Jan 24, 2018 TIANGONG INTERNATIONAL

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1 COMPANY NOTE TIANGONG INTERNATIONAL [826.HK; HK$1.33; NOT RATED] - High Speed Steel Market Leader with Turnaround Potential Analyst: Patrick Leung (patrickleung@chinastock.com.hk; Tel: (852) Summary. We believe the operating environment for Tiangong is becoming more favorable, given 1) foreseeable ASP and margin expansion in 218, thanks to tighter supply of die and high speed (HSS) products as more small players are leaving the industry (Tiangong raised its ASP twice in early January); and 2) further industry consolidation amid stricter safety inspections for heavy industries, like the industry. More importantly, Tiangong is making a solid effort to reduce its high level of receivables by adjusting its delivery and payment policies. Tiangong is trading at.6x PBR, which is lower than its historical average (~.76x PBR). Based on its positive profit alert for 217E (>5% profit growth), the Company is trading at 14x 217E PER. We believe there is still room for re-rating, especially if the Company can show further improvement in receivables collection and inventory management. Market position expected to be strengthened amid supply-side reforms. The Chinese government has called for stricter environmental protection inspections of factory production as part of supply-side reforms, which has impacted the industry and sub-segments, like special s. More small players in the special segment have left the market as they were unable to meet the requirements. However, the impact on Tiangong was limited, as the Company has emphasized and invested in environmental facilities, and passed the environmental inspections by the authorities in 217. Therefore, Tiangong was able to strengthen its leading market position in die and the HSS market in the past year. Currently, Tiangong has c.6% market share in China s die- industry and >6% market share in China s HSS industry. Looking ahead, we expect more small players to leave the market, given 1) stricter approval of new capacity under supply-side reforms; and 2) stricter safety inspections of factory production. This will lead to a more concentrated market. As a result, Tiangong, a leader in die and the HSS market, may gain pricing power. Price hike in early January bodes well for ASP outlook in FY218. Tiangong was able to raise its ASP twice (c.5% for each adjustment) in early January. We believe this was due to 1) rising material costs (e.g. molybdenum) and the cost-plus pricing strategy adopted by the Company; 2) tighter supply of die and HSS products, since more small players have left the industry; and 3) healthy demand for die and HSS products from the manufacturing sector. We expect Tiangong s GPM to see YoY improvement in 218 with higher sales volume, given the Company s stronger pricing power and tighter market supply. Striving to reduce receivables by adjusting delivery and payment policies. As of end-june 217, Tiangong had debt of RMB2.99bn and a net debt/equity ratio of 51%. The Company also had receivables of RMB1.83bn. The relatively high level of receivables was due to the Company s aggressive past delivery and payment policy. For instance, Tiangong s general practice was to keep a relatively high level of inventory, which allowed it to deliver products immediately upon receiving orders from customers. Tiangong also provided a trial period of six months to customers, and the customers only had to pay at the end of the trial period, which led to high receivables. Tiangong s practice was in contrast to that of some of its major peers, which deliver products two months after settlement of payment. Tiangong adopted its aggressive payment policies in the past when it was smaller to gain market share. However, after successful building up its brand reputation and customer loyalty, Tiangong has been switching to a more conservative payment policy since 2H16, which involves shortening the trial period from six months to two and requiring some customers to prepay. We believe these measures should help Tiangong reduce receivables in the future. Although its days receivable and days inventory outstanding are still high, we have seen a gradual improvement in both indicators, with days (HK$) Market Cap: US$381m; Free Float: 38.7% Source: Bloomberg, Company Data TIANGONG INTERNATIONAL RMB (Y/E Dec) Jan 24, 218 (HK$ million). 1/217 3/217 5/217 7/217 9/217 11/217 1/218 Turnover (RHS) Price (LHS) Revenue (m) 3, , , ,376.1 Gross profit (m) Gross margin (%) EBIT (m) Net Profit (m) Net Margin (%) EPS Dividend yield (%) PER (x) PBR (x) receivable dropping from 211 days in 1H16 to 156 days in 1H17 and days inventory outstanding dropped from 253 days in 1H16 to 217 days in 1H17. CAPEX items. CAPEX for equipment upgrades and maintenance in 218 is expected to be RMB1m-2m. On the other hand, CAPEX of ~RMB5m is expected to be spent on a new projects related to powder metallurgy technology. The project is expected to start generating revenue in 2H19. With a net debt/equity of 51%, the Company s financial position is still relatively healthy. Progress of military-related business. The Company has to obtain three military-related licenses from the government before it can participate in the military-use titanium alloy business. So far Tiangong has obtained two of these licenses. The Company is expected to obtain the third license in 218, and the business will gradually contribute revenue in 219. Though the initial revenue contribution may seem insignificant, the GPM of military-use titanium alloy business could be as high as 8%, compared with 1%-15% for normal titanium alloy products. Valuation. Tiangong is trading at.6x PBR, which is lower than its historical average (~.76x PBR) and A-share listed peers average. We believe there is still room for re-rating, especially if the Company can show further improvement in receivables collection and inventory management. Catalysts. 1) News flow on further ASP hikes by the Company; and 2) news flow on the development of new business, such as the militaryuse titanium alloy business. Risk factors. 1) High gearing; 2) higher-than-expected CAPEX for new project related to powder metallurgy technology

