China Huarong (2799 HK)

Transcription

1 Equity Research Financials China Huarong (2799 HK) Accumulate (initiation) Target price: HK$3.4 Wang Wen SFC CE No. BGL GF Securities (Hong Kong) Brokerage Limited 29-3/F, Li Po Chun Chambers 189 Des Voeux Road Central Hong Kong Stock performance Source: Bloomberg Key data Source: Bloomberg China Huarong HSI Mar 27 close (HK$) 3.12 Shares in issue (m) 39,7 Major shareholder MoF (63.36%) Market cap (HK$ bn) M avg. vol. (m) W high/low (HK$) 3.25/2.76 Comprehensive financial service platform with leading profitability; initiate at Accumulate Largest AMC in China by assets China Huarong s total assets amounted to Rmb1.4trn at end- 216, representing a CAGR of 46% since 212. The company maintained leading earnings performance while aggressively expanding its assets. Following its marketization reform, it has obtained various financial business licenses covering securities, financial leasing, banking, trusts and private equity funds. The company s three core business segments, distressed asset management, financial services, and asset management & investment, accounted for 52%, 25% and 22% of total revenue respectively in 216. Acquisition-and-restructuring the focus of distressed asset management business During the previous economic upcycle, China Huarong seized the opportunity to expand its restructuring business, achieving a rapid increase in the gross value of distressed assets under the restructuring model while earning a relatively high NIS and highly visible returns with its annualized return for the business reaching as high as 19.4%. Amid the economic downturn and low interest rate environment, this declined to 12.1% in 216 (though still an industry-leading figure). Expansion of disposal business smoothly underway China Huarong began to expand its acquisition of distressed debt assets under the disposal model in 215, with the proportion of newly acquired distressed debt assets for disposal rising from 14% in 214 to 26% in 215, and further to 44% in 1H16. Net return from the business has continued to decline, down from 26.4% in 212 to 2.9% in 216. However, the IRR has remained quite stable at around 16%. Comprehensive financial service platform The company has established a comprehensive financial service platform with differentiated competitiveness, and the success of its strategy is reflected by its operating data. Each of its eight subsidiaries posted annual revenue above Rmb2bn in 216, while its three main business segments maintained annualized average pre-tax ROE above 2%. Bottleneck for aggressive asset expansion China Huarong maintained an asset CAGR of 46% during , which has provided the foundation for its development as a comprehensive financial service platform. However, as Huarong has purchased a large amount of distressed debt assets during the current upcycle in the supply of these assets, its capital adequacy ratio dropped to a new low level, offering very limited downside compared to the 12.5% regulatory minimum. In light of this, the company is actively seeking an A-share listing in order to replenish its momentum for asset expansion. Initiate at Accumulate with TP of HK$3.4 China Huarong has accumulated considerable operating experience and an extensive client base over the years, with solid government relations and project resources. It has also established a comprehensive financial service platform with sound profitability. The operation of its three main business segments has produced synergy and considerable economies of scale. We believe the company will continue to expand its business over the next three years and will actively push its A-share listing forward to replenish its working capital. Amid an economic recovery and capital market development, distressed debt assets that have been acquired will gradually yield profits, while the company s financial services and asset management & investment segments will also contribute steady revenue growth. Based on an analysis of Chinese banks asset expansion patterns, we think that China Huarong s asset growth will come down from the current level over the next three years. Assuming annual asset growth of 15% during , we expect Huarong to achieve revenue growth of 21%, 19% and 19%, and net profit growth of 13%, 18% and 2% during the period. We initiate coverage of the company with an Accumulate rating and target price of HK$3.4, representing.9x 217E P/B and 6.1x 217E P/E. Risk factors: An abrupt economic slowdown which might lead to continued declines in the return on distressed assets; widespread deterioration in the company s asset quality; full liberalization of AMC license issuance by the government. Stock valuation Revenue (Rmb m) Net profit (Rmb m) Sources: Company data, GF Securities (Hong Kong) EPS (Rmb) EPS YoY P/E BPS (Rmb) % % % % 217E % % 218E % % 219E % % P/B ROE

