China Auto Higher for longer

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1 China Auto 2014 Higher for longer Towards the peak in 2016E: China s passenger vehicle (PV) sales growth is expected to slow, but absolute volumes may not peak until 2016E at 21-22mn units, based on our estimates, thanks to income growth and, to a lesser extent, wealth effect through sustained property prices (at least for now). On demand, our view on PV sales includes: 1. Raise E PV sales growth forecast to 12%, 9% and 8%, respectively, vs previous 1/5%/5%. YTD, the run rate is 14%. 2. Replacement demand in 2-3 years: China's much distorted sales growth of 53%/33% in 2009/10, due to the Rmb4.0 trillion economic stimulus plan in 2008, suggests the next wave of replacement demand should kick in in ~2015/16E, assuming ~6-7 years of car usage life. 3. Geographically, we introduce forecasts of both new car sales and penetration by region towards 2020E. By then, we expect Northern China to see the highest car ownership, while Eastern China is the most crowded (making up 35% of total ~200mn units of PV fleet). 4. Penetration of SUVs should hit 21% in 2015E, if not higher, vs 16% in We believe the saturation point is ~25-3. SUV remains the most promising sector, growing at the expense of sedans. 5. Affordability is a powerful driver for car demand. We estimate in 2014 that China s overall per-capita disposable income will exceed the level of the richest Eastern region as of 2012 and it will take just another three years (i.e. by 2016) for the poorest Northwestern region to reach the same. This implies % growth would be strongest in mid to lower-end cars with engine size below 2.0 liters or price point <Rmb200k. This benefits Chinese and low-end JV models. On supply overcapacity but highly concentrated: Our analysis on capacity expansion suggests that while industry-wide utilization may drop, continued rising concentration means smaller players would suffer most. By Aug-13, the top 10 of the total 70 automakers accounted for 88% of sales in China, while the bottom 50 altogether merely a meagre 3%. Two company-specific milestones and events: 1) Great Wall's H8 SUV, scheduled to launch in Nov-13, is the first Chinese-made model that is priced at the same level of JV models or ~Rmb200k. Contrary to the consensus bearish belief, we believe this model will be successful as it creates an entirely new market that wasn't available in the past at the same price point. 2) Geely s potential acquisition of Volvo operations in China when Volvo China turns profitable in late-14e. Watch two policy moves: 1) Possible further implementation of car purchase limits in tier-two cities to curb pollution and congestion. 2) Support for EV (electric vehicle) will be an ongoing initiative. Recommendations: We prefer OEM over dealers, parts or trucks. Our top picks are Great Wall, Brilliance, GAC and Geely. We would trade dealers depending on pricing and margin momentum. Head of Asia Auto Research Nick Lai AC Bloomberg JPMA LAI <GO> J.P. Morgan Securities (Asia Pacific) Limited Relative share price performance of China auto companies (Oct-11) Company (rating) 1M 3M YTD Brilliance China (OW) 6% 31% 27% DongFeng (UW) -3% 5% -11% GAC (OW) -5% 1 22% Geely (OW) -1% 26% 1 Great Wall (OW) 1 18% 86% Baoxin (N) 5% 52% 26% ZhengTong (N) 4% 52% 1% Zhongsheng (UW) 12% 64% 11% Minth (N) 2% 3% 64% Sinotruk (UW) -5% -37% Source: Bloomberg. Note: Relative performance to Hang Seng Index See page 29 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 Unstopping growth trend Chinese autos, year to date, is among one of the few sectors that has outperformed the market. Can this continue into the 4Q peak season and as we enter 2014? Our view is most likely yes, but investors should differentiate between stocks and subsectors. Simply put, our recommendation is: 1) OEMs over parts or dealers, 2) SUVs over sedans and 3) passenger vehicles (PV) over commercial vehicles (CV). We like Great Wall, Brilliance China, Geely and Guangzhou Auto. In the first half of this report, we aim to address the demand equation of the sector. From acceleration, deceleration to decline The growth of China's PV market can be dividend into two major stages: 1991 to 2010: During this period, growth of the total vehicle fleet or new car sales was significant, at around a 2 CAGR, thanks to rapid economic growth during the previous Five-Year Plans. New car sales, for instance, posted a 27% CAGR in and remained high at 25% in the next five years to 2020E: New car sales growth is expected to first decelerate to midsingle digits before declining in absolute terms after 2016E, in our view. Likewise, vehicle fleet growth is also anticipated to slow down to a 12% CAGR in E vs ~2 in the previous two decades. Figure 1: CAGR analysis: China PV fleet Million units Figure 2: CAGR analysis: China PV sales Million units CAGR: 18% CAGR: 22% E CAGR: 12% CAGR: 27% CAGR: 25% E CAGR: 8% 2015E-2020E CAGR: -4% E 2015E 2017E 2019E E 2020E Source: CEIC, J.P. Morgan estimates. Source: CEIC, J.P. Morgan estimates. We estimate growth of China s total PV fleet to slow down to a 12% CAGR in E from peak levels of a 22% CAGR. PV sales growth is expected to slow to an 8% CAGR in E vs 27% & 25% CAGR in & Absolute volume may not peak until 2016E at 21-22mn units, based on our estimates, thanks to affordability or income growth, as well as replacement demand in ~ 2015/2016E. We believe growth will decline afterwards and CAGR is estimated at -4% in E. 2

3 We raise PV sales forecasts We revise up overall auto sales (incl. PV and CV) growth to 11%/8%/7% in 2013/14/15E, respectively, from our previous estimates of 8%/4%/4%. Year-to-Sept run rate of 13% suggests risk to our revised forecast now could remain on the upside. Our seemingly conservative stance is due to the very high base in 4Q12 but our bottom line is simple we are bullish on auto sales growth and momentum into Specifically, in the PV sector, our revised growth forecast now stands at 12%/9%/8% in E vs previous projections of 1/5%/5%, respectively. Year to Sept, PV growth is 14%, mainly boosted by the surprisingly strong September. (see our report, China Auto Drivers, 11 October 2013). This growth could slow down in 4Q13 as 4Q12 was an unusually strong quarter right after the leadership change in China last October. Table 1: China vehicle demand forecast Sales Unit ('000) E 2014E 2015E Sedan 5,047 7,473 9,494 10,123 10,746 11,498 12,073 12,677 MPV ,033 SUV ,326 1,594 1,998 2,797 3,581 4,297 Minivan 1,064 1,950 2,492 2,258 2,256 2,279 2,347 2,394 Total PV 6,756 10,331 13,757 14,472 15,494 17,405 18,951 20,411 (yoy % change) 7% 53% 33% 2% 4% 12% 9% 8% Bus Truck 1,641 2,250 2,831 2, ,786 2,981 3,130 Trailer Van chassis Truck chassis Total CV 2,626 3,313 4,304 4,033 3,811 4,033 4,281 4,477 (yoy % change) 5% 26% 3-6% -5% 6% 6% 5% Total vehicles 9,381 13,645 18,062 18,505 19,305 21,437 23,232 24,888 (yoy % change) 7% 45% 32% 2% 4% 11% 8% 7% Source: CAM, CEIC, J.P. Morgan estimates. Figure 3: China vehicle sales forecast (PV+CV) million units, % 30 45% % % 7% 8% 7% 2% 4% E 2014E 2015E Total vehicle sales YoY growth (RHS) Source: CAAM, J.P. Morgan estimates. 5 45% 4 35% 3 25% 2 15% 1 5% Figure 4: China vehicle sales growth PV vs CV % % 5% % 53% % Source: CAAM, J.P. Morgan estimates. CV YoY growth 5% 7% -6% -5% PV YoY growth 12% 9% 8% 6% 6% 5% 2013E 2014E 2015E Total vehicle sales estimated at ~24.9mn: We estimate China s total vehicles to grow at 11%/8%/7% in 13E/14E/15E. Total vehicle sales volume is estimated at ~25mn by 2015E. Raise E PV sales growth forecast to 12%, 9% and 8% respectively vs. previous 1/5%/5%. Year to September, the growth rate is 14%YoY. CV growth is expected to recover from By two segment, consecutive SUVs drops remain 2011 stronger and than Growth sedans, expected and PV at 6%/6%/5% stronger than in 13E/14E/15E. CV 3

