COSCO Pacific. Overweight. After restructuring, more stable waters ahead

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1 Completed 02 Aug :29 PM HKT Disseminated 02 Aug :44 PM HKT COSCO Pacific After restructuring, more stable waters ahead Overweight 1199.HK, 1199 HK Price: HK$7.92 Price Target: HK$10.00 Previous: HK$12.60 Assuming coverage of COSCO Pacific with OW, and a Dec-16 price target of HK$10, after CP has emerged from restructuring as a pure port operator and the container leasing segment (for long a drag on earnings/cash flow) has been disposed. Current multiples of 6.6x/6.1x EV/EBITDA and 0.6x P/B for FY16/17E are undemanding in our view, and we think street expectations have been calibrated. We see limited downside catalysts in the near-term and expect the benefits of streamlined operations to come through in the coming quarters, with upside risks to our estimates potentially coming into view as we head toward Our Dec-16 DCF-estimate indicates a valuation of HK$10 and suggests value has emerged in the stock after an extended period of underperformance. Our 2017 estimates are 19% below consensus, but we think the street has yet to fully catch up to the restructured operational outlook, and thus we don t foresee adjustments to 2017E street estimates as a potential negative catalyst. Benefits from transformation into pure terminal operator. CP has sharpened its business focus in recent years, but its shares have been de-rated due to a struggling leasing business since 2H13 as well as declining ROE. We believe the recent restructuring will translate into more stable core earnings growth (Adj. EBITDA CAGR of 7% from ) as well as FCF profile (FCF yield projected at 9~10% by FY18) as terminals offer more steady growth ( CAGR of +14% vs -3% for container leasing). Expectations calibrated with upside risk. CP s shares are down c22% since end-march, underperforming relevant peers and the HSCEI by c20% over this period. We believe CP s underperformance has been driven by a slowdown in throughput growth and near-term disruptions caused by the restructuring. We think expectations are now calibrated and see potential sources of potential upside risk. We thus see a share price facing a balance of risks, which could be increasingly skewed towards the upside over the next months. Key pushback will be continued low bottom-line returns. Low nominal ROE will probably remain a key issue for investors, especially given the further dip in FY16E. This could remain an overhang until the market sees a few quarters of more stable earnings. A key risk then is the stock could remain a market performer in the near-term, though we see upside risk to multiples on a month view as the market looks through the restructuring and focuses on improvements in core earnings and cash flow. COSCO Pacific (Reuters: 1199.HK, Bloomberg: 1199 HK) $ in mn, year-end Dec FY14A FY15A FY16E FY17E FY18E Total Revenue ($ mn) Net Profit ($ mn) EPS ($) DPS ($) Revenue growth (%) 8.9% (8.3%) (25.3%) 3.5% 3.5% EPS growth (%) (59.9%) 29.5% (24.1%) (19.3%) 4.4% ROE 6.3% 6.3% 4.7% 4.9% 4.9% P/E (x) P/BV (x) EV/EBITDA (x) Dividend Yield 3.9% 5.1% 14.0% 3.1% 3.2% Source: Company data, Bloomberg, J.P. Morgan estimates. Hong Kong Infrastructure & Industrial Calvin C Wong, CFA AC Bloomberg JPMA CWONG <GO> Karen Li, CFA (852) karen.yy.li@jpmorgan.com Boyong Liu, CFA (852) boyong.liu@jpmorgan.com Hanli Fan (852) hanli.fan@jpmorgan.com J.P. Morgan Securities (Asia Pacific) Limited Price Performance HK$ Aug-15 Nov-15 Feb-16 May-16 Aug HK share price (HK$) HSI (rebased) YTD 1m 3m 12m Abs -7.3% 2.6% -4.0% -20.2% Rel -8.3% -2.5% -11.0% -10.9% Company Data Shares O/S (mn) 2,786 Market Cap (HK$ mn) 22,066 Market Cap ($ mn) 2,844 Price (HK$) 7.92 Date Of Price 01 Aug 16 Free Float(%) - 3M - Avg daily vol (mn) M - Avg daily val (HK$ mn) M - Avg daily val ($ mn) 4.0 HSI 21, Exchange Rate 7.76 Price Target End Date 31-Dec-16 See page 34 for analyst certification and important disclosures, including non-us analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm 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.

2 Key catalyst for the stock price: Upside risks to our view: Downside risks to our view: Delivery of stable core earnings growth post-restructuring which will demonstrate benefits of streamlined operations Tariff hikes Stronger-than-expected volume growth Faster-than-expected ramp-up of port utilization Materialization of positive synergies from COSCO/China Shipping merger Potential EPS accretive acquisitions Strong improvement of profitability at newly injected assets Revaluation potential for the port assets CP currently holds should China set up more free trade zones Tariff cuts Weaker-than-expected volume growth Execution risk associated with new port investments Key financial metrics FY14A FY15A FY16E FY17E Valuation and price target basis Revenues (LC) We derive our Dec-16 PT of HK$10.0 based on DCF valuation methodology. Our PT corresponds to a P/E of 13.1x, EV/EBITDA of 10.5x and a P/B of 0.8x for FY16E. Revenue growth (%) 9% -8% -25% 3% EBITDA (LC) EBITDA margin (%) 50% 55% 63% 68% Tax rate (%) 11% 11% 18% 19% Net profit (LC) EPS (LC) Core profit growth (%) 2% 3% -26% 5% PT breakdown (FY16E) DPS (LC) BVPS (LC) Operating cash flow (LC mn) Free cash flow (LC mn) (401) (79) Interest cover (X) Net margin (%) 33.6% 37.9% 37.4% 37.9% Sales/assets (X) Debt/equity (%) 37% 39% 45% 45% Net debt/equity (%) 15% 22% 38% 40% ROE (%) 6.3% 6.3% 4.7% 4.9% Key model assumptions FY14A FY15E FY16E FY17E Average tariff growth 0% 0% 0% 0% Total throughput growth 10% 34% 2% 3% HKD % Consolidated ports HKD % JCE & Associates Source: Bloomberg, Company and J.P. Morgan estimates. Source: Company and J.P. Morgan estimates. Sensitivity analysis EBITDA EPS JPMe vs. consensus, change in estimates Sensitivity to FY16E FY17E FY16E FY17E NPAT (US$MM) FY16E FY17E 5% chg in average tariff 3% 3% 5% 6% JPMe old % chg in container throughput 3% 3% 5% 7% JPMe new % chg -6% -28% Consensus Source: Bloomberg, Company and J.P. Morgan estimates. Source: Bloomberg, Company and J.P. Morgan estimates. Comparative metrics CMP Mkt Cap P/E (x) EV/EBITDA (x) P/BV (x) YTD LC $Mn FY16E FY17E FY16E FY17E FY16E FY17E Stock perf. COSCO Pacific , CMHI , Tianjin Port NA NA Dalian Port 1.6 3, NA NA Hutchison Port Holding Trust , Qingdao Port , Source: Bloomberg, Company and J.P. Morgan estimates. Prices are as of 8/2/2016 2

3 Assuming coverage of COSCO Pacific - maintain OW view post-restructuring In light of the company s recent operational developments, we maintain our OW view on the stock and adjust our DCF-based Dec-16 PT to HK$10. We remain positive on CP s story given: (1) CP s pure-play status - we believe the company's shares had previously been penalized given CP s exposure to the underperforming container leasing as well as declining ROE. But the restructured business should result in more stable core earnings growth (Adj. EBITDA CAGR of 7% from ) as well as FCF profile (FCF yield projected at 9~10% by FY18), the benefits of which should be evident in FY16 where assets that were previously disposed of (CIMC and Florens) are expected to record sharp earnings declines in 1H while CP s core operations will be more resilient. Furthermore, we believe CP can raise the profitability of inbound assets (we have factored in limited expectations on this front) which could improve the company s ROE profile. (2) Potential positive synergy effects post-cosco/china Shipping merger which could drive higher port utilization for key hub port assets while seeing greater volume support from newly formed OCEAN alliance in light of CP's close relationship with the parent group and sister companies. Materialization of such potential positive effects would pose as upside risks to our current estimates. (3) Additional capacity for overseas acquisitions given lowered gearing post-restructuring. CP has identified several pipeline projects that mgmt believes could be executed in the near term (in FY16/17) if terms are agreeable. Additional announcements of overseas assets (which are generally more profitable than domestic ports) could help boost the company s overall profitability, with the impact possibly becoming visible in the near-term given CP s stated focus on brownfield assets. Furthermore, recent cooperation with CMHI could set a precedent for future coinvestments which we believe could be beneficial to both parties. We note that CP s share price has fallen c7% YTD, outperforming the HSCEI index by c2% over the same period, but on a total return basis has outperformed the Index by c6% given the CP's special dividend of HK$80 cents per share distributed after the restructuring transaction was completed. Looking more closely, the company's shares actually rallied c30% between January and end-march this year but the share price corrected as much as c26% since then as throughput trends disappointed while the overall sector appeared to fall out of favor. However, we believe at c0.6x FY16 P/B and c6.5x adjusted EV/EBITDA, the stock s valuation is undemanding while we think street expectations have been calibrated to reflect the current lower volume growth environment (along with the rest of the sector). Furthermore, we see limited downside catalysts in the nearterm and expect the benefits of streamlined operations to become more evident in the coming quarters, particularly in light of the earnings volatility seen for disposed 3

4 assets such as CIMC (expected to make a loss in 1H16) and the container leasing business seeing a sharp decline in earnings in 1Q16 (down >70% Y/Y). We further see upside risks to our estimates as our current base case factors in relatively conservative expectations for volume and yield growth while we have not yet quantified the potential positive synergy effects from the COSCO/China Shipping merger. In order for CP to re-rate higher, we believe the company will need to demonstrate its ability to raise its overall return profile, initially through improved yields at the newly injected assets from CSPD where efficiency gains should be achievable given the undemanding base. Furthermore, the Street has been lowering expectations for the Chinese port sector since 2H15 on the back of the weakerthan-expected volume growth trend since 1Q16, and thus any realization of positive synergies from the COSCO/China Shipping merger (which we believe could start making an impact in FY17) would accelerate ROE improvement. Announcements of acquisitions that are at attractive valuations (deviating from recent trend of paying high P/Es for new assets) may also support the share price higher, in our view. How we got here First listed in 1994, CP's business has transformed substantially over the years. The company first began as a container leasing company under the COSCO Group but throughout the 1990s and 2000s, CP diversified its operations beginning with its first port acquisition (a 50% stake in COSCO-HIT Terminals in Hong Kong) in Even though the company expanded its operations to other business segments such as logistics and container manufacturing, container leasing and port operations formed the core of CP's operations. In the late 2000s, CP decided to change course and instead of diversifying its operations, the company looked to sharpen its business focus through divestitures of non-core assets beginning with the disposal of a 20% stake in Chong Hing Bank in CP continued along this path over the next several years until the company was once again focused on two core lines of business, container leasing and terminal operations, but by the mid 2000s, the ports segment had overtaken container leasing as the company s largest operating segment. 4