2 Largest AMC in China by assets In 1999, China Huarong Asset Management Corporation was founded as one of the Big Four AMCs by the Chinese government in the aftermath of the Asian financial crisis. Prior to 26, Huarong was the designated AMC to accept, manage and dispose of distressed assets from ICBC (61398 CH, 1398 HK). Following company marketization during , Huarong completed its joint-stock reform and transformed itself into a large non-bank financial SOE owned by the MoF and China Life Insurance (Group). China Huarong has 33 business branches with service coverage across 3 provinces and municipalities, as well as Hong Kong and Macau. It provides comprehensive financial services including distressed asset management, asset management, banking, securities, trust, leasing, investment, futures and property services through its various subsidiaries such as Huarong Securities, China Huarong Financial Leasing, Huarong Xiangjiang Bank, Huarong International Trust, Huarong Futures, Huarong Rongde Asset Management, Huarong Real Estate, and China Huarong International Holdings. The total assets of China Huarong amounted to Rmb1.4trn by end-216, the largest among all AMCs in China, representing a CAGR of 46% since 212. The company also maintained leading earnings performance while aggressively expanding its assets: net profit (excluding minority interests) picked up 35% YoY to Rmb19.6bn in 216, while its ROE remained relatively high at 18.4%. The company s ROE was lower in 215 mainly due to the dilutive effect of its listing. At present, Moody s (MCO US, NR), Standard & Poor and Fitch have a credit rating of A3, A- and A respectively for China Huarong. Figure 1: Shareholding structure Figure 2: Industry-leading asset scale and profitability % MoF Warburg Pincus China Life Group Fabulous Treasury % 22.2% 19.4% 19.1% 17.3% 18.4% 2.% 63.36% 5.27% 4.22% 4.39% China Huarong % 1.% Huarong Securities 81.56% 75.44% Huarong Futures 79.92% 59.3% Huarong Financial Leasing 5.98% 1% Huarong Rongde Huarong Xiangjiang Bank 98.9% 1% Huarong Real Estate Huarong International Trust Huarong International Holdings H Total assets ROE 5.%.% Sources: Company data, GF Securities (Hong Kong) Comprehensive financial service platform Based on a revenue breakdown, the company s three major business segments are distressed asset management, financial services, and asset management & investment, which accounted for 52%, 25% and 22% of total revenue and 52%, 23% and 25% of pre-tax profit respectively in 216. Distressed asset management is the company s core business, which encompasses distressed debt asset management, DES asset management, custody & agency services for distressed assets, distressed asset-based special situation investments (Huarog Rongde) and distressed asset-based property development (Huarong Real Estate). Segment revenue consists of income from distressed debt assets classified as receivables, fair value changes on distressed debt assets, interest income, investment income, commission & fee income, and other income. As one of the Big Four AMCs set up in the early days, the company has accumulated abundant business experience, professional expertise and client resources in the distressed asset management field, and has established a sound and efficient operating system. As its operation became more market-driven starting from 26, the company has obtained a number of financial business licenses, and have built its securities, financial leasing, banking, trust and private equity fund business platforms, providing diversified financial services as well as asset management and investment support, while these different businesses are integrated with its distressed asset management and asset management & investment businesses to produce synergy. In particular, Huarong Securities, Huarong Financial Leasing, Huarong Xiangjiang Bank 2

3 and Huarong Futures together have formed a comprehensive financial service platform, which provides personalized financing channels and financial products with revenue coming from interest income, investment income, and commission & fee income. The asset management & investment business is an extension of the company s distressed asset management business. It can effectively enrich funding sources and the formats of investment, enhance the overall profitability of the distressed asset management business, and improve the company s business and revenue structure. Under Huarong's asset management & investment business are asset management, financial investment, international business, and other businesses, with commission & fee income and investment income the main sources of revenue. Figure 3: China Huarong revenue breakdown 12, 1, 8, 6, 4, 2, Asset management & investment Financial services Distressed asset management Figure 4: China Huarong pre-tax profit breakdown 35, 3, 25, 2, 15, 1, 5, Asset management & investment Financial services Distressed asset management Source: Company data, GF Securities (Hong Kong) Distressed asset management business overview Acquisition-and-restructuring as the focus The acquisition-and-restructuring business optimizes existing debt assets through restructuring, and provides differentiated financial services for enterprises with temporary liquidity issues; the business discovers and enhances asset value by re-pricing credit risks, revitalizing distressed debt assets with going-concern