Dim Sum Express. A-Share Market. Hong Kong Market. Equity Research. Oct 16, 2015

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1 Equity Research Dim Sum Express Key index performance Chg (%) EPS (%) P/E Market 1D 1M YTD 15E 16E 15E 16E HSI HSCEI MXCN SHSZ SHCOMP SZCOMP INDU SPX CCMP UKX NKY Hong Kong ADRs HK ticker Company Local (HK$) Daily (%) ADR (US$) Daily (%) 941 CHINA MOBILE ICBC PETROCHINA CCB TENCENT BANK OF CHINA HSBC CHINA LIFE PING AN SINOPEC Econ data release China Data Date Period Prior Cons Ind Prod Growth Cum 19-Oct SEP Ind Prod Growth Mthly 19-Oct SEP FAI Cum YoY 19-Oct SEP Retail Sales Cum 19-Oct SEP Retail Sales Mthly 19-Oct SEP GDP Cum YoY 19-Oct 3Q GDP QoQ 19-Oct 3Q GDP Quarterly YoY 19-Oct 3Q US Data Date Period Prior Cons Existing Homes Sales 22-Oct SEP Initial Jobless Claims 22-Oct Cont Jobless Claims 22-Oct Source: Bloomberg A-Share Market Insurance: Market-driven reform the focus of industry law revision The concept of an insurance consumer is brought up for the first time in a revision to the Insurance Law recently submitted for review. This is meaningful given the current lack of transparency in the industry and the large number of frauds and disputes. Consumer protection measures should help improve the overall image of the industry. Under a new solvency regulatory framework, insurance companies with greater capital strength will benefit from more lenient capital requirements. It can be seen as a market-driven mechanism put in place by the regulator to phase out uncompetitive firms. Machinery: 9M15 earnings preview The medians of the forecasted 9M15 earnings range provided by 189 companies add up to Rmb8,984m, representing a YoY decline of 35.9%, which was worse than the actual earnings decline of 31.2% YoY for 1H15. We believe recently issued supportive measures for the property and auto sectors are not sufficient to reverse the slowdown in their related sectors, and that stronger policy support will be needed before machinery demand can pick up. We are particularly positive on the automated equipment, rail, nuclear power and auto aftermarket subsectors. Hong Kong Market Biostime (1112 HK, Buy): A phoenix rising from the ashes The success of Biostime s newly acquired Swisse in China s online health product market means that cross-border e-commerce would be a key area of business development for Biostime. Risks related to increased financing costs, potential goodwill write-down and competition from overseas products should be controllable. We expect Biostime s 2016 and 2017 earnings growth to come in at 93.4% and 9.8% YoY. We value its infant milk formula business at 8x and Swisse at 15x P/E. We upgrade our rating from Underperform to Buy with our target price raised to HK$17.56, equivalent to 10.9x 2016E P/E, from HK$ Non-Bank Financials: Sector update In the securities sector, comprehensive income for A-share firms rose 181% YoY in 9M15. The NEEQ issued preferred share guidelines before the National Day holiday the new exchange s financing functions should see further improvements along with further supportive policies from the CSRC. In insurance, The NDRC and CIRC have jointly issued guidelines for insurance companies to support key construction projects, while the CIRC has also issued a notice on the promotion of participating life insurance pricing policy reform, which should benefit future premium growth. GF events Date Event Location 19 Oct Peak Sport investor luncheon Hong Kong Source: GF Securities (HK) Alex Fan, CFA, Head of Research, SFC CE No. ADJ672 alexfan@gfgroup.com.hk Gao Yedong, Editor, SFC CE No. BAI002 yedonggao@gfgroup.com.hk