5 Figure 1: Earnings composition over time by segment 100% 75% 62% 4% 2% 4% 5% 12% 15% 34% 50% 7% 37% 26% 50% 100% 25% 34% 100% 74% 25% 38% 42% 33% 39% 56% 0% E Container terminal Container leasing Container manufacturing Logistics Banking Source: J.P. Morgan research, Company data. Note: Based on segment profit information excluding corporate income/expenses Leading up to the 2015 restructuring, beginning in mid-2013, the container leasing market started to deteriorate while the company's port operations continued to see growth, further establishing terminal operations as the company s primary business (from , terminal related profits grew at a CAGR of 14% vs -3% CAGR for the leasing business). Figure 2: E segment profit for container terminal and container leasing segments US$ Mn E 2017E 2018E Container terminal Container leasing Source: J.P. Morgan estimates, Company data. Note: E segment profit estimated using (EBIT + share of profit from associates & JCEs)*(1-Tax rate) 5

6 This then brings us to the end of 2015 when, as part of the larger merger of the COSCO and China Shipping groups, CP effectively traded its container leasing division for China Shipping's port assets, completing the company's transformation into a pure-port operator. We currently forecast core segment profit growth (which now only contains port operations) to grow at a CAGR of 10% from E. Valuation and Share price analysis Methodology unchanged DCF-based Dec-16 PT set at HK$10 We valued CP s business using a DCF calculation for consolidated operations while utilizing a DDM to value the company s associates and JCEs, which is a conventional approach given port operators like CP often have a large portfolio of different port assets with many associate/jce stakes accounted through equitymethod accounting. We utilized a 10-year forecast period and our remaining assumptions are as follow: For consolidated ports: WACC of 8.1%, terminal growth of 1%, and debt to capital of 25%; For non-consolidated associates and JCEs: we used a cost of equity of 9.5% and terminal growth of 1% Table 1: PT Breakdown Business segments Valuation methodology EV (US$MM) Net Debt (US$MM) Minority interests (US$MM) NAV (US$MM) Per share value (HK$/share) EBITDA (US$MM) EV/EBITDA (x) Port operations 6,084 1, ,837 HKD Consolidated ports DCF 3,451 1, ,204 HKD 3.2 JCE & Associates DDM 2, ,633 HKD 6.9 Source: J.P. Morgan estimates. At current levels, CP is trading at EV/EBITDA and P/B of 6.6x/6.1x and 0.6x/0.6x for FY16/17E respectively. This is compared to 10.8x/10.2x EV/EBITDA and 1.2x/1.2x P/B for FY16/17E for key domestic peers and 11.2x/10.4x and 2.6x/2.5x for regional/international peers. Thus, at current levels, we believe CP s valuation is undemanding. We do acknowledge the company s below average ROE of 4.7%/4.9% for FY16/17E post-restructuring which is negatively affected by the injection of less profitable assets from CSPD. That said, the increased stability of the company s operations (prior non-port operations such as container manufacturing through a stake in CIMC as well as the recently disposed container leasing business have had highly volatile earnings in recent years), likely improvement of profitability at inbound assets, as well as potential positive synergies from the COSCO/China Shipping merger lead us to have a positive outlook on the stock in light of current market expectations, which have now been calibrated in our view. Our current earnings estimates for FY16/17E are +2%/-19% against consensus, but note that consensus estimates may be stale as some brokers may not yet have 6

7 published updated figures post-consolidation given CP has not released financial data for the combined entity on a port-by-port basis (generally provided on a half-yearly basis). Share price analysis CP s shares were first listed on the Hong Kong Stock Exchange in 1994 when the company's principal business was container leasing. Since then, the company has narrowed down its business focus through non-core divestments while expanding its container terminal operations. The company ultimately transformed into a pure-port operator after the merger of the China Shipping and COSCO Groups resulted in a reshuffling of assets. Like its peers, CP s shares got de-rated during the global financial crisis beginning in late-2007/early-2008 before bottoming out in late-2008, losing over 80% of its value compared to the beginning of The company s shares then rallied c400% between 3Q08 and 1Q11 as CP continued to expand its ports business through a mixture of both international and domestic investments while also beginning to sharpen its business focus through disposal of its logistics business. Figure 3: Share price performance and major events (Jan 2007 = 100) Global financial crisis: Despite the shap decline in share price, during this period of time, throughput growth for CP's port assets remained relatively resilient with annual growth of 21.5% Y/Y in 2007, 17.7% Y/Y in 2008 COSCO Pacific signs concession agreement with Piraeus Port Authority to develop and operate Piers 2 and 3 at port of Piraues in Greece Officially took over Pier 2 of Piraeus Port Announced the acquisition of an additional 10% stake in Yantian Terminal - a key profit contributor for CP Formed a JV company with CSPD and CMHI to invest in Kao Ming Terminal in Taiwan - each with 10% stake Announcement of consolidation of port operations between COSCO and China Shipping groups:1) Acquisition of China Shipping Ports Development; and 2) Disposal of Florences Container (container leasing business). Transforming CP into a pure port operator Announcement of establishment of JV between CP, CMHI and CIC to acquire a majority stake in Kumport in Turkey CP's share's suspend trading on news that China Shipping and COSCO group were engaged in merger talks Established a JV 20 Disposal of COSCO company with HPHT to Disposal of COSCO Announcement of acquisition acquire a majority stake Logistics Co Ltd Container Industries Co Ltd in Euromax port in in ACT in Hong Kong Rotterdam from HPH 0 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 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Source: J.P. Morgan research, Bloomberg, Company data. However, despite a similar strategy being deployed between 2011 and 2015, the company s shares remained range-bound, underperforming global sector peers as well as CMHI (144.HK; OW) since 2009 with the performance gap widening since mid We believe part of the reason for the widening underperformance 7