value, restoring the debtor's corporate credit profile and assessing the price and operational value of the debtor s core assets. Business revenue comes from restructuring income and asset appreciation gains, as well as financial advisory fees. Compared with the acquisition-and-disposal business, the amount of income from the restructuring business was essentially determined when the restructuring agreement was signed, which provides earnings visibility unless a second default happens on the restructured assets. China Huarong was the first of the Big Four AMCs to carry out the distressed asset acquisitionand-restructuring business on a large scale, which has given it a leading industry position. Assets for the restructuring business accounted for more than 7% of the acquisition cost of newly added distressed debt assets each year during As of end-216, assets for the restructuring business represented 77% of the company s booked distressed debt assets, making it the main component of the company s distressed asset management business. During the ongoing operation of the restructuring business, China Huarong has accumulated substantial experience in effectively identifying quality enterprises with short-term liquidity issues as well as that in continuously enhancing and realizing the potential value of distressed assets. The acquisition-and-restructuring business in its essence is the provision of financing/lending services to enterprises with less convincing credit profiles. Apart from financial advisory fees, the income for the business is mainly dependent upon market interest rates and customers risk premium. During the latest economic upcycle, China Huarong seized the opportunity to expand its restructuring business, achieving a rapid increase in the gross value of distressed assets under the restructuring model while earning a relatively high NIS and highly visible returns with its annualized return for the business reaching as high as 19.4%. During the economic downturn, the company has tightened its grip on client and project selection and adopted a more prudent 3

4 business strategy. Amid a low interest rate environment, the monthly annualized return on distressed assets under the restructuring model declined to 12.1% in 216, but the company remained a leader in the industry with this figure. Figure 5: Asset breakdown for the distressed asset management segment (216) Figure 6: Declining returns from restructuring business 25.% 5.% 77% 6% 17% Acquisition and disposal Acquisition and restructuring Debt-to-equity swap 2.% 15.% 1.% 5.%.% 19.4% 17.9% 13.1% 12.9% 12.5% 11.9% 12.1% 2.7% 1.6% 1.6% 1.7% 1.98% 1.5%.9% H H % 3.% 2.% 1.%.% Annualized return on distressed assets under restructuring model Impairment ratio Source: Company data, GF Securities (Hong Kong) Cross-cyclical operation: expansion of disposal business smoothly underway As the major players in the primary market for distressed debt assets, the Big Four AMCs acquire packages of distressed assets from financial institutions through public bidding or negotiated transfers. With an aim to maximize the recoverable value of distressed debt assets, they adopt a variety of methods to dispose of these assets, which include: short-term operations, asset restructuring, debt-to-equity swap, individual transfer, packaged transfer, discounted repayment by debtors, bankruptcy, liquidation, collection through litigation, repayment in kind, and debt restructuring. The core competitiveness of the acquisition-and-disposal business lies in an AMC s acquisition pricing power and asset disposal capabilities. Unlike the acquisition-and-restructuring business which demonstrates pro-cyclical characteristics, the distressed asset acquisition-and-disposal business has certain counter-cyclical features: during an economic downturn, the supply of distressed debt assets increases with greater acquisition price discounts, giving rise to more opportunities for asset acquisition. As the NPL balance at China's commercial banks rose rapidly in 214 (see Figure 9), China Huarong began to expand its acquisition of distressed debt assets under the disposal model in 215, with distressed debt assets under the disposal model as a proportion of new distressed asset acquisition cost rising from 14% in 214 to 26% in 215, and further to 44% in 1H16, reflecting the company s flexible allocation strategy. As for business profitability, net return from the business has continued to decline, down from 26.4% in 212 to 2.9% in 216. However, the IRR of the business has remained quite stable at around 16%, similar to the 212 level. Based on the formula (1 + IRR) n = 1 + net return on disposal, the disposal cycle (represented by n) can be roughly calculated. Huarong s disposal cycle shortened from 1.71 years in 212 to.2 years in 216, indicating that the company holds its disposal assets for less than three months on average. In other words, amid continued declines in the net return of its disposal business, Huarong has achieved a higher IRR by shortening the disposal cycle, which shows the company s leading capability to acquire, manage and dispose of distressed assets. (Note: The disposal IRR is the discount rate that makes the net present value of all cash flows from acquisition-and-disposal projects completed in a given period equal to zero. Meanwhile, the net return on disposal is calculated as realized disposal gains from distressed debt assets / gross value of distressed debt assets disposed of. The main difference between the IRR and net return is that time cost is factored in in the former but not the latter.) 4