2 Company background. Tiangong, listed in 27, is engaged mainly in the manufacture and sale of high speed (HSS), HSS cutting tools and die. In terms of production volume, Tiangong is the largest manufacturer of HSS and HSS cutting tools in China. Figure 1: 1H17 results highlights Y/E Dec (RMB ') 1H16 1H17 YoY change Revenue 1,568,234 1,877,5 19.7% Cost of sales -1,381,37-1,662, % Gross profit 186, , % Margin 11.9% 11.4% Other income 7,325 6, % Operating expenses -112, , % Distribution expenses -28,829-42, % Administrative expenses -67,363-63, % Other expenses -16,424-9,85-4.3% Operating profit 81,636 14, % Net finance costs -54,274-56,438 4.% Share of (losses)/profits of associates 3,513-1, % Share of (losses)/profits of joint ventures 2, % Profit before tax 33,236 46, % Income tax expense -6,372-5, % Minority interest -1,151-1, % Net Profit 25,713 39, % Overview of types. Die and high speed fall under the category of special s, which is a sub-category of and is generally defined as that contains less than.4% sulphur. The major difference between generic and special is the different mixture of metals. Generic is a hard, tough metal composed of iron alloyed with carbon, while special requires strict control of a specific mixture of metals, including tungsten, molybdenum, chromium and vanadium. Moreover, generic has low pressure and low wear resistance, whereas special has high temperature and pressure resistance and high wear endurance. Apart from die and high speed, the family of special s includes bearing, spring and stainless. Each type of special has unique applications in particular industries. For instance, die is often used to produce moulds used to manufacture home electrical appliances and automobiles, while high speed is used to manufacture cutting tools. Figure 2: Overview of types in China Steel Generic Special High speed Stainless Die Steel Spring Bearing Other types of special

3 Figure 3: Die and HSS production by major players in China 35, 3, 25, 2, 15, 1, 5, Figure 4: Average die prices in major cities 45, 4, 35, 3, 25, 2, 15, M217 1, Die Steel Production (t) High Speed Steel Production (t) Average Die Steel Price (Cr12Mov) (RMB/t) Average Die Steel Price (H13 (Electric Furnace)) (RMB/t) Average Die Steel Price (3Cr2W8V) (RMB/t) Sources: Wind Info, CGIS Research Sources: Wind Info, CGIS Research Figure 5: Tungsten and molybdenum prices in China /4/217 12/5/217 12/6/217 12/7/217 12/8/217 12/9/217 12/1/217 12/11/217 12/12/217 12/1/218 Price: 1# Tungsten: 99.95%: China-made (RMB/kg) Price: 1# Molybdenum: 99.95%: Domestic-made (RMB/kg) Sources: Wind Info, CGIS Research Figure 6: Supply Chain of the High Speed Steel, Cutting Tools and Die Steel Industry UpStream Steel Scrap Tungsten Molybdenum Chromium Vanadium Titanium Sponge Midstream High Speed Steel Cutting Tools Die Steel Titanium Alloy End-Market

4 Figure 7: Tiangong s Profitability Trend 3% 25% 2% 15% 1% Figure 8: Tiangong s Cash Conversion Cycle % 5 % GPM NPM H217 Days Inventory Outstanding Days Sales Outstanding Accounts Payable Turnover Days Cash Conversion Cycle Sources: Company, Bloomberg, CGIS Research Sources: Company, Bloomberg, CGIS Research Figure 9: Sales mix by product (1H17) Figure 1: Sales mix by geography (1H17) Trading of Goods 25% Titanium Alloy 5% Die Steel 42% Europe 13% Asia (Ex-China) 5% Others 2% North America 11% Cutting Tools 12% High Speed Steel 16% China 69% Figure 11: Gross profit per tonne H17 Die (RMB/t) High speed (RMB/t) Titanium alloy (RMB/t)