8 since mid-2013 (which is close to when CP disposed of its container manufacturing segment resulting in the company s business narrowing down to just container leasing and terminal operations), is that the container leasing segment started to weaken beginning in 2H13 as the industry environment began to deteriorate resulting in lower yields and container prices. Thus, during this period, the container leasing business acted as a key drag. That said, with the recent restructuring, we believe CP should at least recover some of this underperformance, which currently sits at c50% against the global peer group and c30% against CMHI using Jan 2009 as the base, given the leasing business drag has been removed. We believe this will be driven by the de-cluttered business structure where the terminals segment is expected to drive stable core earnings growth while the company's FCF profile is expected to improve in the coming few years with FCF yield rising to 9%~10% after FY17 (capex is forecast to rise in the next two years as the company accelerates its overseas acquisition program). Furthermore, we believe expectations have now realigned with the current lower growth market environment and see limited downside catalysts in the nearterm. Figure 4: CP's relative share price performance vs global sector peers (Jan 2009 = 100) % % 60% % % 100 0% -20% 50-40% 0-60% Relative Performance to Peers CP Sector Average CMHI Source: J.P. Morgan research, Bloomberg. Note: Jan 2009 = 100; peer group includes ICT.PM, 144.HK, 2880.HK, 3378.HK, 3382.HK, HHFA.GR, POT.NZ, ADSEZ.IN, DPW.DU, NCB.MK, BPH.MK, ESRS.IN, AIO.AU, CH, CH, CH, CH. Looking at the company s historical valuation band charts below, it would appear that the stock's current valuation is not at particularly low levels. That said, CP has been adjusting its business focus over this period of time while slowly developing its now core terminal operations business. Thus, historical valuation trends may not necessarily be representative of how the stock should be valued going forward, especially given the company was only recently able to shed its remaining nonterminals segment. 8

9 Figure 5: LT historical forward P/E band chart 25.0 Figure 6: LT historical forward P/B vs ROE band chart x 12.2x x 1.9x x x LT historical P/E Avg P/E LT historical P/E -1 STDEV LT historical P/E +1 STDEV 1yr fwd P/E (x) Source: J.P. Morgan estimates, Bloomberg, Company data. LT historical P/B Avg P/B LT historical P/B -1 STDEV LT historical P/B +1 STDEV 1yr fwd P/B (x) 1yr fwd ROE (RHS, %) Source: J.P. Morgan estimates, Bloomberg, Company data. That said, we note the declining ROE trend over time. As mentioned above FY16E ROE is actually expected to further decline to 4.7% in FY16 (using recurring profits) vs 6.3% oya. This is largely driven by the lower profitability of inbound assets compared to the company s existing ports portfolio in our view. However, we believe there is room for profitability to improve while earnings and cash flow should be more stable post-restructuring. 9

10 Table 2: Global port terminal business- Valuation comps Global port valuation comp sheet Name Ticker JPM rating JPM PT (LC) Last price Mkt cap P/E (x) P/B (x) ROE (%) ROA (%) EV/EBITDA(x) Dividend Yield (%) LC US$MM FY16E FY17E FY16E FY17E FY16E FY17E FY16E FY17E FY16E FY17E FY16E FY17E HK-listed port operators: COSCO Pacific 1199 HK OW , China Merchants 144 HK OW , Hutchison Port Trust HPHT SP UW , QHD Port 3369 HK UW , Dalian Port 2880 HK NC NA , NA NA Xiamen Int l Port 3378 HK NC NA NA NA NA NA NA NA NA NA NA NA NA NA Tianjin Port Dvlp 3382 HK NC NA NA NA Average China-listed port operators: Ningbo Port Co. Ltd CH NC NA , Tianjin Port-A CH NC NA ,571 NA NA SIPG CH NC NA , Rizhao Port CH NC NA , NA NA NA NA NA NA Average Overseas port operators: Westports WPRTS MK NC NA , Namyong Terminal NYT TB NC NA Hamburger Hafen HHFA GR NC NA , Und Logistik Port of Tauranga POT NZ NC NA , Mundra Port and SEZ ADSEZ IN OW , Ltd DP WORLD LTD DPW DU OW , INTL Container Svc ICT PM N , Bintulu Port BPH MK NC NA Asciano AIO AU NC NA , Average Source: Bloomberg, Bloomberg consensus for stocks Not Covered (NC), J.P. Morgan estimates. Prices and valuations are as of 8/2/2016. Note: For Indian ports, the next fiscal year's financial figures are taken as the year ends in March. 10

11 Transformation complete: COSCO and China Shipping restructuring allows CP to offload final non-port segment As part of the merger between China Shipping Group and COSCO Group, the port operations of the two groups were consolidated into COSCO Pacific. The transaction allowed CP to offload its container leasing business, helping CP transform into a pure port operator. Overall, we view this move as positive for CP given the company has been streamlining its business scope over the past few years with multiple divestitures of non-core businesses with the China Shipping/COSCO merger being the final step. Furthermore, we believe CP may benefit from several sources of positive synergies while also seeing greater throughput volume stability/support from the merged container shipping operations of COSCO and China Shipping. Transformation into pure terminal operator a long-time coming and could help unlock value CP has been proactive in its efforts to narrow its business focus in recent years including two key divestments of non-core businesses: disposal of CP's logistics business in 2009 and container manufacturing segment in However, over the last couple of years, we believe CP's share price has been discounted given the prior dual-segment focus of port operations and container leasing, the latter of which has been struggling in the current operating environment that has seen overcapacity from the shipping liners and falling raw material prices result in lower rental yields as well as second hand box prices with pressures unlikely to ease substantially in the nearterm. Hence, we anticipate the disposal of Florens Container Holdings (FCHL), CP's prior leasing division, to potentially help CP unlock some value (prior to restructuring, CP was trading at 0.6x P/B, substantially lower than peers like CMHI which was at closer to 1x P/B). Impact of COSCO/China Shipping merger - CP comes out the other side leaner, but near term profitability may be diluted In early August 2015, it was reported that the Chinese government had asked the China Shipping Group and COSCO Group to draft a merger plan, resulting in all the relevant stocks under the two groups to suspend trading. Initial information focused on the consolidation of shipping operations, but it was always a likely scenario that a merging of the two groups' port operations would be a part of the overall plan. In the end, there was a large scale reshuffling of assets between the two groups which included the injection of China Shipping's port assets held under China Shipping Port Development ("CSPD") into CP while CP would dispose of FCHL. With respect to valuation, on a historical P/B basis, the valuations of the two assets were c1x for the outbound asset and 1.2x 2014 P/B for the inbound asset. Looking at the transaction from a P/E perspective, however, shows that the acquisition appears to be substantially more expensive, which resulted in some push back from investors. 11

12 Table 3: Summary of key divestitures and recent acquisition of CSPD Announcement Seller Target Acquirer Consideration Stated rationale Valuation (Note 1) Aug-2009 COSCO Pacific Entire 49% stake of COSCO Logistics Co Ltd China COSCO (parent co) Cash Rmb2,000MM+ distribution of 9M09 net profit 49% equity interest in COSCO Logistics was no longer a strategic business unit of COSCO Pacific. 11.5x P/E 1.6x P/B May-2013 COSCO Pacific COSCO Container (whose main asset is 21.8% equity interest in CIMC) COSCO (ultimate parent co) US$1,219.8MM CIMC's business diversification into non-container business deviates from the original intent of investing in CIMC. 22.2x P/E 2.8x P/B Dec-2015 COSCO Pacific 100% of Florens Container Holdings Ltd China Shipping Container Lines Rmb7,784MM Disposal of container leasing business to become pure ports operator 12.6x P/E 1.0x P/B Dec-2015 China Shipping Container Lines 100% of China Shipping Ports Development COSCO Pacific Rmb7,632MM To consolidate all port assets under China Shipping and COSCO group as part of the merger between the two parties 60.5x P/E 1.2x P/B Source: J.P. Morgan research, Company data. Note 1: P/E ratio is the Historical P/E Ratio, i.e. calculation is based on the earnings of the last financial year. With respect to P/E, FCHL was being valued at c12.6x FY14 earnings (but forward earnings would have been higher given profit of the leasing segment was down 13.5% Y/Y in FY15 while noting leasing profits were down 71% Y/Y in 1Q16) and CSPD's assets were being pegged at c60.5x 2014 P/E using the initial consideration amount. We note, however, that CSPD's high P/E number did not reflect the true profitability of CSPD s assets since its stake in a significant port asset, Shanghai Mingdong, was only acquired at the end of FY14. If we look to normalize this number using the published 9M15 numbers as guidance, the valuation would have been closer to 20x P/E for FY15. That said, even though CP s operations have now been restructured, CSPD's overall asset portfolio will likely be dilutive to profitability upon initial consolidation given CSPD's assets are more skewed towards domestic traffic which is less profitable than international volumes (volume split between domestic and international traffic is estimated to be 50/50 for CSPD while CP s original assets had a split closer to 85/15 with substantially more international volume exposure). However, we do see some potential upside to the profitability of more domestic traffic focused ports given the announced port tariff pricing deregulation announced at the beginning of 2015 which could result in domestic charges creeping upwards over time. Positive synergies expected along several lines postmerger CP successfully completed its restructuring exercise on 24 th March 2016 and paid out a conditional special cash dividend of HK$80 cents per share (payment date on 4 th May 2016). As a result, the 1Q16 reported numbers now reflect only the company s continuing port operations (while 2015 numbers were restated on the 12

13 basis of merger accounting) and FY16 results will reflect a full year of post-merger financials. We see several potential sources of positive synergies which could result in improving volume stability/profitability, and strengthened port network coverage. Positive synergy 1: Potential cost savings and increased operating efficiency from greater control at certain ports The most direct of potential positive synergies comes from the consolidation of the stakes at certain port assets where both CP (pre-merger) and CSPD had an interest. This includes ACT in Hong Kong, which would become a subsidiary, Tianjin Five Continents, and Kao Ming in Taiwan. Positive synergy 2: Increased volumes due to merging of container shipping operations of COSCO and China Shipping Another source of potential positive synergies comes from merged container shipping operations of COSCO and China Shipping and the subsequent formation of the new OCEAN alliance which will have the second largest combined global market share behind the 2M alliance (we note that Hyndai Merchant Marine recently signed an MOU to join 2M). Given CP's close relationship with its sister companies and the parent Group, we believe that CP's ports may be able to benefit from stronger and more stable volume flows with key assets serving as hub ports for the alliance while the non-overlapping route coverage of the two shipping companies pre-merger may result in new volumes coming to ports that were not part of the original route rotations. Positive synergy 3: Broadened global port network coverage could drive higher utilization and coordination With the assets of the two groups consolidated under a single platform with limited overlapping stakes, the enlarge scale and widened network of operations could result in higher utilization of certain port assets (both domestically and internationally), particularly those that have the capacity to serve as regional hubs as they could become preferred ports of call for the alliance's vessels. Additionally, in areas where both operators have non-overlapping presences, the consolidation of assets could improve the competitive landscape through increased coordination (though this may take time to materialize). Positive synergy 4: Transfer of management expertise could improve operational efficiency We believe the transfer and exchange of management expertise, likely more from the CP side, could help raise the management and operating efficiency of port assets particularly in regions where both operators had a presence in pre-consolidation. This would have the effect of raising the company s return profile through improving throughput yields. However, we believe these synergies are not easily quantifiable and thus have not explicitly factored such positive effects into our model. 13