5 Figure 7: Huarong s acquisition cost of newly added distressed debt assets, breakdown by business model (Rmb m) Figure 8: Huarong has maintained stable IRR 4, 35, 3, 25, 69% 2, 15, 74% 56% 1, 86% 5, 88% 83% 94% H H Acquisition and disposal Acquisition and restructuring 3.% 25.% 2.% 15.% 1.% 5.%.% % 23.2% 2.2% % 15.7% 16.% 17.% 16.2% 16.% % 11.8% % 3.2% % H H Disposal cycle (years, RHS) IRR on completed projects Return on disposal business Source: Company data, GF Securities (Hong Kong) Substantial market space for distressed asset management The distressed asset management business, which helps to resolve credit risk and revitalize existing assets, has substantial market space amid a quickly expanding overall debt scale. FI distressed assets The NPL balance at Chinese commercial banks has picked up sharply since 214, as overall lending continues to grow and as economic restructuring deepens, which has provided an abundant supply of distressed assets for the acquisition-and-disposal business. Commercial banks dispose of their NPL assets mainly through write-offs or packaged transfers. For distressed loans that are difficult to be collected, a commercial bank can choose to transfer them to an AMC through public bidding or negotiated batch transfer, with the latter remaining the prevalent channel at present. In 216, the NPL ratio of Chinese commercial banks remained stable at 1.75%, but the actual NPL ratios should exceed those disclosed in banks financial reports when we consider the recent increase in the pace at which banks have moved NPLs off their balance sheets. In addition, amid slowing economic growth, ongoing economic restructuring and a tightening regulatory environment, non-bank financial institutions such as trust and fund companies might also have liquidity and asset revitalization demand, which should further increase the supply of FI distressed assets. NFE distressed assets mainly come from enterprises receivables. As their net receivables continue to pick up amid overall economic growth, some companies have suffered from high leverage ratios and low receivable turnover, leaving them in need of debt restructuring and asset revitalization. Net receivables at industrial companies in China continued to increase and amounted to Rmb12.6trn at the end of 216, up 1% YoY. Continuously growing receivables will give rise to a large supply of distressed debt, providing room for the development of the distressed debt asset management business. Figure 9: Commercial banks NPL balance continues to increase 1,6 2. 1,4 1, , Figure 1: Industrial companies net receivables on the rise 14, 12, 1, 8, 6, 4, 2, 3% 25% 2% 15% 1% 5% % NPL balance at commercial banks (Rmb bn) NPL ratio (%) Net receivables at industrial co. (Rmb bn) YoY Source: Wind, GF Securities (Hong Kong) 5

6 Figure 11: China Huarong s key subsidiaries Distressed asset management Financial services Asset mangement & Investment Source: Company data, GF Securities (Hong Kong) A well-developed comprehensive financial platform Following its marketization, by restructuring problematic companies and cooperating with local governments, China Huarong has established a comprehensive financial business platform covering securities, financial leasing, banking and futures. Based on the core competitiveness built in its distressed asset management business and relying on its various licensed subsidiaries, the company has also established an asset management and investment platform with differentiated competitiveness. Subsidiary Business Scope of business Huarong Rongde Huarong Property Huarong Securities Huarong Financial Leasing Huarong Xiangjiang Bank Huarong Trust Huarong Yufu Huarong International Distressed assetbased special situation investments Distressed assetbased property Development Securities & futures Financial leasing Banking Asset management Asset management Financial investment International Business Investing in enterprises with value appreciation potential and ST liquidity issues using debt, equity and mezzanine capital, and profiting by improving the enterprises' capital structure, management and operating performance Restructuring, investing in and developing quality property projects acquired during distressed asset management in order to profit from asset appreciation The securities business mainly covers the prop trading, brokerage & wealth management, asset management and investment banking businesses. The company is also engaged in futures and direct investment through subsidiaries Huarong Futures and Huarong Tianze One of the first financial leasing companies approved by the CBRC; providing customized