A-Share Strategy. September 15, A-Share 1H2015 Results Review: Anemic Earnings Growth amid Decreasing Costs and Weakening Demand

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1 A-Share Strategy September 15, 2015 A-Share 1H2015 Results Review: Anemic Earnings Growth amid Decreasing Costs and Weakening Demand Outlook for corporate earnings is not optimistic. Revenue growth continued to decelerate. Although we see a mild rebound in profit growth thanks to lower raw materials prices and decreasing interest expenses, overall growth outlook is weak. In 2H15, the economy is still expected to face greater downward pressure and demand is likely to remain weak. Corporates are facing a tough business environment and we expect it will be difficult to see a dramatic improvement in profitability in second half. Profitability of some small and mid caps is not justified for their higher valuation. ChiNext posted highest earnings growth but valuation still too high. Comparing various markets, earnings performance of ChiNext was better than main board and SME board, but was still below market consensus, and far below the earnings growth implied by the current valuation. Costs dropped faster than revenue led to higher earnings in some sectors. Comparing various sectors, non-bank financials, media, power equipment, catering and tourism, textile and clothing were performing better, yet we expect non-bank financials will report weaker results in 2H2015 than in 1H after the sharp correction in A-share market. Earnings growth in steel and home appliances sectors recorded a notably drop. Building materials and non-ferrous metal sectors were affected by weak demand and declining raw material costs at the same time. As such, both sectors suffered from slowing revenue growth but their net profit growth rebounded. A range-bound market in 2H15. Market needs some time to restore confidence after the more than 45% correction in major stock indices. Currently the market is still oscillating with a lower trading range. However, value of quality companies will emerge during market landslide. Recap of September monthly portfolio. As regards to strategy, investments still need to be cautious, and value and safety, principally blue chips, shall be focused during stock selection Sun Jianbo, Ph. D Chief Strategist (8610) Practicing Certificate No.: S Wong Chi Man Head of Research (852) cmwong@chinastock.com.hk The September Portfolio includes a non-bank financial stock, a petroleum & petrochemical stock, a traffic & transportation stock, a light industry stock, two electric power stocks, a machinery & military industry stock, a food & beverage stock, a home appliance stock and a pharmaceutical stock. Stock portfolio for the month (pari passu): New China Life Insurance (601336), Sinopec (600028), Daqin Railway (601006), Chenming Paper (000488), Huaneng Power International (600011), Chuantou Energy (600674), SJEC Corporation (601313), Luzhou Laojiao (000568), Robam (002508) and Chase Sun Pharmaceutical (300026). 1

2 I. Overall picture of 1H15 results: weak demand; slowing revenue growth; faster cost decline; rebound in net profit growth All A-share companies reported their interim result for year According to findings of CGS Strategy Team, A-share market as a whole reported slower revenue growth but rebounding net profit growth. Net profit growth rate is even higher especially when financials and petrochemicals sector are excluded. Costs dropped significantly while overall demand was weak. Yet, profitability of some small and mid caps is not justified for their higher valuation. On macro environment, China economy is still going downwards and facing larger pressure. Growth rate of industrial production in July dropped to 6%. Manufacturing PMI in August, as a leading economic indicator, dropped to Growth in fixed asset investment, which includes real estate development, infrastructure and investments in manufacturing industry, continued to decline. We expect the economy will continue to search for the bottom and economic growth will maintain a downward trend in 2H2015. Corporate earnings outlook is not encouraging. For industrial enterprises, a series of rate cuts will help lower finance costs but revenue and profit growth is likely to remain lacklustre. Figure 1: Decelerating growth of industrial production Figure 2: Profitability of the industrial sector remained lacklustre 22 % % % % /05 12/06 12/07 12/08 12/09 12/10 12/11 12/12 12/13 12/14 GDP : Constant Prices: YoY VAI: YoY Figure 3: Manufacturing PMI hit 3-year low Data Source: Wind Info /07 12/08 12/09 12/10 12/11 12/12 12/13 12/14 Industrial Enterprises: Main Business Income: YTD: YoY Industrial Enterprises: Financial Expenses: YTD: YoY Figure 4: FAI growth continued to slow down Industrial Enterprises: Total P rofit: YTD: YoY Data Source: Wind Info % % % % /07 12/08 12/09 12/10 12/11 12/12 12/13 12/14 Caixin China PMI: Output Data Source: Wind Info /05 12/06 12/07 12/08 12/09 12/10 12/11 12/12 12/13 12/14 FAI: YTD: YoY FAI: Transport, S torage and P ost: YTD: YoY FAI: Manufacturing: YTD: YoY FAI: Real Estate: YTD: YoY Data Source: Wind Info 2

3 Regarding overall earnings performance of A-share, revenue growth dropped year-on-year (YoY) but net profit growth rebounded, thanks to faster cost decline. Based on 1H2015 results, revenue of all A- share companies dropped 1.46% YoY. Top line growth rate would be -3.5% and -6.31% if we exclude banks and non-banks financials respectively, but it would be +2.28% if we exclude banks, non-banks financials and oil and petrochemicals. Net profit growth rate of all A-share was 6.43% YoY but if we exclude banks, non-banks financials and oil and petrochemicals respectively, it would be 11.04%, - 5.2% and 23.28% respectively. Declining cost was the reason behind the interim profit growth. Other than lower finance costs after interest rate cuts, declining raw materials cost under weak demand was also accountable. Revenue dropped as a result of declining demand especially during peak season, but an even faster drop in costs led to a rebound of net profit growth of the real economy, akin to a rebound during a recession. Figure 5: Decelerating revenue growth of A-shares Figure 6: Earnings growth of A-shares rebounded Figure 7: Growth of ROE picked up in 1H2015 Figure 8: ROE and recurring ROE in 1H15 (%) All A-shares A-shares (ex-banks) A-shares (ex-nonbank financials) A-shares (ex-banks, oil and petrochem) ROE (diluted) Recurring ROE (diluted) 3

4 Looking specifically on major stock indices, constituents of ChiNext reported 1H15 results much better than other major indices. Revenue of constituents of Shanghai Stock Exchange 50 and CSI 300 dropped 3.57% and 0.65% respectively in 1H15, while CSI 500 and ChiNext grew 0.02% and 56.62% respectively. For net profit, YoY growth rate of SSE 50, CSI 300, CSI 500 and ChiNext were 1.99%, 6.42%, 1.19% and 36.83%. The better performance of ChiNext was mainly due to significant improvement of some heavily-weighted stocks, such as East Money Information ( SZ) and Hithink RoyalFlush Information Network ( SZ). Figure 9: Revenue growth of ChiNext exceeded other indices Figure 10: Earnings growth of ChiNext also exceeded other indices Figure 11: ROE growth rate of major indices Figure 12: Major indices ROE and recurring ROE for 1H15 (%) SSE50 CSI300 CSI500 ChiNext ROE (diluted) Recurring ROE (diluted) 4

5 II. ChiNext performed better than main board, but its high valuation was still not justifiable (1) Revenue growth rate of all markets dropped YoY YoY revenue growth rate in 1H2015 of main broad, SME board and ChiNext was 2.5%, 8.3% and 31.6% respectively, slightly lower than that in Q1 2015, with 0.4, 0.4 and 0.6 ppt lower respectively. Since 2005, overall revenue growth rate of main borad, SME board and ChiNext has been declining. As the demand is weak in the economy, revenue of main board has recorded YoY decline since Q while growth rate of SME board dropped to a 5-year low. ChiNext managed to maintain a relatively higher growth rate at around 30% after the bottom out in Figure 13: 1H15 revenue growth of all markets decelerated versus Q (%) Figure 14: Revenue of main board and SME board has decelerated since Mainboard (ex-sme board) SME board ChiNext (including ST) 1H15 YoY Q YoY 2014 YoY (2) Net profit growth rate of all markets mostly in line with 2014 YoY net profit growth rate in 1H2015 of main board, SME board and ChiNext were 5.6%, 17.5% and 23.9% respectively, higher than Q by 4.0, 0.3 and 15.5 ppt respectively, and higher than 2014 by 0.5, 1.2 and -1.1 ppt respectively. Main board and ChiNext had a lower growth rate in Q but it already rebounded to the level of 2014 in 1H2015. Earnings growth of SME board was relatively stable. In 2012 each board s net profit growth rate reached bottom and since then SME board recorded significant growth while main board remained at a relatively low level. 5

6 Figure 15: Net profit growth in 1H15 returned to the level in 2014 Figure 16: Lacklustre profit growth of main board; profit growth of SME board rebounded Mainboard (ex-sme board) SME board ChiNext (including ST) 1H15 YoY Q YoY 2014 YoY (3) Valuation of each board was more balanced Up to 31 Aug 2015, PER (TTM) of main board, SME board and ChiNext was 15.7x, 50.2x and 71.1x, and the PEG ratio based on 1H2015 earnings growth would be 2.8, 2.87 and 2.97 respectively. From this angle, valuation across the boards seems to be more balanced, but if the fundamentals of 2H2015 to 2016 are worse than expected, the higher multiples of small and mid caps may face pressure of correction. Figure 17: Improved profitability of SME board, main board declined, SME board stable Figure 18: Improved profitability of SME board, main board declined, SME board stable Mainboard (ex-sme board) SME board ChiNext (including ST) ROE (1H15) ROE (1H14) ROE (1H13) ROE (1H12) 6

7 (4) Profitability: Small & mid cap improved, main board declined and ChiNext stayed flat ROE of main broad, small & mid cap and ChiNext was 5.9%, 4.44% and 3.93% respectively in 1H15, and the YoY growth was -0.66, 0.47 and ppt respectively. The trend of declining profitability continued for main board, and the YoY decline was even greater. SME board witnessed significant improvement in profitability, while ROE of ChiNext mostly stayed flat compared with the interim results in the past few years. (5) Gross Profit Margin: Main board and SME board improved, and ChiNext deteriorated Gross profit margin in 1H2015 of main board, SME board and ChiNext changed by 1.0ppt, 0.9ppt and -1.3ppt respectively, and the net profit margin changed by 0.9, 1.4 and -0.8 ppt respectively. Cost dropped significantly, thanks to a subdued Inflation 1H2015. It benefited companies listed on main board, especially the traditional industries, as there was notable improvement in gross profit margin and net profit margin. Meanwhile, ChiNext, which was mainly composed of listed companies in emerging industries, continued to follow the trend of deteriorating gross profit margin and net profit margin. Figure 19: Gross margin improved in main board and SME board; ChiNext declined Figure 20: Net margin improved in main board and SME board; ChiNext declined III. Profitability changes of various sectors From a sector perspective, sectors posting an increasing revenue growth in 1H2015 results were non-bank financials, media, electric equipment, defense & military, catering & tourism, textile & clothing, trading & retail, non-ferrous metal, fishery, forestry, husbandry & farming, real estate, electronic components and coal. Sectors reporting a decelerating revenue growth rate in 1H2015 results were steel, electricity & utilities, construction, building materials, machinery, home appliances, healthcare & pharmaceuticals, food & beverage and transportation. 7

8 Sectors having a growth rate in line with Q results were oil & petrochemicals, basic chemicals, light manufacturing, automobiles, banks, computers and communications. Specifically, performance of non-bank financials was the best, thanks to a very strong performance of A-share market in Q Performance of media sector was also good, led by Huayi Brothers Media ( SZ), leader in the industry. Figure 21: Revenue growth of various sectors For net profit growth, sectors having improvement in 1H2015 results were non-bank financials, media, communications, real estate, fishery, forestry, husbandry & farming, textile & clothing, trading & retail, defense & military, machinery, basic chemicals, light manufacturing and oil & petrochemicals. Sectors having slower net profit growth in 1H2015 results were coal, non-ferrous metal, electricity & utilities, home appliances, food & beverage, transportation and computers. Sectors with net profit growth in line with Q were steel, construction, automobiles, catering and tourism, healthcare & pharmaceuticals, banks, electric equipment and electronic components. 8

9 Figure 22: Operating profit growth of various sectors When comparing various sectors revenue growth rate and profit growth rate, there was divergence between revenue growth and profit growth in non-ferrous metal and building materials sectors. We saw sectors like non-bank financials, media, electric equipment, catering & tourism and textile & clothing having an overall improvement. Sectors like steel and home appliance recorded an overall deterioration. In 1H2015 results, sectors recorded a faster growth rate in ROE were electricity & utilities, automobile, home appliances, textile & clothing, food and beverage, banks and non-bank financials. Steel sector recorded a negative ROE. 9

10 Figure 23: ROE of various sectors (1H15) Sectors with significant improvement in ROE were non-ferrous metal, electric equipment, textile & clothing, non-bank financials and transportation. Sectors with significant deterioration in ROE are steel, coal, oil & petrochemicals, building materials and defense & military. Figure 24: ROE growth of various sectors (1H15 YoY) 10

11 IV. Overview of profitability & market strategy (1) Overview of A-share 1H2015 results Summarizing the results of overall A-share market and important companies across different sectors and markets: (i) Corporate earnings outlook has no room for optimism. Revenue growth continued to slow down. Net profit growth rebounded as raw materials cost declined and interest rate has been cut. However, this should be viewed as a recessionary rebound. In 2H2015, Chinese economy still faces greater downward pressure. Demand is going to remain weak and corporates are facing a tough business environment and we expect it will be difficult to see a dramatic improvement in profitability in second half. Profitability of some small and mid caps is not justified for their higher valuation. (ii) Comparing various markets, earnings performance of ChiNext was better than main board and SME board, but was still below market consensus, and far below the earnings growth implied by the current valuation. (iii) Comparing various sectors, non-bank financials, media, electric equipment, catering and tourism, textile and clothing were performing better, yet we expect non-bank financials will have weaker results in 2H2015 than 1H2015 after the sharp correction in A-share market. Earnings growth in steel and home electric appliances sectors has dropped notably. Building materials and non-ferrous metal sectors were affected by weak demand and declining raw material costs at the same time. As such, both sectors suffered from slowing revenue growth but their net profit growth had rebounded. (2) Market strategy: trading range keeps moving down amid oscillation; no basis for a sustainable rebound Overall A-share market does not have a solid basis for a sustainable rebound, and the trading range continues to move down. The main reason is the uncertainty on market liquidity. There are bigger changes in monetary liquidity on macro level, as well as the liquidity of leverage on micro level. For liquidity on macro level, there are several dilemmas in 2H2015. Internally, downward pressure of economy is still huge. Growth of industrial production, investment, consumption and international trade continued to slide. Official Manufacturing PMI in August dropped to 49.7, a 3- year low. This indicates the overall macroeconomic environment is not optimistic, and support from monetary policy is required. Externally, Federal Reserve of the US is going to raise interest rates. Capital outflow is accelerating and it remains to be seen whether the exchange rate of RMB could remain stable after the sudden depreciation. Again this implies more monetary stimulus is needed. Yet, at the same time, monetary policy faces certain limitations as recent property prices in China soared too quickly, CPI rebounded as pork price continued to go up, and the views that virtual economy could lift real economy are rejected at the moment. 11

12 Although monetary policy is expected to remain accommodative to ease the concern of economy, there will be a tough period and we expect the overall liquidity will be tighter than in 1H2015. As the expectation of rate hike in the US is strengthening and asset prices in China are falling (the slump in A-share market), capital outflow in China is accelerating. Funds outstanding for foreign exchange in July witnessed a record decline of RMB bn. Exchange rate of RMB is still facing a huge pressure. After the central bank proactively depreciated RMB on 11 Aug 2015, banks were facing pressure in liquidity followed by capital outflow. As a result, prices of fund, i.e. interest rate, increased. We expect central bank will not give up low interest rate to stabilize exchange rate, as interest rate is the key to stabilize the economy of China. Therefore, monetary policy easing will be followed undoubtedly. Recently central bank have been using measures such as reverse repo, SLO, MLP and cutting of interest rates and required reserve ratio to keep money supply increasing. For liquidity on micro level, market regulation is tightening. It is unlikely to see high leverage accounts using off-market funds to return again. Leverage is one of the largest forces behind this bull market. After the market slump, regulators tightened off-market margin financing. Margin financing in 2H2015 will be dominated by authorized brokers and off-market margin lending is very unlikely to be as popular as in 1H2015. Currently the balance of margin financing dropped to around RMB1trn, down by more than 50% or around RMB1.27trn from the peak level. We expect it will continue to drop. After the 45% plummeting of major indices, it takes time for the market to restore confidence. Currently the market is still seeking for a bottom amid oscillation, and the trading range will continue to move lower. 12

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