14 Overseas port acquisitions to remain key element of current growth strategy, particularly in light of OBOR initiative Pace of overseas expansion has been slow and steady but appears to be accelerating CP has gradually been expanding its international exposure having made their first overseas investment in 2003 through the acquisition of a 49% stake in COSCO-PSA in Singapore. Since then, CP has made several other overseas acquisitions, but these transactions have been spaced apart over the past decade or so. Main highlights include: Table 4: CP's key overseas acquisitions Year Asset Country Equity stake 2003 COSCO-PSA Singapore 49% 2004 Antwerp Terminal Belgium 25% 2005 Suez Canal Egypt 20% 2008 Piers II & III at Piraeus Port Greece 100% 2012 Kao Ming Taiwan 10% 2014 Asia Container Terminal Hong Kong 40% Source: J.P. Morgan research, Company data. In between these acquisitions, CP has also expanded its Chinese port network coverage with multiple acquisitions across the country including acquisitions of assets in Dalian, Guangzhou, Tianjin, and Xiamen among others. That said, we believe focus will now turn towards accelerating the company s overseas presence, particularly as China continues to roll out its ambitious One Belt One Road initiative. Over the last year or so, CP s management has stressed that they are looking to further strengthen the company s port network along the Maritime Silk Road as infrastructure and economic development along this route (as well as the revival of the overland Silk Road Economic Belt) is expected to bring about stronger volumes. As such, CP has been actively identifying viable acquisition opportunities to play on this theme while having already completed one deal and signed another in recent months. Common concerns have been more on the valuation front rather than operational execution given the company s fairly long track record. On this point, CP's management continues to assert that even though historical/current valuations have been on the high side, the company is still focused on asset quality and believes the recent deals give them strong presence in solid markets. Acquisition of c26% stake in Kumport in Turkey (completed at end 2015) In Sep 15, CP along with CMHI and CIC joined together to acquire a 65% stake in Kumport in Turkey (CP and CMHI both with 40% stake in the JV while CIC holds the remaining 20%) for a total consideration of US$940MM (CP s share was US$376MM). Project IRR was estimated at >10% at the time but push back was primarily on valuation as Kumport s 14

15 P/E was estimated at c43x 2014 historical P/E. This is admittedly high but profit growth in 2015 while noting we don t have final full year financials for the port should have brought this figure down. The deal has since been completed and this brownfield project has started making contributions since the beginning of this year. Purchase of 35% stake in Euromax port in Rotterdam, Netherlands (announced in May'16 and targeting completion in 2H16) - CP recently announced that it would be acquiring a stake in Euromax Port from HPH for a total consideration of EUR125.43MM (US$143MM) which includes cus96mm to be paid for a 35% shareholder s loan. Valuation was once again a key concern as the implied historical P/E was 42.9x based on the share sale consideration. That said, CP expects Euromax to be able to serve as a hub port location for the new OCEAN alliance which could result in more volume security while the port is still young (operations only began in mid-2010 and only turned profitable in 2014) which could skew the P/E upwards since the profit level is still low. During the FY15 results briefing, CP s management indicated that they had 7 projects on hand along the Maritime Silk Road that would be executable in the near term (6 left if we exclude the already announced Rotterdam acquisition - see below for map of locations) and another two potential assets in the Yangtze River Economic Belt. As a result, we believe the company could announce additional deals in the coming two years as CP jostles for positioning along the Maritime Silk Road (we note that other operators, including CMHI, are employing similar strategies and are thus also actively engaged in looking at overseas assets). Hence, we believe additional announcements of earnings/value accretive deals could support the share price higher. Taking a look at CP s 1Q16 balance sheet, we estimate that the company has another US$1.1B of capital capacity for deployment in the near term (closer to US$1B if we include the announced Rotterdam acquisition) suggesting we could see more acquisition announcements in the coming quarters. We believe CP s overseas execution track record, overseas presence, as well as close relationship with the COSCO shipping operations will give CP an advantage when looking to secure additional overseas deals. Expecting more cooperation between CP and CMHI for future acquisitions? Potential win-win situation for China's two largest port operators The partnership between CMHI and CP on the Kumport deal is intriguing given the two companies are often looked at as being rival operators. However, we do note that the two have actually worked together in the past with overlapping minority stakes in Taiwan and Tianjin. But last year s Kumport deal was the first time the two joined forces to purchase a controlling stake. Both companies cited that they had identified Kumport as a potential acquisition target on their own and ultimately decided to form a partnership in order to avoid a bidding war which would have pushed the purchase 15

16 Figure 7: CP's identified investment opportunities on hand price even higher. However, taking a closer look at this leads us to believe that this is a model that will be repeated for future acquisitions as well. Source: Company data, J.P. Morgan research As mentioned above, overseas expansion has become a key trend for port operators, particularly since China revealed its ambitious plans to revive the old Silk Road trade routes. As a result, competition for overseas acquisitions has been increasing making it very difficult to find 'bargain' deals anymore (valuations of recent deals have gone up while expected returns have seen downward pressure). Thus, we believe both CP and CMHI would benefit from co-investing more as it would allow both companies to do more deals (and hence potentially broaden their networks more than they would be able to if they ventured overseas alone) while reducing competition (which could help control valuations). Furthermore, as a unified investor, a JV between CMHI and CP may have more bargaining power given their overseas track record and parent group support. And lastly, this could bring the two companies closer together which may allow the two companies to leverage off of each others' port networks while CMHI would get the added bonus of benefitting from potential volume support given CP's close relationship with COSCO shipping (and the new OCEAN alliance). 16