financial solutions through finance leasing services based on equipment (in relation to manufacturing, public transportation, environmental & new energy, healthcare, shipping) A regional bank with strong market competitiveness; committed to serving the local economy, small and micro enterprises, rural area/agriculture/farmer-related industries, and people's livelihood Providing customized trust products, with a diversified business structure and broad product coverage; businesses mainly include managing and deploying trust assets as trustee to earn a trust fee, and providing financial advisory services Huarong's PE investment business covers equity investment, equity investment management, fixed income investment and investment advisory services, with a focus on investment opportunities from quality SOEs during their reform, restructuring and listing processes, as well as those from private enterprises with strong grwoth momentum Mainly consisting of fixed income and equity investments; also investing in certain companies qualified for listing through mezzanine investment; ensuring stable returns by making fixed income investment, and seeking greater returns through convertible debt and stock option arrangements Huarong's overseas investment and financing platform; conducting equity, debt and mezzanine investment and financing businesses by tapping into Hong Kong's mature capital markets and legal environment; also acting as Huarong's globalized asset management platform through which to invest in overseas projects Under group-level coordination and cooperation between the eight key subsidiaries, China Huarong provides comprehensive financial solutions for corporate clients. Large client focused: Huarong focuses on local governments, large enterprises, major corporate groups and large financial institutions as its key clients, and has established in-depth cooperation with its clients. Network support: Synergy is produced between the company s headquarter, its 33 branches across the country and eight subsidiaries. Comprehensive solutions: The company aims to provide customized financial products and services that cover enterprises full life cycle and the full economic cycle relying on its diversified product and service offering. China Huarong s strategy to develop itself as a financial holding group has met with considerable success judging by its operating data. Its eight subsidiaries have reached a mature stage of development, with each posting annual revenue above Rmb2bn in 216. In YoY terms, the PE 6

7 investment, financial investment, international business and property development divisions achieved particularly strong revenue growth. In addition, its subsidiaries also demonstrated solid profitability, with the three main business segments of distressed asset management, financial services and asset management & investment maintaining annualized average pre-tax ROE above 2%. The mismatching cyclical patterns of different business segments can help smoothen the volatility in its distressed asset management business and increase asset utilization efficiency. For example, the average pre-tax ROE of the three major segments were 26.3%, 23.6% and 2.6% in 214, and the percentages changed to 2.2%, 25.1% and 23.4% in 215, with the profitability decline in the distressed asset management segment balanced out by increases in the other two (annualized average pre-tax ROE = annualized pre-tax profit / average of beginning and ending net asset balances). In addition, China Huarong has made a series of attempts to develop innovative financial businesses, including the issuance of non-performing asset securitization products, the online sales of distressed asset packages in collaboration with Taobao, and the establishment of a consumer finance subsidiary in Jan 216. Figure 12: China Huarongs s subsidiary revenue Figure 13: Annualized average pre-tax ROE by segment 12, 1, 8, 6, 4, 2, 11,382 7,54 5,924 2,79 2,253 5,33 9,516 2,382 3, % 4.% 35.% 3.% 25.% 2.% 15.% 1.% 5.%.% H H Distressed asset management Asset management & investment Financial services Source: Company data, GF Securities (Hong Kong) Bottleneck for aggressive asset expansion In the CBRC s "Notice on the Issuance of Off-Site Supervision Report Standards for Financial Asset Management Companies (Provisional)", AMCs are required to meet certain standards in terms of five regulatory indicators, namely qualified capital, minimum capital, group consolidated financial leverage ratio, AMC leverage ratio and AMC liquidity ratio. Among them, the minimum capital for a group is determined based on the calculation standards set out by the Guidelines for the Consolidation of Financial Asset Management Companies, while the minimum capital for an AMC is calculated as 12.5% of its risk-weighted assets (OBS assets included), where the weights are determined mainly based on the level of risks and relevance to core business. The minimum capital for securities, insurance, trust and leasing companies should be calculated in accordance with the regulatory requirements of relevant regulatory bodies. In addition, the leverage ratio