4 Our sub-sector preferences SUV > sedan: We believe the SUV (sport utility vehicles) cycle in China will not peak until 2016 or so when penetration hits similar levels to those seen in Korea, Taiwan or the US. The growth of SUVs is clearly at the expense of sedans. By September for instance, the SUV sector is growing at 45%, over three times higher than broader PV of 14%. PV > CV: CV in China is mainly truck or those related to FAI (fixed asset investment). Structurally we believe the truck sector is facing two challenges: 1) China s economy moving towards a more balanced model between FAI and consumption and 2) substitution effect from better railway network. Both of these factors will reduce truck demand in the longer term, in our view. In contrast to CV, we believe PV will continue to grow at higher rates than CV in the next couple of years. OEM > dealers or parts because the former generally has the upper hand in terms of pricing power than the latter. Figure 5: China PV sales forecast sedans vs SUVs % % 47% % 2 25% 28% 2 2 7% 6% 7% 5% 5% E 2014E 2015E Sedan SUV Source: CAM, CEIC, J.P. Morgan estimates. Figure 6: China CV sales forecast buses vs trucks 4 37% 31% 3 26% 2 13% 1 7% 9% 6% 5% 7% 5% 3% 3% -1-5% -2% E 2014E 2015E Bus Truck Source: CAM, CEIC, J.P. Morgan estimates. SUV expected to grow at the expense of sedans: SUV remains the most promising sector, in our view, growing at the expense of sedans. SUV growth is expected at 4/28%/2, with sedans at only 7%/5%5% in 13E/14E/15E, based on our forecasts. In the CV segment, buses are expected to outperform trucks in 13E, but growing at a slower rate in 14E and 15E. Figure 7: China PV sales breakdown % 6% 1 11% 13% 16% 19% 21% 75% 72% 69% 7 69% 66% 64% 62% E 2014E 2015E Source: J.P. Morgan estimates. Sedan SUV Minivan MPV Figure 8: China CV sales breakdown % 68% 66% 67% 7 69% 7 7 Source: J.P. Morgan estimates. 8% 8% 1 11% 12% 11% 11% E 2014E 2015E Truck Bus Trailer Chassis Penetration of SUVs set to hit 21% in 2015E, if not higher, versus 13% in We believe the saturation point is ~25-3, which is similar to levels seen in Korea, Taiwan or the US. In the CV segment, trucks and buses are expected to remain at similar market share as seen in 2012: trucks at ~ 7 of total CV market and buses at ~ 11% of total CV. 4

5 Replacement demand to kick in around E China s Rmb4 trillion economic stimulus plan in 2008 during the global financial crisis helped boost PV sales growth to historical highs of 53% in 2009 and then 33% in Such abnormal growth implies two things: On the negative side, some of the demand in was potentially brought forward. Indeed, growth in 2011 did slip to 5% and 2012 remained low at 7%. On the positive side, we should expect the next wave of replacement demand to kick in around E, assuming the average car usage life of 6-7 years. This is also our thesis that new car sales will hit the peak in 2016E at 21-22mn units. Afterwards, we expect growth and absolute volume to both decline towards 2020E; by then penetration of car ownership will reach around 146/1,000 people. Figure 9: China PV sales 000 units, % 53% growth in 2009 and 25,000 33% in ,000 15,000 10,000 5, Source: J.P. Morgan estimates PV sales , E 21, E YoY growth 2018E 2020E Figure 10: China PV sales by region 000 units, 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1, Source: J.P. Morgan estimates E 2016E 2018E Eastern Northern Southern Central Western Northeastern Northwestern 2020E Peak volume likely in ~2016E: China's much distorted sales growth of 53%/33% in 2009/10 due to the Rmb4.0 trillion economic stimulus plan in 2008 suggests the next wave of replacement demand should come in ~2015/16E assuming ~6-7 years of car usage life. We forecast China s passenger vehicle (PV) sales growth to slow, but absolute volumes may not peak until 2016E at 21-22mn units, thanks to affordability or income growth and, to a lesser extent, wealth effect through sustained property price (for now). By region, we expect Eastern China to see the highest PV sales for two reasons: 1) disposable income per capita in Eastern China is expected to reach ~Rmb56k, or 1.2 times the China average by 2020E; and 2) population is expected to be nearly 3 of total China market. Penetration on the rise towards 2020E With our optimistic view on new car sales and growth, we forecast PV penetration, measured by car ownership, will reach ~146 units per 1,000 people by 2020E or more than double from 66 units in Similarly, we estimate the total PV fleet would increase to ~200mn units in 2020 from 89mn units in One key takeaway from this report is we introduce sales volume and penetration forecasts by region in China based on affordability and historical trends of respective regions. 5

6 By region, we believe Eastern China will continue to see the highest level of vehicle fleet due to better affordability, while Northern China (including Beijing) would have the highest level of car ownership. Figure 11: China PV fleet size 000 units 250, , , ,000 50, Source: CEIC, J.P. Morgan estimates , 89, E 2020E, 207, E 2018E 2020E Figure 12: China PV fleet size by region 000 units 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10, Source: CEIC, J.P. Morgan estimates E 2016E 2018E 2020E Eastern Northern Southern Central Western Northeastern Northwestern Total PV fleet size expected at ~200mn by 2020: We believe sales volumes will peak in ~2016 then decline afterwards with the PV fleet size hitting ~200mn units in 2020 vs 89mn in By region, we expect Eastern China to dominate PV ownership in China because: 1) disposable income per capita in Eastern China is expected to reach ~Rmb 56k, or 1.2 times the China average by 2020E; and 2) population set to be nearly 3 of total China market. Figure 13: China PV penetration units per 1000 people Figure 14: China PV penetration by region units per 1000 people , E, Northern Eastern Southern Northeastern Northwestern Western Central E 2016E 2018E 2020E E 2016E 2018E 2020E Source: CEIC, J.P. Morgan estimates. Source: CEIC, J.P. Morgan estimates. China PV penetration estimated at ~146 per 1,000 people by 2020, vs 66 per 1,000 people in This means China will reach similar levels to Taiwan in and Korea in By region, Northern China is expected to see the highest PV penetration. Currently, PV penetration in Northern China is ~1.5 times that of overall China as the PV fleet in this region accounts for 19% of the total China market, while the population is only 12.5% of total China. 6

7 Figure 15: PV penetration comparison units per 1000 people Japan US Korea Taiwan China E 2016E 2018E 2020E Figure 16: GDP per capita comparison USD 60,000 50,000 40,000 30,000 20,000 10,000 0 US Japan Korea Taiwan China E 2016E 2018E 2020E Source: CEIC, J.P. Morgan estimates. Source: CEIC, J.P. Morgan estimates. Note: China GDP per capita forecast for 13E and 14E is from J.P.Morgan economic and policy research team while 15E-18E derived from IMF s growth forecast of 1YoY. Forecasts for 19E and 20E derived from 1YoY growth rate. We forecast China s PV penetration to reach ~146 per 1000 people, or a similar level to Taiwan in and Korea in China s GDP per capita is estimated to reach similar levels to the US in , Japan in , Taiwan in or Korea in Affordability: Richer and richer Affordability measured by disposable or household income has and will continue to be a powerful trend to auto demand. In the last two decades during 1992 to 2012, we find extremely high statistical correlations between per-capita disposable income (for the urban population) and PV penetration in every region across China. Figure 17: PV penetration a function of disposable income per capita (historical analysis from 1992 to 2012) units per 1000 population, Rmb PV penetration (unit per 1000 ppl) Source: CEIC, J.P. Morgan estimates. Northern R² = Eastern R² = Southern R² = ,000 10,000 15,000 20,000 25,000 30,000 Disposable income per capita (urban population) Figure 18: PV penetration a function of disposable income per capita (historical analysis from 1992 to 2012) units per 1000 population, Rmb PV penetration (unit per 1000 ppl) Source: CEIC, J.P. Morgan estimates. Northwestern R² = Northeastern R² = Western R² = Central R² = ,000 10,000 15,000 20,000 25,000 Disposable income per capita (urban population) According to our China economists, Haibin Zhou and Grace Ng, household income growth is expected to remain at a slightly higher rate of GDP or an ~8-1 CAGR in the next couple of years. This implies: 7

8 Overall per capita disposable income in China will exceed Rmb28,000 in This will be higher than the richest region Eastern China s Rmb27,451 as of At similar income growth, even the poorest Northwestern region will exceed Rmb27,000 in 2016E. China s per capita income will likely double by 2020E from Figure 19: Disposable income per capita (urban population) Rmb 60,000 50,000 40,000 30,000 20,000 10, E 2016E 2018E 2020E Source: CEIC, J.P. Morgan estimates. Eastern Southern Northern Central Western Northeastern Northwestern Figure 20: 2020E population forecast by region Million people Source: CEIC, J.P. Morgan estimates. Total China population in 2020E = 1.4bn Western, 164 Northern, 191 Southern, 209 Central, 224 Eastern, 419 China population Northwestern, 102 Northeastern, 112 China's overall disposable income per capita is expected to reach ~Rmb 48k by 2020, or twice the level of 2012 number (Rmb 23.6k). Eastern regions (including Shanghai, Fujian, etc.) are the richest regions, with disposable income per capita at ~1.2x of the country. Economic and compact car most welcome Affordability through growth of disposable income will be a powerful driver to car demand especially in the inner land areas, in our view. As discussed above, with the current run rate, even the relatively poor western China can reach the same level of household income in a couple of years as eastern regions as of The implication of this is simple percentage PV sales growth will be strongest in the mid to lower end segment. By definition, this segment can be categorized as: Either engine size below 2.0 liters Or retail price point below Rmb200,000 Indeed, the latest statistics of Aug-2013 from CAAM (China Association of Automotive Manufacturers) show that, among all domestic-made PVs (including CKD or complete knock-down): Cars with engine size of liters accounts for 61% of total PV sales. Meanwhile, this particular segment grows at 21% YoY vs total PV market's 13% in the same period. This niche segment is predominantly led by Chinese brands, as the price point in this segment is mostly ~Rmb100,000 or below. 8

9 Secondly, cars with an engine size of liters account for 24% of the total market and grew at 13% YoY. The price point of this segment is largely Rmb100,000 to 200,000, with Chinese brands and low-end JV models. Figure 21: China s domestic-made PV sales breakdown (incl. sedan, SUV, MPV and crossover) by engine size by Aug-13 (incl. CKD) liters, 7% liters, 24% Source: CAAM. <1.0 liter, 7% liters, 61% <1.0 liter liters liters liters liters liters >4.0 liters Figure 22: China s domestic made PV sales growth (incl. sedan, SUV, MPV and crossover) breakdown by engine size by Aug-13 (incl. CKD) 25% 2 15% 1 5% -5% -1-15% -2-25% <1.0 liter Source: CAAM. 21% 13% 13% liters liters liters liters liter engine cars are mainly dominated by Chinese brands while are led by Chinese and low-end JV models liters >4.0 liters Total Obviously, compact vehicles, i.e. those with engine size of liters, are the most popular in China. The latest statistics suggest that this segment accounts for 61% of total domestic-made PVs in China and grew at 21% YoY vs overall PV of 13%. Figure 23: China s domestic-made sedan sales breakdown by engine size by Aug-13 (including CKD) , 22% Source: CAAM , 5% <1.0, 3% , 69% < >4.0 Figure 24: China s domestic made sedan sales growth breakdown by engine size by Aug-13 (including CKD) 2 15% 1 5% -5% -1-15% -2-25% -3 Source: CAAM. 16% 5% 1 < >4.0 Total Likewise, in the sedan segment specifically, compact sedans with engine sizes of liters make up an even higher proportion (69%) of the total sedan market in China. This segment is led by Chinese brands with retail price points mainly below Rmb100,000. Sedans with engine sizes of liters account for 22% of the total market and the price point in this segment is mainly Rmb ,000 with players from both Chinese and JV brands (but for JV brands, models are mainly entry level). 9

10 Figure 25: China s domestic-made SUV sales breakdown by engine size by Aug-13 (including CKD, 2-wheel and 4-wheel drive) , 19% Source: CAAM , 5% , , 24% < >4.0 Figure 26: China s domestic made SUV sales growth breakdown by engine size by Aug-13 (including CKD, 2-wheel and 4-wheel drive) Source: CAAM. 176% 32% This segment ( liters) accounts for 24% of SUV sales and grows the fast. It is dominated mainly by Chinese brands This is the biggest segment by volume and most lucrative one. It is dominated by Chinese and JV models. 43% < >4.0 Total In the SUV space, the sales pattern is very much the same as overall PV or sedans: Compact SUVs with engine sizes of liters are the most popular in China accounting for 5 of sales. Retail price in this segment is largely Rmb ,000 and is dominated by both Chinese brands and low-end JV models. In the low end segment, i.e. price point ~Rmb100,000 and below or engine size of liters, it is mainly controlled by Chinese brands. This segment accounts for 24% of total SUV market and grows rapidly at 176% YoY by Aug-13. In the mid end segment, namely price point of ~Rmb ,000 or engine size of liters, it is mainly led by JV models. This segment makes up 19% of the SUV market. Figure 27: China s PV sales volume breakdown by province in 2012 Heilongjiang 2% Xinjiang 2% Tibet Qinghai 2% Inner Mongolia Jilin 2% 3% 4% Liaoning Beijing Hebei 2% Tianjin 6% Shanxi Ningxia Shandong 1% 3% 9% Gansu Henan Jiangsu 1% Shaanxi Anhui 8% 3% 5% Shanghai Hubei 3% 3% 3% Zhejiang Sichuan 2% Chongqing 7% 4% Jiangxi Hunan 2% Guizhou 3% Fujian 1% 2% Yunnan Taiwan Guangxi 2% Guangdong 2% 8% Hainan Source: China Auto Market. 10

11 Capacity is a challenge, but the industry remains highly concentrated The demand to supply ratio can continue to worsen in China's motor vehicle market if we simply take collective capacity expansion plans (on a standard double-shift basis) by OEMs. In 2012 for instance, total PV sales were 15,494k units, while at the same time collective designed capacity in the system is as high as 23mn units, based on our analysis. While we do understand that some of the capacity was only completed during the year and will only translate into production output afterwards and there is a ramp-up period from single to double shifts, the implication for industry players remains the same the sector is potentially facing overcapacity issues and such pressure would only rise in the next couple of years. If we simply look at total sales to year-end capacity ratio, the industry-wide ratio is expected to decline gradually from 66% in 2012 to 56% by 2015E. Similarly, in the PV market, the ratio would drop from 67% to 55% in the same period. Nonetheless, utilization, measured by sales to capacity, varies significantly between the top 10 automakers and the smaller players, and also JVs versus domestic small Chinese brands. As competition continues to intensify, we believe industry leaders will continue to gain share at the expense of the rest. In our analysis, we find: Utilization of top 10 automakers should be sustained at ~8, while the remaining 60 will suffer from 46% in 2012 to below 2 by end-2015e. The auto industry in China remains highly concentrated. The top 10 of the total 70 automakers accounted for 88% of total sales by August this year, a moderate and continued increase from 87% last year. Conversely, the bottom 50 manufacturers altogether only accounted for a meagre 3% by Aug-13. Those are the ones who will suffer the most and would eventually be forced to exit, in our view. Table 2: China auto supply-demand forecast Million units E 2014E 2015E Total auto (PV+CV) Demand (sales) Supply (capacity) Demand as % of supply (capacity) 66% 63% 59% 56% Total PV Demand (sales) Supply (capacity) Demand as % of supply (capacity) 67% 63% 58% 55% Source: J.P. Morgan estimates. 11

12 Figure 28: China auto demand vs supply analysis (PV+CV) Million units 50 66% 63% 59% 45 56% E 2014E 2015E Demand Supply (capacity) Demand as % of supply Source: Company, J.P. Morgan estimates Figure 29: China PV-demand vs supply analysis Million units % 63% Source: Company, J.P. Morgan estimates. 58% 55% E 2014E 2015E Demand Supply (capacity) Demand as % of supply Still over capacity: Our analysis on capacity expansion in China suggests that while industry-wide utilization may drop, continued rising concentration means smaller players would likely suffer most. Total industry capacity (on a double-shift basis) is expected to top ~40mn units by end-2015, implying utilization rates (sales as % of capacity) may drop to ~56% vs ~66% in Meanwhile, overall PV capacity is estimated to reach ~ 37mn by 2015, implying utilization may slip to ~55% from ~67% in Figure 30: Utilization rate analysis: Top 10 players vs the rest 9 76% 85% 81% 76% % 4 23% 3 19% 19% E 2014E 2015E Top 10 players Source: J.P. Morgan estimates, Company data. Others Figure 31: Utilization rate analysis: JVs vs domestic brands 10 93% 9 87% 83% 81% % 5 44% 41% 39% E 2014E 2015E JV Source: J.P. Morgan estimates, Company data. Domestic brand Bigger players enjoy higher utilization rate: As we expect leading automakers would continue to gain market share, utilization (measured by sales as % of year-end capacity) of the top 10 players is expected to stand at around 8 in the next few years, while the overall utilization rate of the other 60 automakers collectively may drop to as low as 19% in 2015 from ~46% in JVs enjoy better utilization rate compared with domestic players, especially small ones. Whilst the utilization rate of JVs is estimated to slip to ~81% by 2015E from 93% in 2012, domestic brands could be worse from 48% in 2012 to 39% in 2015, according to our estimates. 12

13 Figure 32: China autos market share (PV+CV), Jan-Aug 2013 BAIC, 9% Dongfeng, 16% Figure 33: China autos YoY growth (PV+CV), Jan-Aug % Others, 12% 3 29% 29% Jianghuai, 3% Geely, 2% SAIC, 24% 23% 25% Great Wall, Top 10 players: 2 16% 4% 15% 88% of total sales 15% 15% 14% 14% Brilliance, 4% 15% Bottom 50 players: 1 GAC, 4% 5% 5% 3% of total sales 3% 5% Changan, 1 Source: J.P. Morgan,CAAM. FAW, 13% Source: J.P. Morgan, CAAM. Market share: The top 10 of the total 70 automakers accounted for 88% of sales volume during Jan-Aug 2013, while the bottom 50 accounted for merely 3%. YoY growth: Top 10 players exhibited average of 16% YoY growth, while the other 60 players grew at only 3% in Jan-Aug In conclusion, our analysis on auto supply and demand in China suggests that while industry-wide utilization may drop, continued rising concentration means smaller players would likely suffer the most. Two major policy initiatives in 2014 We expect two major policies in the automobile space next year: Car purchase restrictions to be implemented in selective tier-two cities or provinces, as Chinese leaders attempt to control air-pollution and curb worsening traffic congestion. Encouragement of new energy cars, especially EV (electric vehicles). It is clear that China has "skipped" the first stage in development of new energy cars (i.e. hybrid) and directly focuses on the other three-plug-in hybrid, fuel-cell vehicle and pure EV when we examine its nationwide subsidy plan. First, further car purchase restrictions still likely We believe tackling pollution remains one of the top policy priorities in China. While trying to predict Chinese leaders policy moves is unwise, we maintain our view that the likelihood of implementing car purchase limits or quotas in selective tier-two cities or provinces remains high next year. Where is the auto industry responsible for air pollution? Autos contribute the majority of toxic gas and inhalable particles. According to China s Ministry of Environmental Protection (MEP) and our analysis: 13

14 The inconvenient truth: 1. Less than 15% of motor vehicles contribute over 4 of total vehicle emissions in China 2. The auto industry accounts for around 27% of NOx emissions in China 3. Diesel vehicles (mainly trucks) generate more pollution than petrol-powered vehicles Motor vehicle accounts for around 27% of total NOx (nitrogen oxide) emissions in China. The remainder is from thermal power and non-metal mining industry (which together account for more than half of NOx emissions). Within the auto industry, related pollutants in addition to NOx include CO (carbon monoxide), PM (particulate matters) and HC (hydrocarbon). Nearly 6 of NOx emissions are from diesel-powered vehicles, mostly trucks. Over 9 of PM emissions are from diesel vehicles, mostly trucks. 7 of CO and HC emissions are from petrol-powered vehicles, of which, most are poor quality fleet. When examining China s passenger vehicle (PV) fleet, we find that only around 4 of the motor vehicle fleet meets China III (equivalent to Euro III, which was implemented in July 2007) emission standards. Of the remainder, around 25% only meet China II, ~2 China I and the rest ~10-15% not even China I. However, those vehicles which fail to meet China I standards (i.e. less than 15% of vehicles) contribute over 4 of total vehicle emissions in China. Likely outcome Currently, three tier-one cities have already introduced car plate quotas or purchase restrictions: Shanghai was the earliest in 1994, followed by Beijing on Dec 23rd 2010 and Guangzhou on June 30th Table 3: Car licence scheme comparison in tier-one cities Beijing Shanghai Guangzhou How to acquire a car plate Lottery Bidding Bidding Lottery Last average bidding price RMB 84k RMB 12k Bidding rate/winning rate 1% 37% 10 5% Holding period 3 years 3 years 3 years For electronic vehicles No detail Free plate Lottery (current winning rate is 10) Avg license price in the 2nd hand market >RMB 150k RMB 81~82k n/a Source: Beijing Municipal Commission of Transport, GEMAS, Shanghai Municipal Transport and Port Authority. Share price implications What can we learn from history? In the following analysis, we examine the share price performance of all major OEMs (mainly H shares) three months after the car purchase restrictions were put in place in Beijing in Dec-10 and Guangzhou in Dec-12. We arbitrarily exclude Shanghai in the analysis here as the purchase restriction was implemented a while ago (1994); auto industry dynamics are very different in the last few years versus nearly two decades ago, in our view. Our findings are: Three months following Beijing s imposed car purchase quota, the share prices of Great Wall, SAIC and Brilliance China outperformed the market while Dongfeng Motor, Guangzhou Auto (GAC) and Geely underperformed. 14

15 Similarly, three months following Guangzhou's implemented car plate quota, Great Wall, Brilliance China and SAIC still outperformed, while Geely was largely in line but Dongfeng and GAC underperformed. Among the outperformers in the last two cycles', Great Wall and Brilliance China are proxies for China's SUV and luxury car players, as Great Wall is the first among listed companies to have meaningful exposure (in terms of percentage contribution to the top and bottom line) to SUVs, while Brilliance has a JV with BMW, producing BMW s 3- and 5-series sedan and X1 compact SUV. On the other hand, Dongfeng Motor and GAC underperformed in the analysis here as they are proxies for the mass market, in our view, given their volume and price points in the retail market. As a result, we believe if China does impose a broader scale of car purchase limits as we expect now, the share price of Dongfeng (Underweight) might be under pressure again as it is perceived as mass market players with exposure to tier 1 to 5 cities. On the other hand, we believe niche players, such as Brilliance China, Great Wall as well as Geely should weather such regulatory "storm" better given their focus on the luxury car and SUV segments, respectively. We expect both segments to be a multi-year theme. Figure 34: Three-month relative share price performance of major OEMs following Guangzhou imposed car purchase restriction on June 30th (10) (20) (30) (40) Source: Bloomberg. Consistent outperformers Underperformers T+90 T+88 T+86 T+84 T+82 T+80 T+78 T+76 T+74 T+72 T+70 T+68 T+66 T+64 T+62 T+60 T+58 T+56 T+54 T+52 T+50 T+48 T+46 T+44 T+42 T+40 T+38 T+36 T+34 T+32 T+30 T+28 T+26 T+24 T+22 T+20 T+18 T+16 T+14 T+12 T+10 T+8 T+6 T+4 T+2 T Geely Great Wall Dongfeng Brilliance GAC SAIC Great Wall Brilliance SAIC Geely GAC Dongfeng Figure 35: Three-month relative share price performance of major OEMs following Beijing imposed car purchase restriction on December 23rd (10) (20) (30) Source: Bloomberg. Consistent outperformers Underperformers T T+3 T+6 T+9 T+12 T+15 T+18 T+21 T+24 T+27 T+30 T+33 T+36 T+39 T+42 T+45 T+48 T+51 T+54 T+57 T+60 T+63 T+66 T+69 T+72 T+75 T+78 T+81 T+84 T+87 T+90 Geely Great Wall Dongfeng Brilliance GAC SAIC Great Wall SAIC Brilliance Dongfeng GAC Geely Second, encouragement of new energy car China s NDRC recently jointly announced with the Ministry of Industry and Information Technology (MIIT) the subsidy policy for new energy cars, covering: 1. Pure electric vehicle (EV) 2. Plug-in hybrid (but not hybrid) 3. Fuel-cell vehicle 15

16 Of note is that there is still no subsidy for hybrids at a national level, but only for plug-in hybrids (up to Rmb35k), although there is no commercially available plug-in hybrid model in China now. Our sensitivity analysis on the potential size of the EV market in China Table 4: Base case analysis on various assumptions of sales volume, ASP and margin Total addressable market analysis Aggregate sales volume in E (units) In the following analysis, we adopt various assumptions to derive our assessment of the potential size of the EV market in China: Total aggregate volume (units) Estimated ASP (Rmb'000/unit) Estimated net margin (%) Estimated net profit per car (Rmb'000) Total revenue (RMBmn) Total profit (RMBmn) No. of tier one cities 5 10,000 50, % , No. of tier two cities 35 5, , % ,000 1,050 Total = 225,000 45,000 1,350 Source: J.P.Morgan. Table 5: Sensitivity analysis on industry volume, revenue and profit on different assumptions Sensitivity analysis Total sales volume (units, E) Total revenue in addressable target market (Rmb million) Total profit in addressable target market (Rmb'000) Total sales volume % to 2013E PV market Base case 225,000 45,000 1, % Scenario (1): Sales volume 1 higher 247,500 49,500 1, % Scenario (2): Sales volume 2 higher 270,000 54,000 1, % Scenario (3): ASP 1 higher 225,000 49,500 1, % Scenario (4): ASP2 higher 225,000 54,000 1, % Scenario (5): Net margin 4% 225,000 45,000 1, % Scenario (4): Net margin 5% 225,000 45,000 2, % Source: J.P.Morgan. With the above assumptions, we find: 1. Collective size of new energy cars in E would range around ,000 units. This is equal to % of the total PV market in 2013 based on our estimates; in other words, EV and new energy cars will remain a tiny portion of China s passenger vehicle market even by 2015E. Likewise, CAAM (China Association of Automotive Manufacturers) forecasts total EV and new energy cars will top 273,000 units by 2017E from merely 27,432 units in Even so, 273,000 units represent only 1.6% of China's PV market in In terms of potential industry revenue, it would be around Rmb45-54 billion. Assuming automakers can make a profit from new energy car business, at 3-6% net margin, estimated industry profit can top Rmb bn. Who are relevant players in the EV theme? Whilst the size of total EV market in China will likely remain tiny, it could be meaningful as we believe only a few selective players will be viable players and share this niche business: Brilliance China is scheduled to introduce its own-brand EV, Zinoro, in end-13, based on jointly developed technology with BMW. Brilliance targets to sell collectively 1,000 units of EV in , equivalent to 0.5% of Brilliance's estimated sales in 2013E. We believe Brilliance China can reach higher sales volume through ramping up its capacity if there is such demand. 16

17 BYD currently has e6, a crossover EV with sales of 1,690 units last year or 0.4% of its total vehicle shipment. BYD also has electric buses that can benefit from the subsidy program. Geely s Panda compact EV, while not widely commercially available in the market now, sources technology from its 50-5 JV with Kandi Technologies (stock code: KNDI US). Guangzhou Auto's Toyota Camry hybrid, although not covered by NDRC's national subsidy program, receives Rmb10k subsidy from Guangzhou government. Two company-specific events Great Wall Motor (GWM) First Chinese automaker attempting to penetrate into mid-end market. Can it succeed? We believe so despite 80-9 of people disagreeing or doubting GWM is scheduled to launch its largest SUV, H8, in late Expected price point of the model will be around Rmb200,000, at a similar level to several most popular SUV models by JVs, such as Honda CR-V (retail price range ~Rmb k), VW Tiguan (~Rmb k), Toyota RAV4 (~Rmb k) and Ford Kuga (~Rmb k). The consensus belief is that GWM's H8 will not sell simply because Chinese customers wouldn t bother buying a local brand when they have several choices from local-made models by established foreign brands at the same price point. This is only partially true. Contrary to consensus, we believe GWM s H8 will be a success because it creates a new market that simply wasn't available in the past with the same budget. Specifically, what differentiates H8 from other JV models in the same price level is: H8 is significantly larger in size; equivalent JV models mentioned above in the same price level are much smaller. In other words, if Chinese customers want to buy an SUV with the same size of H8, their budget needs to be at least nearly twice as high in the past. It is not the case anymore as they will have a new choice (i.e. H8) that was completely not available in the marketplace before. Functionality of H8 is much better than equivalent models in the same price point, such as window roof, keyless-go, all-in-one control panel (including multi-media and GPS navigation system), automatically adjust seats, 6 air bags, section air-conditioner, etc. Such functionality is almost completely not available from JV models in the same price level. In other words, if Chinese customers want to buy an SUV equipped with such functionality, they have to buy the highest-end JV models or imported ones which are priced 2-4 times higher. Surely, we understand quality, durability and price in the second hand car market of H8 and other JV models would be different. We believe H8 would be a success if it can reach ~3,000 units of monthly sales in 1H14 and gradually ramp up to ~5,000 units per month in 2H14. Such volume expectations are not aggressive, in our view, when considering current monthly sales volume of equivalent JV models in 1H13- e.g. VW Tiguan around 16-17k units, Honda CR-V around 14k units, Toyota RAV4 around 7k units and Ford Kuga around 6k units. 17