17 Risk analysis Figure 8: Quarterly throughput growth for Chinese ports by region 12% Negative driver #1: weaker-than-expected volume growth to have negative impact on port operations Throughput growth for Chinese ports has likely entered into a lower growth paradigm as global economic growth has slowed while the domestic economy continues to rebalance. With 89% of CP's asset portfolio in terms of throughput in 2015 (and 80% by profit) being from Chinese ports, the company s operational performance is still greatly leveraged to Chinese trade activity and volume trends. 10% 8% 6% 4% 2% 0% -2% -4% 9% 10% 8% 9% 7% 8% 7% 7% 7% 7% 7% 7% 6% 6% 6% 5% 5% 4% 4% 4% 3% 4% 3% 3% 3% 3% 3% 3% 2% 2% 3% 1% 2% 1% 1% 1% 1% 0% -3% -3% YRD PRD Bohai Region Total by China coastal ports Source: Ministry of Communications, J.P. Morgan research. 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 The charts above and below show that the overall growth rate of Chinese port volumes has been decelerating over the past decade with a marked slowdown over the past few quarters. Even though we have seen this growth rate pick up in 2Q16, we do not believe volume growth can revert to the levels seen in the early 2010s, while mid to low single digit growth appears to be a reasonable assumption in the coming few years. However, if volume growth continues to decline faster-thanexpected, it would result in potential downside to our assumptions. 17

18 Figure 9: Annual throughput growth for Chinese ports by region 30% 25% 20% 15% 10% 5% 0% 24% 10% 20% 21% 20% 20% 19% 19% 16% 14% 13% 13% 12% 11% 12% 10% 7% 7% 8% 7% 7% 5% 6% 6% 5% 5% 4% 5% 3% 4% 4% 2% 2% 2% 0% 1% 0% -5% -10% -9% -9% -6% -15% YRD PRD Bohai Region Total by China coastal ports H16 Source: Ministry of Communications, J.P. Morgan research. Negative driver #2: execution risk related to new port acquisitions As CP looks to accelerate its overseas acquisition program, the company s asset portfolio will continue to grow with likely expanding geographical coverage. As a result, the company's ability to operate ports in different jurisdictions will be paramount to its success. Furthermore, CP would have to effectively control for differing risks across various jurisdictions, which could pose a challenge if the stability of domestic economies and governments becomes an issue. So far, it appears that CP has been able to export its operational expertise from China to foreign terminal assets while demonstrating the ability to manage these operations effectively as demonstrated by the company's track record so far. Nonetheless, this is a key risk not only for future acquisitions, but for legacy assets as well. Hence we believe that additional cooperation with CMHI would allow the company to better hedge/control for this risk both on the operational side (given CMHI s successful track record in Africa and South Asia) but also during the project selection phase. Negative driver #3: adverse FX movements and falling yields Despite most of the company s assets being located in China, the company reports in US$ (a result of the company's original container leasing focus whereby revenue and profits were primarily in USD/HK$) and thus adverse currency movements against the US$ (such as the recent Rmb depreciation trend which has seen the Rmb fall c5% against the dollar during 1H16) would affect CP's effective yield. Furthermore, as the company expands its overseas presence, exposure to non-us$ currencies (such as the EUR at PCT) will likely rise. Hence, if local functional currencies weaken substantially against the dollar, it would also have a negative impact on CP's profits. 18

19 Snapshot of consolidated ports portfolio Both domestic and international coverage expanded post-merger as asset portfolio of the two groups have limited overlap Prior to the merger, CP had 26 core port assets (many of which are associates or JCEs) with relatively diversified exposure to the various key economic regions in China (Bohai Rim, YRD, and PRD) as well as overseas assets, in terms of profit distribution. With respect to attributable profit, Yantian, Qingdao Qianwan, and Piraeus were the largest profit contributors in FY15. Table 5: COSCO Pac Profit contribution of legacy ports for FY15 US$ 000 % Equity interest FY15 FY14 Y/Y % of total (FY15) Bohai Rim 54,691 48,307 13% 23% Qingdao Qianwan 20.0% 42,898 39,034 10% 18% Dalian Port 20.0% % 0% Dalian Automobile 30.0% 838 1,395-40% 0% Yingkou 50.0% 1,900 2,122-10% 1% Tianjin Five Continents 14.0% 2,214 2,034 9% 1% Tianjin Port Euroasia 30.0% 4,406 2,249 96% 2% Dongjiakou 12.5% 2, % 1% Yangtze river delta 42,110 43,762-4% 18% Shanghai Container Terminal 25.0% % 0% Shanghai Pudong 30.0% 21,511 20,689 4% 9% Zhangjiagang Win Hanversky 51.0% 3,595 3,819-6% 2% Yangzhou Yuanyang 55.6% 48 2,033-98% 0% Nanjing Longtan 16.1%-20% 2,416 2,578-6% 1% Ningbo Yuan Dong 20.0% 10,094 10,523-4% 4% Taicang Terminal 39.0% 3,567 3,686-3% 2% Pearl River Delta 80,800 76,480 6% 35% COSCO-HIT 50.0% 16,376 16,487-1% 7% Yantian 14.6% 53,667 49,446 9% 23% Guangzhou South China (Nansha) 39.0% 8,503 8,948-5% 4% ACT 40.0% 2,254 1,599 41% 1% Southeast Coast & others 9,372 3, % 4% Quan Zhou Pacific 82.0% 8,673 8,180 6% 4% Jinjiang Pacific 80.0% 293 1,704-83% 0% Xiamen Ocean Gate 70.0% 137 (6,858) -102% 0% Kao Ming 10.0% % 0% Overseas 46,331 48,067-4% 20% COSCO-PSA 49.0% 3,214 3,536-9% 1% Antwerp Gateway 20.0% 5,529 4,469 24% 2% Suez Canal 20.0% 8,743 11,082-21% 4% Piraeus 100.0% 28,845 28,980 0% 12% Other non-classified 349 1,157-70% 0% Terminal Segment--Total profit 233, ,978 6% 100% Source: J.P. Morgan research, Company data. 19

20 Table 6: CSPD major port assets Port name (Chinese) Port name (English) 5M TEUs China Shipping Stake (%) Attributable Throughput 锦州新时代 Jinzhou % 66.0 大连大港 Dalian % 2.4 连云港货柜 Lianyungang 1, % 广州南沙 * Guangzhou Nansha 2, % 天津五洲 Tianjin Five Continents 1, % 秦皇岛新港湾 Qinhuangdao % 57.7 营口新世纪 Yingkou % 大连国际 Dalian Int'l 1, % 广西钦州 Guangxi Qinzhou % 上海明东 Shanghai Mingdong 2, % 洛杉矶西港池 Los Angeles % 美国西雅图 Seattle % 6.2 台湾高明 Taiwan % 68.3 泽布吕赫 Zeebrugge (Belgium) % 35.9 香港 ACT Hong Kong ACT % 87.2 韩国釜山 Busan % Total Throughput: 12,763 Equity Attributable Throughput: 4,116 Source: J.P. Morgan estimates, Company data. Note: CSPD also has a 20% stake in Ningbo Meishan Bonded Port New Harbour Terminal (not yet commenced operations); and 20% in Qingdao Qianwan Intelligent Container Terminal (not yet commented operations) CSPD, on the other hand, had about 16 core assets which will now be absorbed into CP's asset portfolio. This will have the effect of changing the company's regional exposure as well as further diversifying the company's profit composition (though profits will still likely be concentrated in a few of the larger port assets). Table 7: Total throughput distribution by region FY13 FY14 Pre-merge Post-merge FY16E FY17E ( '000TEU) FY15 FY15 Bohai Rim 38.4% 37.3% 37.4% 34.5% 35.1% 35.3% Yangtze river delta 15.5% 14.7% 14.4% 21.1% 20.1% 20.1% Pearl River Delta 27.6% 28.4% 28.4% 27.9% 27.0% 26.7% Southeast Coast & others 5.4% 5.6% 6.0% 4.6% 4.7% 4.8% Southwest Coast 0.0% 0.0% 0% 1.0% 1.2% 1.3% Overseas 13.2% 14.0% 13.9% 11.0% 11.8% 11.9% Total throughput 100.0% 100.0% 100% 100.0% 100.0% 100.0% Source: J.P. Morgan estimates, Company data. We further note that there are several assets including ACT in Hong Kong, Kao Ming in Taiwan, and Tianjin Five Continents that actually overlaps with CP s existing portfolio of ports. Thus, the shareholding within the restructured group will be consolidated as well (with ACT becoming a subsidiary given the combined stake will now increase to 60%). 20

21 Table 8: 1H16 throughput of consolidated port assets post-merger ('000 TEUs) Port Name 1H2016 1H2015 Y/Y Growth Bohai Rim 16, , % 1 Qingdao Qianwan Container Terminal Co., Ltd. 8, , % 2 Dalian Port Container Terminals Co., Ltd. 1, , % 3 Dalian International Container Terminal Co.,Ltd. 1, , % 4 Dalian Dagang Container Terminal Co.,Ltd % 5 Tianjin Port Euroasia Int l Container Terminal Co., Ltd. 1, , % 6 Tianjin Five Continents Int'l Container Terminal Co., Ltd. 1, , % 7 Yingkou Container Terminals Co., Ltd % 8 Yingkou New Century Container Terminal Co., Ltd % 9 Jinzhou New Age Container Terminal Co., Ltd % 10 Qinhuangdao Port New Harbour Container Terminal % Yangtze River Delta 9, , % 11 Shanghai Pudong Int'l Container Terminals Ltd. 1, , % 12 Shanghai Mingdong Container Terminals Limited 2, , % 13 Ningbo Yuan Dong Terminals Ltd. 1, , % 14 Lianyungang New Oriental Int l Terminals Co.,Ltd. 1, , % 15 Zhangjiagang Win Hanverky Container Terminal Co % 16 Yangzhou Yuanyang Int'l Ports Co., Ltd % 17 Nanjing Port Longtan Container Co., Ltd. 1, , % 18 Taicang International Container Terminal Co., Ltd % Southeast Coast and others 2, , % 19 Xiamen Ocean Gate Container Terminal Co., Ltd % 20 Quan Zhou Pacific Container Terminal Co., Ltd % 21 Jinjiang Pacific Ports Development Co., Ltd % 22 Kao Ming Container Terminal Corporation % Pearl River Delta 11, , % 23 Yantian Int'l Container Terminals Ltd. 5, , % 24 Nansha Stevedoring Corp Limited of Port of Guangzhou 2, , % 25 Guangzhou South China Oceangate Container Terminal 2, , % 26 COSCO-HIT Terminal (Hong Kong) Ltd % 27 Asia Container Terminal Holdings Limited % Southwest Coast % 28 Guangxi Qinzhou Int l Container Terminal Co., Ltd % Overseas 6, , % 29 Piraeus Container Terminal S.A. 1, , % 30 Suez Canal Container Terminal S.A.E. 1, , % 31 Kumport Liman Hizmetleri ve Lojistik Sanayi ve Ticaret A.Ş 367 n.a. 32 Antwerp Gateway NV 1, , % 33 APM Terminals Zeebrugge N.V % 34 COSCO-PSA Terminal Private Ltd % 35 CJ Korea Express Busan Container Terminal Corp n.a. 36 SSA Terminals (Seattle), LLC % Total 46, , % Source: Company data, J.P. Morgan research 21