of the group and the AMC shall not be less than 6%, while the liquidity ratio of the AMC shall not be less than 15%. Both the acquisition-and-disposal and DES businesses involve purchasing and holding assets for value appreciation, while the acquisition-and-restructuring business can essentially be seen as the provision of financing/lending to enterprises with less convincing credit profiles. All three are asset-heavy businesses with revenue growth dependent upon asset expansion. Among the businesses of Huarong s eight major subsidiaries, business growth for distressed asset-based special situation investment, distressed asset-based property development, banking, financial leasing, financial investment and part of the international business are reliant upon large-scale asset expansion. China Huarong maintained an asset CAGR of 46% during , which has provided the foundation for its development as a comprehensive financial service platform. However, as Huarong has purchased a large amount of distressed debt assets during the current upcycle in the supply of these assets, its capital adequacy ratio dropped to a new low of 12.86% 7

8 at end-216, offering very limited downside compared to the 12.5% regulatory minimum. Its net capital has now become a bottleneck hindering further expansion in its distressed asset management business. In light of this, the company is actively seeking an A-share listing in order to replenish its momentum for asset expansion. However, no new progress has been made after its application for listing was accepted by the CSRC in Dec 216. Figure 14: Continued asset expansion Figure 15: Net capital now a bottleneck for asset expansion 1,6 1,4 1,2 1, ,73 1,412 7% 6% 5% 4% 3% 2% 15.% 13.7% 13.45% 13.58% 13.% 11.% 9.% 7.% 14.75% 13.71% 12.86% H Total assets (Rmb bn) YoY (annualized) 1% % 5.% H Capital adequacy ratio Source: Company data, GF Securities (Hong Kong) Asset growth and earnings Forecasts Asset growth forecasts Based on an analysis of Chinese banks asset expansion patterns, we think that China Huarong s asset growth will come down from the current CAGR of 46% over the next three years. Our arguments are presented as follows. 1) Asset growth slows as asset base expands We have chosen A- or H-share listed Chinese banks with total assets in the range of Rmb.8trn- 5trn at mid-216 and calculated their asset CAGR during 212-1H16 (mid-216 instead of 216 data used to ensure comparability, see Figure 16). China Huarong topped the chart with an asset CAGR of 42%. However, half of the banks with assets below Rmb.4trn in 212 saw asset CAGRs above 35% during the period, while those with assets smaller than Rmb1trn in 212 experienced asset CAGRs of above 2%; banks with total assets above Rmb1trn in 212 posted annual asset growth of less than 2%. 2) Asset growth drops below 2% after Rmb1trn mark is passed Looking back at the patterns of asset expansion at the four banks which had total assets above Rmb1trn in 212, their asset CAGR over the 3.5/4-year period after total assets exceeded the Rmb1trn threshold was significantly slower than the CAGR for the preceding period when their assets were in the Rmb.3trn-1trn range. For example, Bank of Beijing, whose total assets went above Rmb1.1trn in 212, saw its asset CAGR slow from 26% in (when its assets ranged between Rmb.3trn and 1trn, same idea below) to 18% during 212-1H16. Ping An Bank, whose total assets broke Rmb1.2trn in 211, saw a CAGR slowdown from 37% during to 19% during Similarly, Hua Xia Bank s asset CAGR decelerated from 24% during to 16% during , while China Everbright Bank saw a slowdown from 23% during to 19% during (23% is likely an underestimation as data prior to 25 are not available). 3) Financial deleveraging weighing on asset growth The Chinese government has repeated on various occasions that it will maintain neutral monetary policy this year, while the interest rate upcycle in the US coupled with the upward pressure on 8

9 China s PPI mean that the Chinese government will take further measures to facilitate financial deleveraging. The PBoC s moves to increase interbank interest rates through MLF and reverse repo rate adjustments earlier this year and the implementation of MPA checks have also put pressure on banking system liquidity. As AMCs asset expansion to a large extent needs to be funded by corresponding expansions in their liabilities, financial deleveraging means AMCs business growth might be restricted. 