2 Insurance: Market-driven reform the focus of industry law revision Law revision as part of ongoing industry reform A consultation paper on the CIRC s draft revision of the Insurance Law has been submitted for review. This came after a series of industry reform measures issued so far this year, including the preferential tax policy for purchasing health insurance introduced in 1H15, and the latest pricing reform for personal participating insurance. This draft revision to the Insurance Law reaffirms the importance of the insurance industry and the long-term goal to achieve market-driven industry operations. Consumer protection to improve industry image The concept of an insurance consumer is brought up for the first time in this revision, which is meaningful given the current lack of transparency in the industry and the large number of frauds and disputes. Some of the key issues are addressed: insurance agents are forbidden to conduct misleading marketing activities and divulge customer information; in addition, long-term policyholders (with contract duration above one year) should be granted a cooling-off period of 20 days. These consumer protection measures should help improve the overall image of the industry. New solvency regulation to phase out less competitive players China s new generation of riskoriented solvency regulatory framework is also touched upon in the paper. Under this new regulatory framework, insurance companies with greater capital strength will benefit from more lenient capital requirements, whereas those with less capital will be faced with tougher requirements. As such, this new regulatory framework can be seen as a market-driven mechanism put in place by the regulator to phase out uncompetitive firms. Sector worth long-term holding Overall, the law revision focuses on developing a market-driven mechanism and pushing forward industry reform. The insurance sector is worth holding in the long term given that its low valuation offers a considerable margin of safety. We like Ping An Insurance ( CH) best, followed by New China Life Insurance ( CH), CPIC ( CH) and China Life Insurance ( CH). Key risks include potential slowdowns in 3Q15 sector earnings growth as result of recent stock market declines. Machinery: 9M15 earnings preview 9M15 earnings to weaken from 1H of the sector s 260 listed companies have released a 9M15 profit alert so far. The medians of the forecasted earnings range provided by 189 of the companies add up to Rmb8,984m, representing a YoY decline of 35.9%, which was worse than the actual earnings decline of 31.2% YoY for 1H15. Among the 189 firms, 95 expect a YoY earnings decline (calculated based on the median of their forecasted range, same for the following), with 71 anticipating a decline of more than 20% and 45 projecting a drop of more than 50%. More policy support needed We believe recently issued supportive measures for the property and auto sectors are not sufficient to reverse the slowdown in their related sectors, and that stronger policy support will be needed before machinery demand can pick up. Meanwhile, strengthening progrowth efforts from the government will lead the market to expect a lower risk of economic growth deceleration, which would help leading machinery firms with their business transformation and upgrade. Watch list We are particularly positive on the automated equipment, rail, nuclear power and auto aftermarket subsectors, and suggest watching Dalian Refrigeration ( CH), SGSB ( CH), Tofflon Science & Technology ( CH), China High-Speed Railway Technollgy ( CH), Kangni Mechanical & Electrical ( CH), Huanghe Whirlwind ( CH), Miracle Automation Engineering ( CH), Nanfang Pump Industry ( CH), Great Star Industrial ( CH) and Yingliu Electromechanical ( CH). Biostime (1112 HK, Buy): A phoenix rising from the ashes China to be key growth driver for Swisse The revenue of the health food product industry in China reached Rmb193.2b in 2014, with 52%, or Rmb100bn, coming from dietary supplements whose sales have grown at a CAGR of 12.6% over the past three years. The dietary supplements industry is growing steadily, with demand growth mainly driven by consumers income growth and their strengthening health awareness. Per capita spending on and the penetration rate of dietary supplements in China are very low compared with developed countries, pointing to substantial room Page 2

3 for growth. China will be a key growth driver for Swisse, an industry leader with considerable business experience, a diverse product portfolio and well-established brand recognition. Regulation the major entry barrier There are currently two ways for imported health products to be sold in the offline market in China: 1) By obtaining a certificate for imported health food products issued by the CFDA, commonly known as the Blue Hat, a logo which is required to be printed on the outer package of the approved products. 2) By obtaining a hygiene license issued by the entryexit inspection and quarantine authorities and being sold as imported special food products, i.e. dietary supplements; this method is only applicable to a limited variety and quantity of products and represents a grey area under current regulations. The government s prudence towards approving health product imports (i.e. strict control over Blue Hat issuance) has created extremely high entry barriers for imported health products being sold offline in China. Currently 95% of all Blue Hats issued are granted to domestically made products. Cross-border e-commerce key starting point for Biostime given Swisse s sales strength in China According to an industry expert, Swisse likely takes the biggest share of the online health product market in China by a large margin. It has seen strong sales growth relying purely on wordof-mouth and the overseas online shopping channel, rather than on proper brand management and marketing organized by the Australian firm. Focusing on cross-border e-commerce will help Biostime by 1) overcoming the policy barrier, 2) avoiding existing offline competitors, and (3) minimizing conflicts between online and offline sales. Risks under control 1) We estimate that the company s one-year bridge loan will generate interest expense of Rmb143m, and that to make up the funding shortfall resulting from the repayment of the bridge loan in 2016 will lead to financing costs of Rmb166m-182m, which can be fully covered by its expected net profit of Rmb832m in ) The likelihood of a new share placement is rising as financing needs increase. 3) Goodwill might be written down following the Swisse acquisition, but it is hard to quantify by how much at this stage. 4) In view of increasing competition from imported products, we believe it is crucial for Biostime to start fighting for its market position as early as possible. Swisse growth potential undervalued; upgrade to Buy We expect Biostime s 2016 and 2017 earnings growth to come in at 93.4% and 9.8% YoY. We believe its infant milk formula business will deteriorate in 2H15 due to fierce competition. However, Swisse is set to grow rapidly on the back of the expanding cross-border e-commerce channel and ongoing consumption upgrade. We value Biostime s infant milk formula business at 8x and Swisse at 15x P/E (representing a 26% discount to its acquisition price, and discounts of 43.6% and 69.4% to BY-Healthy ( CH) and Blackmores (BKL AX)). We upgrade our rating from Underperform to Buy with our target price raised to HK$17.56, equivalent to 10.9x 2016E P/E, from HK$12.45 (please refer to our report on Jul 29, 2015 for details related to the previous TP). (Alex Fan, CFA, Head of Research, SFC CE No. ADJ672, alexfan@gfgroup.com.hk ) (Yang Ke, Research Analyst, SFC CE No. BEZ121, yangke@gfgroup.com.hk ) Non-Bank Financials: Sector update Securities sector update Comprehensive income of A-share securities firms up 181% YoY in 9M15 Daily trading volume on the mainland stock market was Rmb1,086.3bn in 9M15, up 394% YoY. Total equity financing amounted to Rmb925.1bn, an increase of 72% YoY. Outstanding margin loans and short selling totaled Rmb901.4bn, up 47% YoY, but down 12% compared to the end of Based on monthly data, we estimate that comprehensive income and net profit at A-share securities firms rose 181% and 205% YoY respectively, mainly due to improved daily trading volume, a bullish bond market, and increased margin trading and stock-pledged repo business in 1H15. NEEQ policy update NEEQ issued preferred share guidelines before the National Day holiday. According to the documents, the technology for preferred stock transfers will be ready by the end of Nov. A spokesman also announced that the NEEQ s next task is to determine the basic principles, an implementation scheme and related institutional arrangements for internal market stratification, which will start before the end of the year. Further differentiation of services and regulatory requirements could be built on internal market stratification in order to reduce information gathering costs for investors as well as better encouraging innovative companies in their early stage. As of Sep 30, there were 3,585 companies listed on the NEEQ, far more than the total of 2,800 on the Page 3

4 Shanghai and Shenzhen Exchanges. The NEEQ s financing functions should see further improvements along with further supportive policies from the CSRC. Insurance sector update Guidelines for insurance companies to support key construction projects The NDRC and CIRC jointly issued a document on Oct 9, which aims to expand the range of services of insurance agencies while also better achieving the long-term investment and risk protection function of insurance, and strengthening the role of the insurance industry in supporting economic growth and economic restructuring. The guidelines encourage insurance companies to increase long-term investment, improve supportive policies and update related risk management. Notice on the promotion of participating life insurance pricing policy reform The CIRC issued this notice along with Actuarial provisions of participating life insurance on Sep 28, effective Oct 1, marking the realization of domestic rate marketization in life insurance. According to the notice, insurance companies can determine the rates under the principle of prudence. The valuation interest rate for unearned premium reserves will be the pricing interest rate or 3%, whichever is lower. Participating insurance with rates no higher than 3.5% need to be submitted to the CIRC for their records; if the rate is higher than 3.5%, CIRC approval is required. Our comments: Premium growth expected in participating life insurance The CIRC began life insurance pricing reform in Pricing reform of traditional life insurance and universal life insurance was carried out in Aug 2013 and Feb 2015 and participating life insurance is the last step in this life insurance pricing reform scheme. Premium growth in participating life insurance is expected as the premiums of traditional life insurance and universal life insurance increased 265% and 66% respectively after the reform. Considering that participation insurance accounted for 70-80% of total life insurance premium income, future premium growth in the life insurance industry will benefit from this reform. Impact remains to be seen According to the old regulation, the rate for participating life insurance was a minimum of 2.5% plus (investment yield -2.5%)*70%, which means at least 70% of excess returns should be distributed to clients besides the promised 2.5%. Compared with traditional life insurance, this reform for participating insurance impacts costs less theoretically (from 70% to 100%). However, insurance companies seldom distributed profit following this equation. The main pricing mechanism depends on the company s investment yield as well as peer s participating standard. So the impact of this reform on insurance companies costs remains to be seen. Large insurance companies with sufficient capital to benefit more In order to prevent malicious competition with exorbitant rates, strict capital requirement regulation is implemented. According to CIRC regulation, insurance companies have to cease any new business when its solvency ratio falls below 150%. Thus, this reform benefits large insurance companies with sufficient capital, while small companies will be unable to launch a price war under the strict capital supervision. (Felix Luo, Research Analyst, SFC CE No. AQF573, felixluo@gfgroup.com.hk ) Page 4

5 Rating Definitions Benchmark: Hong Kong Hang Seng Index Time horizon: 12 months Company ratings Buy Stock expected to outperform benchmark by more than 15% Accumulate Stock expected to outperform benchmark by more than 5% but not more than 15% Hold Expected stock relative performance ranges between -5% and 5% Underperform Stock expected to underperform benchmark by more than 5% Sector ratings Positive Sector expected to outperform benchmark by more than 10% Neutral Expected sector relative performance ranges between -10% and 10% Cautious Sector expected to underperform benchmark by more than 10% Analyst Certification The research analyst(s) primarily responsible for the content of this research report, in whole or in part, certifies that with respect to the company or relevant securities that the analyst(s) covered in this report: (1) all of the views expressed accurately reflect his or her personal views on the company or relevant securities mentioned herein; and (2) no part of his or her remuneration was, is, or will be, directly or indirectly, in connection with his or her specific recommendations or views expressed in this research report. 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