18 Figure 36: Great Wall s H8 SUV first seen in Shanghai Auto Show in April 2013 (exterior) Figure 37: Great Wall s H8 SUV first seen in Shanghai Auto Show in April 2013 (interior) Source: Photo taken in Shanghai Auto Show in April-13. Source: Photo taken in Shanghai Auto Show in April-13. Table 6: Comparison of price and size of major large size SUV in China Size (mn) GWM H8 Toyota Highlander Hyundai Santafe Audi Q5 Audi Q7 (imported) Length 4,806 4,795 4,725 4,629 5,089 Width 1,975 1,910 1,880 1,898 1,983 Height 1,794 1,760 1,686 1,656 1,737 Retail price (Rmb'000) ~ ,578 Source: Respective automaker. The size of GWM s H8 SUV is larger than most domestic-made JV models and with a lower price point. Meanwhile, entry-level JV models normally are equipped with only basic functionality and not as fancy as the H8. Geely Auto: Asset injection from Volvo operation in China Volvo currently has three major operations or production plants in China Chengdu, Daqing and Taizhou. The Chengdu and Daqing plants are expected to manufacture S60 long-wheel base sedans and XC90 SUV, respectively, and both will start production in 2H13. Presently, Geely s parent company holds 7 of Volvo operations in China and the rest is held by Volvo itself. Under China's regulations, foreign partner's holding in an automaker in China can not exceed 5 (and Geely listco is considered a foreign company given it is registered in the Cayman Islands). We believe Geely s parent will plan to inject its stake in Volvo into Geely listco when Volvo China turns profitable sometime toward end This, if it materializes, would be a major positive event for Geely listco, in our view. Whilst it is still sometime from here, the key to watch, in our view, is Volvo's sales performance in China as it not only implies the profitability of Volvo but also the timing of such asset injection. In fact, in the year to date, Volvo's sales growth in China has beaten most of its comparable European peers. 18

19 In the following sensitivity analysis, we estimate the profit contribution to Geely could range from ~Rmb mn in 2015 if the asset injection takes place in late This would be equivalent to 12-19% of Geely's anticipated profit in Table 7: Profit contribution estimate from Volvo asset injection to Geely listco in 2015 based on various assumptions Base case Daqing plant Chengdu plant Total Models XC90 SUV S60L sedan Expected sales volume in ,000 40,000 50,000 Estimated net profit per unit (Rmb'000) Estimated profit (Rmb millions) 800 1,600 2,400 Geely parent holding 7 Profit to Geely parent (Rmb millions) 560 1,120 1,680 Injection to Geely listco (assuming 2) 2 Profit contribution to Geely listco Source: J.P.Morgan estimates. Table 8: Sensitivity analysis of profit contribution to Geely listco based on different assumptions from base case Scenario analysis Profit contribution (Rmb million) Base case 336 Volume 1 higher 347 Volume 2 higher 358 Profit per unit 1 higher 347 Profit per unit 2 higher 358 Asset injection 25% stake 420 Asset injection 3 stake 504 Source: J.P.Morgan estimates. Valuation and recommendation Our preference in Chinese auto stocks is OEM over parts or dealers, and SUV over sedans. Our top picks include: Great Wall Motor (OW): Our view on GWM is simple: investors should hold on to the stock throughout the SUV up-cycle until it peaks out in ~2016E. From a bottom-up perspective, we would watch price discount momentum of its major models as a leading indicator of underlying competition dynamics. At the moment, the discount of GWM's most popular SUV, H6, remains negligible at ~2%. Guangzhou Auto (OW): GAC is a turnaround story driven by its comprehensive new model cycle in the next months. (please click here for detailed analysis on GAC). Between two major SOEs, we prefer GAC over Dongfeng Motor (Underweight). Brilliance China (OW): We believe Brilliance is a long-term strong story, driven by potentially better-than-expected earnings in 2H13 in the near term and also the introduction of the BMW X5 SUV in late-15 or 2016 which could bring significant profit to the company. 19

20 Geely Auto (OW): Geely is a late comer in China s SUV theme. We believe its sales momentum in SUV should pick up strongly from 1Q14 vs the current monthly run rate as the company revises interior designs and also introduces another model (EX8) in late-13. Instead of purely focusing on monthly sales, we would watch Volvo s localization and corresponding sales performance in 1H14 in China closely as it is leading indicator of potential timing and profit size of Geely's asset injection story towards late On the cautious side, our bearishness is with: Dongfeng Motor (UW): We believe DFM is a fundamental avoid stock in China in the long term due to inefficient allocation of capital, which explains why its ROE is anticipated to decline almost every year since 2012 based on either our forecasts or Bloomberg consensus. Arguing DFM is a Buy due to its cheap valuation wouldn't work, in our view, as the stock is on average trading at ~9x forward PER in the last three years due to a lack of capital management. The company's recent acquisition or expansion into truck business (with Volvo Truck) and also PSA further enhances our reservation on the stock. Zhongsheng Auto (UW): We believe the stock has run ahead of its fundamentals. Our UW is a valuation call as we would find the stock more attractive towards ~HK$8-9/shr. (Please also click here for our recent analysis on its valuation). Table 9: Valuation comparison table for China s auto companies Company Code Rec Price Mkt Cap (LC) (US$ Mn) PE(x) PB(x) ROE Div. Yield 11-Oct 11-Oct 13E 14E 13E 14E 13E 14E 13E Brilliance 1114 HK OW , % 27% 1. ZhengTong Auto 1728 HK N , % 14% 0.9% DongFeng Motor 489 HK UW , % 16% 2.1% Great Wall Motor 2333 HK OW , % 38% 0.8% Geely 175 HK OW , % 2 1.2% GAC 2238 HK OW , % 12% 0.3% Minth Group 425 HK N , % 13% 2.3% Baoxin Auto 1293 HK N , % 27% 0. Zhongsheng 881 HK UW , % 15% 1.1% Sinotruk 3808 HK UW , % 3% 2.6% Average % 18% 1.2% Source: Bloomberg, J.P. Morgan 20

21 Table 10: Summary of PTs and risks Company Ticker Rtg Share price PT 11-Oct (HK$) (HK$) Brilliance China 1114 HK OW China ZhengTong 1728 HK N DongFeng Motor 489 HK UW Great Wall Motor 175 HK OW Geely Auto 2333 HK OW PT analysis We remain OW. Our PT (June-14) is HK$13 based on 13x forward PER. This is based on the average and midend of the company s historical trading range (~9-17x) in the last couple of years. We believe this is reasonable considering the company's exposure to China's luxury boom but also in light of increasing competition in China in 2H In the Chinese luxury car segment, Brilliance is our preferred pick. We are Neutral and our Jun-14 PT is HK$5.5 based on SOTP analysis where we examine and differentiate underlying values between aftermarket and new car sales businesses. We estimate ZhengTong s afterservice business alone is worth HK$4.0/shr (on DCF basis). This implies the market is currently paying a low multiple to the company's new car sales, accessory and future car finance businesses. This is potentially aggressive, in our view, although we also recognize that cheap valuation itself is rarely a share price catalyst. Our June-2014 PT is HK$8.5 based on FY13E P/E of 6.5x and DCF analysis. This multiple is the mid-range of DFM s historical trough valuation of around 5-8x forward P/E. Given our expectation that DFM will be undergoing a de-rating (due to competition from entry level luxury brands and weak truck demand), we believe that applying an average trough valuation is reasonable. In our DCF analysis, our key assumptions include riskfree rate of 5%, risk premium 6%, WACC of 12% and terminal growth of 2%. We maintain OW on GWM with PT of HK$65 (Dec-14) on 13x forward PER. Here we take into account nearly 2 earnings upgrade in 2014 and potential re-rating resulting into PER expansion given our bullish view on SUV and GWM's H8/H2 new model launches. Historically, GWM is trading at largely 10-12x PER with the peak of 18x when it was re-rated. We believe a rerating is possible in 2014 and hence see our 13x PER as reasonable. We maintain our OW rating on Geely and June-14 PT is HK$7.5 based on 13.5x forward PER or the higher end of its historical trading band but in line with Great Wall Motor when it re-rated back in when the PER multiple expanded from 5x to 18x. This may sound aggressive, but we believe it's not considering Geely's rapid growth expected in the next 3-4 years, which suggests a PEG of only x. Similarly, during the rerating cycle of Geely s closet peer- Great Wall Motor, its PER multiple expanded from ~5x to 18x in Considering Geely s strong model line-ups in Risks to PT and analysis Key risks include weaker-than-expected sales volume of BMW s cars in China, and a sharperthan-expected price cut in China s auto market, including luxury segment that Brilliance focuses on. We are also cautious on any higher-thananticipated loss from mini buses and future new energy car business. Key upside and downside risks include: (1) better or worse than expected sales volume and margin, 2) ability to refinance upcoming due Rmb2.0bn debt and lower interest in 4Q13. Key upside risks to our PT include: (1) betterthan-expected sales of Japanese cars in China, including DFM s Nissan and Honda vehicles, (2) stronger-than-expected margin improvement for its passenger and commercial vehicle businesses, (3) higher than expected dividend payout and hence higher yield. Key downside risks to our PT: worse-thanexpected competition in SUVs and pick-up trucks, both of which are Great Wall s target segments. Also, policy risk such as car purchase restrictions can lead to negative sentiment in the broader auto market in China. Key risks to our PT include: Lower-than-expected sales volume of Geely s sedan and SUV businesses and lower-than-expected margins on heightening competitive pressure along with an oversupply in the passenger vehicle sector in 2H13-14E leading to a worse-than-expected price war. Slower-than-expected development and cooperation with Volvo Car is another potential swing to the company s longer-term profitability and share price performance.. 21

22 GAC 2238 HK OW Minth 425 HK N Baoxin Auto 1293 HK N Zhongsheng 881 HK UW Sinotruk 3808 HK UW Source: Bloomberg, J.P. Morgan. both sedan and SUV business in 2H E, JV development with Volvo in 2014 and consensus earnings upgrade (which has been the case since 4Q12), we believe our PT is achievable.. We remain OW on GAC and expect consensus to catch up with our 2014/15 estimates. Our June-14 PT of HK$12 is based on an expected re-rating multiple of 14x and DCF analysis. We believe this target is achievable considering GAC's estimated robust profit rebound in the next two years. In the DCF analysis, key assumptions include a risk free rate of 5%, a risk premium of 6% and terminal growth of 2%. We maintain a Neutral rating on Minth. Our PT HK$12 (June-2014) is based on 10x forward PER, which is the average of Minth's historical average since We believe this approach is reasonable considering 1) the company s improving sales momentum of Japanese brands and 2) higher cash dividend payout- 4 this year (vs 3 in the last few years). This places Minth at the highest payout auto company in our coverage universe in the China auto space. Our Jun-14 PT of HK$7.00 is based on an SOTP analysis where we examine the underlying value between aftermarket and new car sales businesses. We estimate Baoxin s AM business alone is worth HK$5.00/share (on a DCF basis). On the new car sales business, we assign an industry average P/E of 10x, which we consider reasonable in a stabilizing pricing environment in the dealership business. Our Jun-14 PT of HK$8.0 is based on a conservative AM business value (HK$6.5/shr on DCF analysis with key assumptions including discount rate 11% and terminal growth 3%) plus 6.0x new car sales 2014E multiple (similar to its peers, Zhengtong or Baoxin) We maintain our UW rating on Sinotruk. PT (June-14) is HK$3.7 based on conservative P/B multiple of 0.4x. We believe this is reasonable as 0.4x is the trough valuation of the company's historical trading band (largely between 0.5 and 1.0x). This is based on our longer-term cautious stance on China s truck sector. Key downside risks include: (1) worse-thanexpected sales volumes and margins; and (2) a failure of new model launches in 2H Key downside risks to our PT include weakerthan-expected passenger vehicle sales and a price war in China s passenger vehicle sector forcing OEMs to cut their purchase prices of auto parts. Key upside risks to our PT include: (a) a valueaccretive M&A in Japanese auto parts market; (b) faster- and sharper-than-expected recovery in China's car market. Key upside and downside risks include: (1) better- or worse-than expected sales volumes and margins; and (2) a better- or worse-than anticipated macro environment and credit conditions in China in 2H13. Key risks to our PT and analysis include: a) better-than-expected improvement of Japanese brands in China in 4Q , b) Benz reverses its sales and pricing momentum and catches up with its peers-bmw and Audi in China. c) higher than anticipated support from automakers in the form of rebate or subsidy to dealers. Key upside risks to our price target and analysis include: (1) stronger-than-expected heavy-truck demand in 2H E; and (2) another major economic stimulus from the government. 22