4) Huarong s asset growth in 2H16 might have materialized part of its future growth potential Huarong s total assets already reached Rmb1.7trn at mid-216, but continued to grow strongly to reach Rmb1.4trn at the end of last year. However, the increased assets are yet to be put to use effectively as the company s asset turnover ratio declined from 1.3%, 1.1% and 1.3% during to 8.4% in 216. Moreover, a low capital adequacy ratio of 12.86% means that the momentum for further asset expansion will be restricted until the company s A-share listing or preferred share issuance is approved. As such, assuming that Huarong will see an asset CAGR of 22% during the 3.5 years after its total assets exceeded Rmb1trn, its asset CAGR from end-216 to end-219 will be 15%. We believe an equity financing activity by the company might take place in 2H17, which might have an impact on its asset utilization efficiency. Figure 16: Asset expansion at Chinese banks during 212-1H16 Figure 17: Asset growth before and after Rmb1trn mark is reached (Rmb bn) Ticker H16 CAGR China Huarong 2799 HK % Zheshang Bank 216 HK % Bank of Nanjing 619 CH % Shengjing Bank 266 HK % Bank of Ningbo 2142 CH % Bank of Jiangsu 6919 CH % Bank of Shanghai CH % Bank of Beijing CH % Ping An Bank 1 CH % China Everbright Bank CH % Hua Xia Bank 615 CH % 4% 35% 3% 25% 2% 15% 1% 5% % 26% 18% 37% 19% 24% 23% 19% 16% Bank of Beijing Ping An Bank Hua Xia Bank China Everbright Bank CAGR when assets were in Rmb.3-1trn range CAGR over yr after total assets exceeded Rmb1trn Sources: Wind, GF Securities (Hong Kong) Earnings forecasts Given deepening economic restructuring and supply-side in China, we expect the supply of distressed debt assets from both FIs and NFEs to remain high over the next three years. Amid declining market interest rates, the IRR of completed acquisition-and-disposal projects, the annualized return on the acquisition-and-restructuring business, and companies funding cost were at low levels during 216. That said, interest rates bottomed out in Nov 216, while total financing data showed signs of a recovery in corporate financing demand in early 217. These changes are favorable for the disposal of distressed debt assets and the realization of revenue for AMCs, with the enhancement of project returns potentially to exceed the slight increase in financing cost. Low-cost funds provided by banks will continue to support business expansion in Huarong s financial services segment. Its banking and leasing businesses might see slight NIS improvements amid rebounding market interest rates. In the absence of any systematic risks in the capital markets, the company s securities, asset management and investment businesses should also maintain solid earnings performance. In terms of costs, Huarong s interest expense might have bottomed in 216, and might see upward pressure during Commission and fee expenses are likely to increase along with the expansion of the financial services segment, with the cost ratio to remain stable. Asset 9

10 Figure 18: Key assumptions impairment losses might shrink as the economy stabilizes and recovers. Overall, we expect China Huarong to maintain a relatively stable cost-to-income ratio. Assuming annual asset growth of 15% during , we expect Huarong to achieve revenue growth of 21%, 19% and 19%, and net profit growth of 13%, 18% and 2% during the period. Given that Huarong s capital adequacy ratio was already approaching the regulatory minimum level at end-216, we expect the company to increase equity through an A-share IPO or preferred share issuance in 217; otherwise, its asset growth in 217 will not reach the level assumed in our model. According to the company s A-share listing prospectus submitted for the CSRC s review, it will issue no more than 6,895m new shares, which will represent no more than 15% of the company s enlarged capital; the issuance price should be no lower than the company s BPS of Rmb2.77 prior to the issuance (end-june 216 figure; 1H16 EPS: Rmb.41). The company has indicated that all of the proceeds from the listing excluding listing fees will be used to replenish its working capital for core business development. (Rmb m) E 218E 219E Revenue YoY 43% 37% 48% 26% 21% 19% 19% YoY growth: Income from distressed debt assets classified as receivables 92% 76% 47% 9% 3% 18% 21% Fair value changes in distressed debt assets 14% 74% 85% 135% 11% 39% 9% Fair value changes in other financial assets 15% 37% 16% 73% 2% 15% 15% Interest income 4% 2% 17% 17% 32% 19% 18% Net investment income 54% 2% 96% 29% 2% 2% 2% Commissions and fee income 29% 18% 3% 24% 2% 18% 18% Cost-to-revenue ratio 63% 62% 65% 68% 65% 67% 68% 67% Pre-tax profit Effective tax rate -23% -26% -22% -24% -24% -24% -24% -24% Net profit YoY % 44% 29% 3% 36% 13% 18% 2% Net profit margin 27% 27% 26% 22% 24% 23% 22% 23% Net profit attributable to equity holders Source: GF Securities (Hong Kong) Valuation and investment highlights As the largest AMC in China by total assets, China Huarong has accumulated considerable operating experience and an extensive client base over the years, with solid government relations and project resources. It has also established a comprehensive financial service platform with sound profitability. Relying on its extensive business network across the country, the company provides diversified products and services through its synergetic business segments of distressed asset management, financial services and asset management & investment, and has achieved significant economies of scale. We believe the company will continue to expand its business and will actively push its A-share listing forward to replenish its working capital. Meanwhile, China Huarong has built effective operating models for both its distressed asset management business and