5 Figure 12: PBR range Figure 13: PER range Sources: Bloomberg, CGIS Research PBR Average +1 S.D. -1 S.D. PER (TTM) Average +1 S.D. -1 S.D. Sources: Bloomberg, CGIS Research Figure 14: Peer comparison Market cap PER(x) PBR(x) Dividend Yield (%) Company Ticker Price (LC) (US$m) 216A 217E 218E 216A 217E 218E 216A 217E 218E Tiangong International Co Ltd 826 HK EQUITY n.a. n.a..6 n.a. n.a. n.a. n.a. n.a. Steel Sector Angang Steel Co Ltd 347 HK EQUITY Maanshan Iron & Steel Co Ltd 323 HK EQUITY n.a Xiwang Special Steel Co Ltd 1266 HK EQUITY n.a Da Ming International Holdings 19 HK EQUITY n.a. n.a. 1.4 n.a. n.a. n.a. n.a. n.a. Lee Kee Holdings Ltd 637 HK EQUITY n.a. n.a..5 n.a. n.a. n.a. n.a. n.a. Shanxi Taigang Stainless Steel 825 CH EQUITY n.a..8.7 Xining Special Steel Co 6117 CH EQUITY n.a. n.a. n.a. n.a. n.a. Daye Special Steel Co Ltd 78 CH EQUITY n.a Nanjing Iron & Steel Co Ltd 6282 CH EQUITY n.a. n.a. n.a. Baoshan Iron & Steel Co Ltd 619 CH EQUITY n.a Machine & tooling Lung Kee Bermuda Holdings 255 HK EQUITY n.a. n.a. 1.1 n.a. n.a. n.a. n.a. n.a. Techtronic Industries Co Ltd 669 HK EQUITY n.a Haitian International Holdings 1882 HK EQUITY n.a Chen Hsong Holdings 57 HK EQUITY n.a. n.a..5 n.a. n.a. n.a. n.a. n.a. Precision Tsugami China Corp L 1651 HK EQUITY n.a n.a n.a LK Technology Holdings Ltd 558 HK EQUITY n.a. n.a..7 n.a. n.a. n.a. n.a. n.a. Good Friend International Hold 2398 HK EQUITY n.a. n.a..9 n.a. n.a. n.a. n.a. n.a. Chongqing Machinery & Electric 2722 HK EQUITY n.a. n.a..4 n.a. n.a. n.a. n.a. n.a. Sources: Bloomberg, CGIS Research

6 Figure 15: Tiangong s Simplified Consolidated Statement of Profit and Loss In Millions of CNY FY 213 FY 214 FY 215 FY 216 Year ended 31 Dec 12/31/213 12/31/214 12/31/215 12/31/216 Revenue 3, , , ,376.1 Cost of Revenue (2,582.5) (3,626.8) (3,38.1) (3,3.9) Gross profit Other operating income Operating expenses (15.7) (236.5) (194.6) (29.2) Operating profit Net finance costs (124.9) (141.9) (14.7) (13.3) Other non-operating gains and losses Profit before tax Income tax expense (138.6) (81.4) (13.1) (14.9) Profit after tax Minority interest Net Income Sources: Bloomberg, CGIS Research Figure 16: Tiangong s Simplified Consolidated Statement of Financial Position In Millions of CNY FY 213 FY 214 FY 215 FY 216 Year ended 31 Dec 12/31/213 12/31/214 12/31/215 12/31/216 Current assets Cash, Cash Equivalents & STI Accounts & Notes Receiv 1, , ,67.2 1,368. Inventories 1, , , ,91.8 Other ST Assets Total Current Assets 4, , ,951. 4,558.9 Non-current assets PPE, Net 2, ,74.2 3, ,516.8 LT investments & receivables Other LT assets Total Noncurrent Assets 2, , ,433. 3,737. Total Assets 7,16.3 8, ,384. 8,295.9 Current liabilities Accounts Payable , , ST Borrowings 2, , ,58.9 2,678.9 Others Total Current Liabilities 3, , , ,831.4 Non-current liabilities LT Borrowings Other non-current liabilities Total Noncurrent Liabilities Total Liabilities 3, ,435. 4,57.7 4,14.5 Shareholder's equity 3, , , ,17.7 Minority Interest Total Equity 3, , , ,155.4 Sources: Bloomberg, CGIS Research

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Explanation on Equity Ratings BUY SELL HOLD : : share price will increase by >2% within 12 months in absolute terms share price will decrease by >2% within 12 months in absolute terms : no clear catalyst, and downgraded from BUY pending clearer signal to reinstate BUY or further downgrade to outright SELL Copyright Reserved No part of this material may be reproduced or redistributed without the prior written consent of China Galaxy International Securities (Hong Kong) Co., Limited. China Galaxy International Securities (Hong Kong) Co. Limited, CE No.AXM459 2/F, Wing On Centre, 111 Connaught Road Central, Sheung Wan, Hong Kong. General line: