrial companies are faced with either relocating or switching to a non-coal alternative, natural gas being the cheapest option. Environmental considerations and policy only add more customers waiting in line for their share of natural gas. The real benefit is insulating it from government regulation The natural gas industry is in its infancy. There is substantial investment needed including the buildout of a massive network of CNG and LNG refuelling stations, midstream pipelines and more downstream pipelines. The government will need to rely on private natural gas distributors and their expertise in building the necessary infrastructure. We believe there is no immediate threat to distributors despite their high returns. Too much is at stake. Valuation Shares of the pure-play natural gas distributors are trading at 15x-17x 2014 P/E, in-line with their historical trading range. We believe shares will continue to trend higher though as the companies executes on earnings growth and multiples remain stable. Stock recommendation. We are positive on the whole sector and we would look to opportunistically accumulate shares of ENN Energy (2688 HK, Buy), China Gas (384 HK, Buy), and Towngas China (1083 HK, Buy) on dips and pull-backs. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 218 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 220. Wind Outlook: More Upside Ahead with New Farms and Less Curtailment 2013 has been a good year for wind farm operators as they saw their utilization hours recover on the back of improving curtailment and better wind resources, driving an earnings recovery. In 2014, we expect earnings to continue to improve as utilization hours improve incrementally, and as wind farm operators build new capacity. In addition, with CDM income effectively a non-factor in 2013, the wind farm operators will benefit from an easier compare. Our top pick in the sector is Huaneng Renewable. Utilizations hours set to improve further in 2014 2013 has been a good year for wind farm operators as utilization hours recovered on the back of improving curtailment and better wind resources. We expect 2014 to see incrementally higher utilization hours as curtailment should continue to ease, offsetting a possible normalization in wind resources. Approval for new transmission lines still too slow We believe the grid companies have picked up investments in grid upgrades and new transmission lines. In the first nine months of 2013, the length of new transmission lines over 220kV increased by 9% YoY. In addition, the Huainan to Shanghai and Hami to Henan UHV loops are set to be commissioned by year-end. However, according to recent discussions with the China Electricity Council and the NDRC Energy Research Institute, the construction of new transmissions lines, particularly UHV lines, continue to be held back by difficult regulatory approval process. A faster, or even a more transparent, approval process would help curtailment in China. New installed capacity should accelerate modestly in 2014 Our channel checks suggest China will not be able to meet the NEA’s 2013 target of 18GW of WTG installments and a more realistic figure may be ~15GW; we forecasted WTG installments 15.5GW in 2013 earlier in the year. In our discussion with wind farm operators, management were optimistic in regard to 2014 and would look to increase their new capacity additions to varying degrees. Any increase in WTG installments in 2014 would be modest, though. Wind farm operators are still concerned about curtailment and while interest in new capacity has definitely improved, it is a far cry from the boom years. We believe WTG installments would be hard pressed to bounce back to levels seen in 2010 in the near-term, but could potentially reach 20GW in 2016. Growing interest in solar The sentiment surrounding the solar industry has improved considerably compared to the beginning of the year. The 10GW of new solar capacity target may be out of reach this year (8GW seems more realistic), but there appears to be considerable upside to solar demand in 2014. Wind farm operators have likewise turned more positive on solar, but their enthusiasm was more controlled and noted their focus remains primarily on wind. According to wind farm operators, the returns of wind farms are still higher than the returns of utility scale solar projects. In addition, there are concerns over the reliability of the equipment and stability of solar power. Concerns over a tariff cut overdone One lingering question that has dogged wind farm operators has been the risk of a potential cut in the feed-in-tariff, especially in light of the recent cut in on-grid thermal power tariffs. The FiT was designed "according to the determining principles of economic reasonableness and of benefiting the promotion of renewable energy development." Although we understand the wind FiT will likely decline in time as WTG costs decline, we do NOT believe it is a near-term risk. There appears to be a general consensus within the industry that with curtailment negatively impacting profitability, revisions to the FiT would be a mistake. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 219 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 221. Policy support remains firmly in place We believe alternative energy will continue to benefit from policy support especially if China is to meets its 2015 and 2020 target of non-fossil fuels accounting for 11.4% and 15% of total primary energy demand, respectively. New announcements should help sentiment We believe more environmental policies will come out in the coming months and years that should help the sentiment of alternative energy names. The Renewable portfolio standard could be announced next year and the emissions trading scheme could be rolled out nationwide in time. Furthermore, we expect local government to announce new policies, emission and zoning requirements in order to alleviate local air pollution. Utilization Hours continue to beat our expectations The recovery in utilization hours has continued to beat our expectations and, as a result, we have recently raised our 2013 and 2014 earnings estimates. Huaneng Renewable reported 9M13 YTD power generation of 8,213GWh, +50% YoY, and Longyuan reported total wind power generation of 17,877GWh, +34% YoY, as of October 2013. Huaneng Renewable our preferred name Our order of preference within the sector is Huaneng Renewable, Longyuan and Datang Renewable. We believe Huaneng Renewable should benefit from a continued sector re- rating and we believe its discount to Longyuan should narrow; Huaneng Renewable is trading at a 10% discount to Longyuan on a P/E basis. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 220 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 222. Analyst Certification I, Christie Ju, CFA, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. I, Laban Yu, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. I, Julian Bu, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. I, Venant Chiang, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. I, Sean Darby, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. I, Jessie Guo, PhD, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. I, Johnson Leung, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. I, Jessica Li, Ph.D., certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. I, Rong Li, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. I, Cynthia Meng, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. I, Ming Tan, CFA, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Registration of non-US analysts: Christie Ju, CFA is employed by Jefferies Hong Kong Limited, a non-US affiliate of Jefferies LLC and is not registered/ qualified as a research analyst with FINRA. This analyst(s) may not be an associated person of Jefferies LLC, a FINRA member firm, and therefore may not be subject to the NASD Rule 2711 and Incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst. Registration of non-US analysts: Laban Yu is employed by Jefferies Hong Kong Limited, a non-US affiliate of Jefferies LLC and is not registered/ qualified as a research analyst with FINRA. This analyst(s) may not be an associated person of Jefferies LLC, a FINRA member firm, and therefore may not be subject to the NASD Rule 2711 and Incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst. Registration of non-US analysts: Julian Bu is employed by Jefferies Hong Kong Limited, a non-US affiliate of Jefferies LLC and is not registered/ qualified as a research analyst with FINRA. This analyst(s) may not be an associated person of Jefferies LLC, a FINRA member firm, and therefore may not be subject to the NASD Rule 2711 and Incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst. Registration of non-US analysts: Venant Chiang is employed by Jefferies Hong Kong Limited, a non-US affiliate of Jefferies LLC and is not registered/ qualified as a research analyst with FINRA. This analyst(s) may not be an associated person of Jefferies LLC, a FINRA member firm, and therefore may not be subject to the NASD Rule 2711 and Incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst. Registration of non-US analysts: Sean Darby is employed by Jefferies Hong Kong Limited, a non-US affiliate of Jefferies LLC and is not registered/ qualified as a research analyst with FINRA. This analyst(s) may not be an associated person of Jefferies LLC, a FINRA member firm, and therefore may not be subject to the NASD Rule 2711 and Incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst. Registration of non-US analysts: Jessie Guo, PhD is employed by Jefferies Hong Kong Limited, a non-US affiliate of Jefferies LLC and is not registered/ qualified as a research analyst with FINRA. This analyst(s) may not be an associated person of Jefferies LLC, a FINRA member firm, and therefore may not be subject to the NASD Rule 2711 and Incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst. Registration of non-US analysts: Johnson Leung is employed by Jefferies Hong Kong Limited, a non-US affiliate of Jefferies LLC and is not registered/ qualified as a research analyst with FINRA. This analyst(s) may not be an associated person of Jefferies LLC, a FINRA member firm, and therefore may not be subject to the NASD Rule 2711 and Incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst. Registration of non-US analysts: Jessica Li, Ph.D. is employed by Jefferies Hong Kong Limited, a non-US affiliate of Jefferies LLC and is not registered/ qualified as a research analyst with FINRA. This analyst(s) may not be an associated person of Jefferies LLC, a FINRA member firm, and therefore may Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 221 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 223. not be subject to the NASD Rule 2711 and Incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst. Registration of non-US analysts: Rong Li is employed by Jefferies Hong Kong Limited, a non-US affiliate of Jefferies LLC and is not registered/ qualified as a research analyst with FINRA. This analyst(s) may not be an associated person of Jefferies LLC, a FINRA member firm, and therefore may not be subject to the NASD Rule 2711 and Incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst. Registration of non-US analysts: Cynthia Meng is employed by Jefferies Hong Kong Limited, a non-US affiliate of Jefferies LLC and is not registered/ qualified as a research analyst with FINRA. This analyst(s) may not be an associated person of Jefferies LLC, a FINRA member firm, and therefore may not be subject to the NASD Rule 2711 and Incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst. Registration of non-US analysts: Ming Tan, CFA is employed by Jefferies Hong Kong Limited, a non-US affiliate of Jefferies LLC and is not registered/ qualified as a research analyst with FINRA. This analyst(s) may not be an associated person of Jefferies LLC, a FINRA member firm, and therefore may not be subject to the NASD Rule 2711 and Incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst. As is the case with all Jefferies employees, the analyst(s) responsible for the coverage of the financial instruments discussed in this report receives compensation based in part on the overall performance of the firm, including investment banking income. We seek to update our research as appropriate, but various regulations may prevent us from doing so. Aside from certain industry reports published on a periodic basis, the large majority of reports are published at irregular intervals as appropriate in the analyst's judgement. Company Specific Disclosures For Important Disclosure information on companies recommended in this report, please visit our website at https://javatar.bluematrix.com/sellside/ Disclosures.action or call 212.284.2300. Meanings of Jefferies Ratings Buy - Describes stocks that we expect to provide a total return (price appreciation plus yield) of 15% or more within a 12-month period. Hold - Describes stocks that we expect to provide a total return (price appreciation plus yield) of plus 15% or minus 10% within a 12-month period. Underperform - Describes stocks that we expect to provide a total negative return (price appreciation plus yield) of 10% or more within a 12-month period. The expected total return (price appreciation plus yield) for Buy rated stocks with an average stock price consistently below $10 is 20% or more within a 12-month period as these companies are typically more volatile than the overall stock market. For Hold rated stocks with an average stock price consistently below $10, the expected total return (price appreciation plus yield) is plus or minus 20% within a 12-month period. For Underperform rated stocks with an average stock price consistently below $10, the expected total return (price appreciation plus yield) is minus 20% within a 12- month period. NR - The investment rating and price target have been temporarily suspended. Such suspensions are in compliance with applicable regulations and/ or Jefferies policies. CS - Coverage Suspended. Jefferies has suspended coverage of this company. NC - Not covered. Jefferies does not cover this company. Restricted - Describes issuers where, in conjunction with Jefferies engagement in certain transactions, company policy or applicable securities regulations prohibit certain types of communications, including investment recommendations. Monitor - Describes stocks whose company fundamentals and financials are being monitored, and for which no financial projections or opinions on the investment merits of the company are provided. Valuation Methodology Jefferies' methodology for assigning ratings may include the following: market capitalization, maturity, growth/value, volatility and expected total return over the next 12 months. The price targets are based on several methodologies, which may include, but are not restricted to, analyses of market risk, growth rate, revenue stream, discounted cash flow (DCF), EBITDA, EPS, cash flow (CF), free cash flow (FCF), EV/EBITDA, P/E, PE/growth, P/CF, P/FCF, premium (discount)/average group EV/EBITDA, premium (discount)/average group P/E, sum of the parts, net asset value, dividend returns, and return on equity (ROE) over the next 12 months. Conviction List Methodology 1. The aim of the conviction list is to publicise the best individual stock ideas from Jefferies Global Research 2. Only stocks with a Buy or Underperform rating are allowed to be included in the recommended list. 3. Stocks are screened for minimum market capitalisation and adequate daily turnover. Furthermore, a valuation, correlation and style screen is used to ensure a well-diversified portfolio. 4. Stocks are sorted to a maximum of 30 stocks with the maximum country exposure at around 50%. Limits are also imposed on a sector basis. 5. Once a month, analysts are invited to recommend their best ideas. Analysts’ stock selection can be based on one or more of the following: non-Consensus investment view, difference in earnings relative to Consensus, valuation methodology, target upside/downside % relative to the current stock price. These are then assessed against existing holdings to ensure consistency. Stocks that have either reached their target price, been downgraded over the course of the month or where a more suitable candidate has been found are removed. 6. All stocks are inserted at the last closing price and removed at the last closing price. There are no changes to the conviction list during the month. 7. Performance is calculated in US dollars on an equally weighted basis and is compared to MSCI World AC US$. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 222 of 228 8. The conviction list is published once a month whilst global equity markets are closed. Please see important disclosure information on pages 221 - 226 of this report.
  • 224. 9. Transaction fees are not included. 10. All corporate actions are taken into account. Risk which may impede the achievement of our Price Target This report was prepared for general circulation and does not provide investment recommendations specific to individual investors. As such, the financial instruments discussed in this report may not be suitable for all investors and investors must make their own investment decisions based upon their specific investment objectives and financial situation utilizing their own financial advisors as they deem necessary. Past performance of the financial instruments recommended in this report should not be taken as an indication or guarantee of future results. The price, value of, and income from, any of the financial instruments mentioned in this report can rise as well as fall and may be affected by changes in economic, financial and political factors. If a financial instrument is denominated in a currency other than the investor's home currency, a change in exchange rates may adversely affect the price of, value of, or income derived from the financial instrument described in this report. In addition, investors in securities such as ADRs, whose values are affected by the currency of the underlying security, effectively assume currency risk. Other Companies Mentioned in This Report • Agile Property Holdings Ltd. (3383 HK: HK$9.01, UNDERPERFORM) • Agricultural Bank of China Limited (1288 HK: HK$3.98, BUY) • AIA Group Limited (1299 HK: HK$38.85, BUY) • Anta Sports (2020 HK: CNY11.12, BUY) • Axis Bank (AXSB IN: INR1,135.05, HOLD) • Baidu Inc. (BIDU: $163.12, BUY) • Bank of Baroda (BOB IN: INR640.10, HOLD) • Bank of China Limited (3988 HK: HK$3.72, BUY) • Bank of Communications Co., Ltd. (3328 HK: HK$5.80, HOLD) • Belle International (1880 HK: HK$9.72, UNDERPERFORM) • Biostime International Holdings (1112 HK: HK$69.30, HOLD) • CapitaMalls Asia Ltd. (CMA SP: SGD2.01, BUY) • China CITIC Bank Corporation Limited (998 HK: HK$4.55, BUY) • China Coal Energy (1898 HK: HK$4.94, UNDERPERFORM) • China Construction Bank Corporation (939 HK: HK$6.29, BUY) • China Cosco Holdings - H (1919 HK: HK$3.78, UNDERPERFORM) • China Foods Ltd. (506 HK: HK$3.40, HOLD) • China Gas Holdings (384 HK: HK$9.19, BUY) • China Huishan Dairy (6863 HK: HK$3.17, BUY) • China Life Insurance Company Limited (2628 HK: HK$24.35, HOLD) • China Lilang (1234 HK: CNY5.09, HOLD) • China Mengniu Dairy Co. Ltd. (2319 HK: HK$34.75, HOLD) • China Merchants Hldgs Intl. (144 HK: HK$28.95, BUY) • China Merchants Property - A (000024 CH: CNY23.13, BUY) • China Merchants Property - B (200024 CH: HK$21.38, BUY) • China Minsheng Banking Corp., Ltd. (1988 HK: HK$9.37, BUY) • China Modern Dairy Holdings Ltd. (1117 HK: HK$4.39, HOLD) • China National Building Material Company Ltd. (3323 HK: HK$8.39, UNDERPERFORM) • China Overseas Grand Oceans (81 HK: HK$8.90, BUY) • China Overseas Land & Investment (688 HK: HK$24.50, BUY) • China Pacific Insurance (Group) Co., Ltd. (2601 HK: HK$31.35, BUY) • China Resources Enterprise, Limited (291 HK: HK$27.05, BUY) • China Resources Land Ltd. (1109 HK: HK$21.50, BUY) • China Taiping Insurance Holdings Company Limited (966 HK: HK$14.80, HOLD) • China Vanke Co. Ltd. - A (000002 CH: CNY9.10, BUY) • China Vanke Co. Ltd. - B (200002 CH: HK$13.31, BUY) • Chongqing Rural Commercial Bank Co., Ltd. (3618 HK: HK$4.06, BUY) • Chow Tai Fook Jewellery Co. Ltd (1929 HK: HK$12.48, BUY) • CITIC Securities Company Limited (6030 HK: HK$19.24, BUY) • Country Garden Holdings Co. (2007 HK: HK$5.15, BUY) • Daphne International (210 HK: HK$3.25, HOLD) • DBS Group Holdings Ltd. (DBS SP: SGD16.99, BUY) • Digital China Holdings Ltd (861 HK: HK$9.41, UNDERPERFORM) • Dongfeng Motor Group Co Ltd (489 HK: HK$12.50, BUY) • Evergrande Real Estate Group (3333 HK: HK$3.30, BUY) • Fosun Pharma (2196 HK: HK$21.45, BUY) • Franshion Properties (817 HK: HK$2.57, BUY) • Galaxy Entertainment (27 HK: HK$59.15, BUY) • Giordano (709 HK: HK$7.16, BUY) • Glorious Property Holdings (845 HK: HK$1.24, UNDERPERFORM) • Golden Eagle Retail Group Ltd. (3308 HK: HK$11.58, HOLD) • Guangzhou R&F Properties - H (2777 HK: HK$13.02, HOLD) • Haitong Securities Company Limited (6837 HK: HK$12.88, BUY) • HDFC Bank (HDFCB IN: INR660.05, BUY) Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 223 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 225. • Hengdeli Holdings (3389 HK: CNY1.91, HOLD) • Hopson Development Holdings (754 HK: HK$9.51, HOLD) • Huaneng Power International (902 HK: HK$7.69, BUY) • Huaneng Renewable Corp (958 HK: HK$3.27, BUY) • Hutchison Port Holdings (HPHT SP: $0.71, BUY) • ICICI Bank (ICICIBC IN: INR1,085.00, HOLD) • Industrial and Commercial Bank of China Limited (1398 HK: HK$5.54, BUY) • KWG Property Holdings (1813 HK: HK$4.72, BUY) • L'Occitane International S.A. (973 HK: HK$17.20, HOLD) • Lifestyle International Holdings Ltd. (1212 HK: HK$16.48, HOLD) • Li Ning Co Ltd (2331 HK: CNY6.72, HOLD) • Longfor Properties (960 HK: HK$11.94, UNDERPERFORM) • Luk Fook Holdings (Intl) Ltd (590 HK: HK$30.00, UNDERPERFORM) • MGM China Holdings (2282 HK: HK$27.10, HOLD) • Mitsubishi UFJ Financial Group (8306 JP: ¥653, BUY) • Mizuho Financial Group (8411 JP: ¥216, BUY) • New China Life Insurance Company Ltd. (1336 HK: HK$27.10, BUY) • Parkson Retail Group Ltd. (3368 HK: HK$2.73, HOLD) • Petrochina Co. Ltd - H (857 HK: HK$9.59, BUY) • PICC Property and Casualty Company Limited (2328 HK: HK$13.04, HOLD) • Ping An Insurance (Group) Company of China, Ltd. (2318 HK: HK$71.40, BUY) • Poly Property (119 HK: HK$4.61, HOLD) • Powerlong Real Estate Holdings Ltd. (1238 HK: HK$1.65, BUY) • Resona Holdings (8308 JP: ¥526, BUY) • Sands China Ltd. (1928 HK: HK$56.55, BUY) • Shanghai Industrial Hldg Ltd. (363 HK: HK$26.70, BUY) • Shenzhen Investment Ltd. (604 HK: HK$3.10, BUY) • Shimao Property Holdings Ltd. (813 HK: HK$19.44, BUY) • Sino-Ocean Land Holdings (3377 HK: HK$4.94, HOLD) • Sinopharm (1099 HK: HK$22.35, BUY) • SJM Holdings Ltd. (880 HK: HK$23.65, HOLD) • Soho China Ltd. (410 HK: HK$6.88, HOLD) • Springland International Holdings Ltd. (1700 HK: HK$4.15, BUY) • State Bank of India (SBIN IN: INR1,823.40, UNDERPERFORM) • Sumitomo Mitsui Financial Group (8316 JP: ¥5,030, BUY) • Sumitomo Mitsui Trust Holdings, Inc. (8309 JP: ¥489, HOLD) • Tianjin Port Development Hldgs Ltd (3382 HK: HK$1.40, BUY) • Tingyi Holdings Corp. (322 HK: HK$22.15, HOLD) • Towngas China (1083 HK: HK$7.90, BUY) • Trinity (891 HK: HK$3.00, HOLD) • Tsingtao Brewery Co. Ltd. (168 HK: HK$67.75, UNDERPERFORM) • Tsingtao Brewery Co. Ltd. (600600 CH: CNY46.42, UNDERPERFORM) • United Overseas Bank Ltd. (UOB SP: SGD21.07, BUY) • Want Want China Holdings Ltd. (151 HK: HK$11.22, UNDERPERFORM) • Yanlord Land Group Ltd. (YLLG SP: SGD1.24, UNDERPERFORM) • Yanzhou Coal Mining (1171 HK: HK$7.94, UNDERPERFORM) • Zhaojin Mining Industry Company Limited (1818 HK: HK$5.41, UNDERPERFORM) • Zijin Mining Group Co Limited (2899 HK: HK$1.84, UNDERPERFORM) Distribution of Ratings IB Serv./Past 12 Mos. Rating Count Percent Count Percent BUY 829 47.78% 186 22.44% HOLD 764 44.03% 121 15.84% UNDERPERFORM 142 8.18% 1 0.70% Other Important Disclosures Jefferies Equity Research refers to research reports produced by analysts employed by one of the following Jefferies Group LLC (“Jefferies”) group companies: United States: Jefferies LLC which is an SEC registered firm and a member of FINRA. United Kingdom: Jefferies International Limited, which is authorized and regulated by the Financial Conduct Authority; registered in England and Wales No. 1978621; registered office: Vintners Place, 68 Upper Thames Street, London EC4V 3BJ; telephone +44 (0)20 7029 8000; facsimile +44 (0)20 7029 8010. Hong Kong: Jefferies Hong Kong Limited, which is licensed by the Securities and Futures Commission of Hong Kong with CE number ATS546; located at Suite 2201, 22nd Floor, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 224 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 226. Singapore: Jefferies Singapore Limited, which is licensed by the Monetary Authority of Singapore; located at 80 Raffles Place #15-20, UOB Plaza 2, Singapore 048624, telephone: +65 6551 3950. Japan: Jefferies (Japan) Limited, Tokyo Branch, which is a securities company registered by the Financial Services Agency of Japan and is a member of the Japan Securities Dealers Association; located at Hibiya Marine Bldg, 3F, 1-5-1 Yuraku-cho, Chiyoda-ku, Tokyo 100-0006; telephone +813 5251 6100; facsimile +813 5251 6101. India: Jefferies India Private Limited, which is licensed by the Securities and Exchange Board of India as a Merchant Banker (INM000011443) and a Stock Broker with Bombay Stock Exchange Limited (INB011491033) and National Stock Exchange of India Limited (INB231491037) in the Capital Market Segment; located at 42/43, 2 North Avenue, Maker Maxity, Bandra-Kurla Complex, Bandra (East) Mumbai 400 051, India; Tel +91 22 4356 6000. 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This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 225 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 227. Jefferies. Neither Jefferies nor any officer nor employee of Jefferies accepts any liability whatsoever for any direct, indirect or consequential damages or losses arising from any use of this report or its contents. For Important Disclosure information, please visit our website at https://javatar.bluematrix.com/sellside/Disclosures.action or call 1.888.JEFFERIES © 2013 Jefferies Group LLC Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 226 of 228 Please see important disclosure information on pages 221 - 226 of this report.
  • 228. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 227 of 228 Please see important disclosure information on pages 221 - 226 of this report. Notes
  • 229. Equity Strategy China 20 November 2013 , Equity Analyst, +852 3743 8012, cju@jefferies.comChristie Ju, CFApage 228 of 228 Please see important disclosure information on pages 221 - 226 of this report. Notes
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