comprehensive financial service platform. Amid an economic recovery and capital market development, distressed debt assets that have been acquired will gradually yield profits, while the company s financial services and asset management & investment segments will also contribute steady revenue growth. Compared with China Cinda, China Huarong has a better defined strategy for expansion and a more stable profit-making model, and the company has been given a higher market valuation previously as a result. That said, China Cinda has seen a re-rating recently as a beneficiary of the Stock Connect thanks to the recent increase in southbound trading. China Huarong has been trading within a P/E range of [5.x, 7.2x] with an average of 6.1x over the past year, and within a P/B range of [.8x, 1.x] with an average of.9x. Its P/B valuation was consistently below 1x during 216, mainly due to market concerns about potential deterioration of acquired distressed 1

11 asset quality amid the economic downturn. Indeed, AMCs that acquire and operate debt assets with problematic quality over the long term might be subject to major internal financial disruptions in the case of long-term economic depression. However, the profitability of the company s distressed asset management business will be safeguarded by a significantly shortened disposal cycle for the acquisition-and-disposal business, a relatively high NIS for the restructuring business, and high exit multiples for the DES business. Taking into account the uncertainties surrounding the company s pace of asset expansion and based on its average valuation over the past year, we initiate coverage of the company with an Accumulate rating and target price of HK$3.4, representing.9x 217E P/B and 6.1x 217E P/E. The stock is likely to see re-ratings after it is included as an HSI constituent and a tradable stock under the Stock Connect. Risk factors: An abrupt economic slowdown which might lead to continued declines in the return on distressed assets; widespread deterioration in the company s asset quality; full liberalization of AMC license issuance by the government. Figure 19: Peer valuations (Rmb bn) Market cap (HK$ bn) Total assets Net assets Revenue Net profit P/E P/B ROE E E E 2799 HK China Huarong HK China Cinda Source: Wind, GF Securities (Hong Kong) Note: 1) Closing prices on Mar 3, 217 are used where share price data are involved; Rmb1 = HK$1.1238; 2) 216 actual financial data used for both companies, except that Bloomberg consensus book value per share is used in calculating China Cinda s 216 P/B. Figure 2: Historical P/E and P/B P/E P/B Source: Wind, GF Securities (Hong Kong) 11

12 Figure 21: Financial statements Balance sheet Income statement Year ended 31 Dec Year ended 31 Dec E 218E 219E (Rmb m) (Rmb m) E 218E 219E Total assets Income from distressed debt assets classified as receivables Cash and balances with Fair value changes on distressed central bank debt assets Deposits with financial Fair value changes on other institutions financial assets Placements with financial institutions Interest income Finanical assets held for trading Investment income Finanical assets designated as at fair value through profit or loss Commission and fee income Financial assets held under Net losses/gains on disposal of resale agreements associates Loans and advances to Other income and other net customers gains or losses Finance lease receivables Total Available-for-sale financial assets Interet expense (2592) (31417) Held-to-maturity investments Commission and fee expense (945) (136) Financial assets classified as rceivables Impairment losses on assets (1264) (16717) Interests in associates Operating expanese (11488) (12287) Investment properties Total (5939) (61457) (77975) (93739) (11313) Change in net assets attributable Property and equipment to other holders of consolidated (2457) (3376) (34) (3587) (4919) structured entities Deferred tax assets Share of results of associates Other assets Profit before tax Source: Wind, GF Securities (Hong Kong) Income tax expense (5295) (741) (8379) (9856) (11822) Liabilities Profit for the year Borrowings from central bank Profit attributable to equity holders Deposits from financial institutions Non-controlling interests Placements from financial Profit attributable to holders of institutions perpetial capital instruments Financial assets sold under repurchase agreements Borrowings Financial ratios Due to customers Year ended 31 Dec E 218E 219E Bonds and notes issued Cost-to-income ratio 68% 65% 67% 68% 67% Tax payable Return on distressed debt assets classified as receivables 13% 11% 11% 11% 11% (estimate) Deferred tax liabilities IRR on completed projects under disposal model (estimated) 2% 16% 17% 17% 17% Other liabilities Income tax rate 24% 24% 24% 24% 24% Equity Profitability Euiqty attributable to equity holders ROA 2.3% 2.% 1.7% 1.8% 1.8% Share capital ROE 17.3% 18.4% 17.1% 16.7% 17.7% Others Leverage (A/E) Perpetual capital instruments Valuation Non-controlling interests P/E Total liabilities and equity P/B Dividend yield (%)

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