23 Great Wall Motor Company Limited Can a stock perform after 50 rally? Overweight 2333.HK, 2333 HK Price: HK$46.20 Price Target: HK$65.00 Previous: HK$46.00 Great Wall (GWM) has rallied by over 50 in the last three years (Hang Seng index returned 3% over the same period), thanks to solid earnings growth and SUV up-cycle. Despite this, we maintain our bullish stance on the stock and further raise our earnings and PT again both now stand at the highest end of the Street. GWM is one of our top picks in China s auto space together with Brilliance, GAC and Geely. Why so bullish? Our investment thesis on GWM is simple Investors will be better off holding on to a stock throughout its cycle until it peaks than trying to buy low/ sell high during the cycle. Downgrading a stock during its up-cycle is generally wrong in our view which we witness from consensus rating changes YTD (according to Bloomberg). In the case of SUVs, we believe penetration will not hit saturation point in China until ~2016E. From a bottom-up view, we believe price discounting is a leading indicator of competitiveness and popularity of underlying models. In GWM s case, discount of its SUVs is merely ~2-3%. Consensus too bearish about GWM s H8 SUV launch: GWM is scheduled to launch its highest end SUV (H8) in end-13 which will be priced at ~Rmb200k, a similar level to several entry level SUV models by JVs. We believe H8 will be successful with its much better functionality and larger size. In other words, H8 is a new product and creates a new market that wasn't available in the past for the same budget. Earnings upgrade: Back in March when GWM reported strong 2012 results, our earnings estimates and PT were among the highest on the Street (click here). The stock s continued performance has invited several downgrades afterward which we believe was too early. To reinforce our bullish view; we are revising our 2013/14E estimates by 1%/19% respectively. Our 2014 forecast now stands at 24% above consensus. Rating, risk: We retain our OW on GWM and increase our PT to HK$65 (Dec-14) on 13x PER from previous HK$46 (Jun-13 or 11x). Risks: worse than expected sales and production shortfall from capacity bottleneck. (Please also refer to our sector note on Oct 13th China Auto 2014 for further discussion of our bullish view on SUV and GWM). China Automobile Manufacture Nick Lai AC Bloomberg JPMA LAI <GO> J.P. Morgan Securities (Asia Pacific) Limited YTD 1m 3m 12m Abs 85.2% 11.3% 26.7% % Rel 96.3% 11.8% 15.9% % Great Wall price performance (rebased) Source: Bloomberg Great Wall Motor Company Limited (Reuters: 2333.HK, Bloomberg: 2333 HK) Rmb in mn, year-end Dec FY11A FY12A FY13E FY14E FY15E Revenue (Rmb mn) 29,037 41,565 54,195 71,497 82,203 EBIT (Rmb mn) 4,090 6,833 10,176 14,095 15,819 Net Profit (Rmb mn) 3,426 5,692 8,575 11,832 13,305 EPS (Rmb) DPS (Rmb) Revenue growth (%) 30.9% 43.1% 30.4% 31.9% 15. EPS growth (%) 23.6% 53.7% 50.6% % ROE 25.6% 29.8% % 32.1% P/E (x) P/BV (x) Dividend Yield 0.5% 0.8% 0.8% 1.6% 2.7% Source: Company data, Bloomberg, J.P. Morgan estimates. Company Data 52-week Range (HK$) Shares O/S (mn) 3,042 Market Cap (Rmb mn) 110,911 Market Cap ($ mn) 18,127 Price (HK$) Date Of Price 11 Oct 13 Free Float(%) M - Avg daily volume (mn) M - Avg daily value ($ mn) 27.1 HSCEI 1, Exchange Rate 7.75 See page 29 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.

24 Key catalyst for the stock price: Upside risks to our view: Downside risks to our view: 1) Strong earnings results in 3Q13 in late Oct ) Successful model launch especially H8 SUV in late ) Longer term, consensus earnings upgrade in 2014 where we are 24% above the Street 1) Sales performance of its SUV models especially H8 2) Sustainability of margin in ) Competition in SUV business leafing to price competition and margin contraction 2) Failure of new model launches including H8 and H2 SUVs in 4Q13-1Q14 Key financial metrics FY12A FY13E FY14E FY15E Valuation and price target basis Revenues (LC) 41,565 54,195 71,497 82,203 We maintain OW on GWM and increase our PT to HK$65 (Dec-14) on Revenue growth (%) 43.1% 30.4% 31.9% x forward PER from previous HK$46 (Jun-14, on 11x PER). Here EBITDA (LC) 7,723 10,658 14,655 16,437 we take into account nearly 2 earnings upgrade in 2014 and EBITDA margin (%) 18.6% 19.7% 20.5% 20. potential re-rating resulting into PER expansion given our bullish view Tax rate (%) % 15.7% 16. on SUV cycle and GWM's H8/H2 new model launches. Historically, GWM is trading at largely between 10-12x PER with the peak of 18x when it was re-rated. We believe a re-rating is possible in 2014 and Net profit (LC) 5,692 8,575 11,832 13,305 hence see our 13x PER reasonable. EPS (LC) EPS growth (%) 53.7% 50.6% % GWM forward PE band DPS (LC) BVPS (LC) Operating cash flow (LC mn) 4,337 9,207 12,577 14,057 Free cash flow (LC mn) 90 5,712 10,082 11,564 Net margin (%) 13.7% 15.8% 16.5% 16.2% Sales/assets (X) Net debt/equity (%) (29.3%) (39.1%) (50.7%) (57.4%) ROE (%) 29.8% % 32.1% Key model assumptions FY12A FY13E FY14E FY15E Auto sales growth (YoY) 38% 36% 33% 15% Auto gross margin 27% 28% 28% 28% Source: Bloomberg, Company and J.P. Morgan estimates. Source: Bloomberg, Company and J.P. Morgan estimates. Sensitivity analysis Impact on EBIT (%) Impact on EPS (%) JPMe vs. consensus, change in estimates Sensitivity to FY13E FY14E FY13E FY14E EPS FY13E FY14E 1% decrease in sales volume -0.8% -0.8% -0.8% -0.8% growth JPMe old % decrease in gross margin -5.3% -5.1% -5.3% -5.1% JPMe new assumption % chg % Consensus Source: Bloomberg, Company and J.P. Morgan estimates. Source: Bloomberg, Company and J.P. Morgan estimates. China auto valuation summary Company Code Rec Price Mkt Cap (LC) (US$ Mn) PE(x) PB(x) ROE Div. Yield 11-Oct 11-Oct 13E 14E 13E 14E 13E 14E 13E Brilliance 1114 HK OW , % 27% 1. ZhengTong Auto 1728 HK N , % 14% 0.9% DongFeng Motor 489 HK UW , % 16% 2.1% Great Wall Motor 2333 HK OW , % 38% 0.8% Geely 175 HK OW , % 2 1.2% GAC 2238 HK OW , % 12% 0.3% Minth Group 425 HK N , % 13% 2.3% Baoxin Auto 1293 HK N , % 27% 0. Zhongsheng 881 HK UW , % 15% 1.1% Sinotruk 3808 HK UW , % 3% 2.6% Average % 18% 1.2% Source: J.P. Morgan estimates, Bloomberg. 24

25 Table 11: Great Wall Motor earnings revisions RMB mn 2013E 2014E Revised Previous Change % Revised Previous Change % Net Sales 54,195 54, % 71,497 62, % Sales growth (%) 3 32% 32% 14% COGS -38,355-39, % -50,426-45, % Gross profit 15,839 15, % 21,071 17, % Gross margin (%) 29.2% % 28. Operating profit 10,176 9, % 14,100 11, % Operating margin (%) 19% 18% 2 19% Pre-tax profit 10,205 10, % 14,125 11, % Net profit 8,575 8, % 11,832 9, % Net margin (%) 16% 15% 17% 16% Net profit growth (%) 51% 49% 38% 17% EPS % EPS growth (%) 45% 43% 38% 17% Source: J.P.Morgan estimates. Table 12: GWM earnings estimate comparison between J.P. Morgan and Bloomberg consensus RMBmn 2013E 2014E JPM 8,575 11,832 consensus 7,955 9,578 Difference (%) 8% 24% Source: J.P. Morgan. Bloomberg. Figure 38: Great Wall H-share vs A-share Rmb Figure 39: Great Wall A-share Premium (as % of H-share) Source: Bloomberg. Source: Bloomberg. 25

26 Figure 40: GWM forward PE band Figure 41: GWM forward PE with +/-1.0 standard deviation Source: Bloomberg, J.P.Morgan estimates. Source: Bloomberg, J.P. Morgan estimates. Figure 42: GWM forward PB band Figure 43: GWM forward PB with +/-1.0 standard deviation Source: Bloomberg, J.P. Morgan estimates. Source: Bloomberg, J.P. Morgan estimates. 26