Dim Sum Express. A-Share Market. Hong Kong Market. Equity Research. Jul 27, 2015

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1 Equity Research Dim Sum Express Key index performance Chg (%) EPS (%) P/E Market 1D 1M YTD 14E 15E 14E 15E HSI HSCEI MXCN SHSZ SHCOMP SZCOMP INDU SPX CCMP UKX NKY Hong Kong ADRs HK Local Daily ADR Daily ticker Company (HK$) (%) (US$) (%) 857 PETROCHINA ICBC CHINA MOBILE BANK OF CHINA CCB TENCENT HSBC CHINA LIFE SINOPEC PING AN Econ data release China Data Date Period Prior Cons Westpac MNI Con Sen 28-Jul JUL Manufacturing PMI 31-Jul JUL Non-Mfg PMI 31-Jul JUL Caixin Mfg PMI 2-Aug JUL F US Data Date Period Prior Cons Dur Goods New Ord 27-Jul JUN S&P/CS Comp Jul MAY Markit US Serv PMI 28-Jul JUL P Pending Home Sales 29-Jul JUN Q GDP QoQ 30-Jul 2Q A Initial Jobless Claims 30-Jul 25-Jul Cont Jobless Claims 30-Jul 18-Jul Source: Bloomberg GF events Source: GF Securities (HK) A-Share Market Investment Strategy: State-level SOE reform plan to come out soon We continue to like the SOE reform theme in the medium term and see it as the most important market driver in 2H15 as it is supported by a sustainable investment logic, covers a large number of investment targets and benefits from strong policy support. Once a state-level reform plan is accepted by the market and the second group of central SOE reform pilot is announced, we expect to see overall share price strength in the SOE reform theme, with companies affiliated to local SASACs to become popular stocks in the market later on. Container Shipping: Sector to enter up cycle in 2016 Industry concentration is set to increase further as companies seek bigger business scale under the liner-based operating model. The arrival of a new sector up cycle hinges upon a stable competition landscape and certain changes in global trade, i.e. 1) easing sector supply growth amid declining new ship orders; 2) rebounding demand amid OECD economic recovery; and 3) increased imports by China. We believe sector supply will rebalance in 2016, at which point the sector will likely enter an up cycle given China s Silk Road initiative and the economic recovery in Europe. Property: Price growth momentum strong in 1st/2nd-tier cities Overall home prices are set to pick up on a sequential basis with the pace of growth to vary in different cities. The momentum for price growth in first-tier and key second-tier cities is relatively strong on owner-occupied and upgrading demand, whereas price growth in third and fourth-tier cities is limited by high inventories. Overall, mainstream developers are expected to see re-ratings on sustainable increases in property sales volume and prices. In addition, we also like SOE reform plays. Hong Kong Market Investment Strategy: Further easing needed given weak China data China s economy performed worse than expected again in July. Although 2Q GDP data show emerging signs of economic stabilization, manufacturing data illustrate that the recovery is still not yet steady. We therefore believe a combination of monetary and fiscal measures will be introduced in the second half. Further IR and RRR cuts are coming, and the third round of the local government debt swap plan is likely to be granted in order to reduce financing costs for companies and support the economy. Yashili (1230 HK, NR): Acquisition of Dumex from Danone Danone plans to sell its 100% stake in Dumex to Yashili and will use the funds from the sale to purchase shares in Mengniu. Dumex s performance has remained weak this year as it is focused on offline channels online sales of infant milk formula are taking market share from traditional channels. We believe this may be the reason that Danone wants to sell the brand now. We see limited synergy between Dumex and Yashili, and we do not expect Yashili to perform well this year, especially given sector headwinds. NetDragon (777 HK, Hold): Takeaways from company visit Revenue from online games, its main source of revenue, should maintain low-teen growth in 2015, driven by new PC and mobile games. The company has increased its headcount by around 50% as of end-1q15 from one year ago in order to support R&D in its new education business. As the company will continue to invest heavily on education this year, net profit is estimated to decline by a substantial 72% in The online education business will start to generate revenue in 2H15 along with the commercial launch of the 101 student tablet. 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 Investment Strategy: State-level SOE reform plan to come out soon Strong performance of our recommended investment themes Stocks related to investment themes that we highlighted last week demonstrated strong share price performance. The index tracking stocks related to SOE reform rose 20.07% last week, leading other investment themes; the military equipment sector led other sectors by picking up 14.65%, while several stocks driven by the 2022 Winter Olympics also significantly outperformed their respective sectors. SOE reform as mid-term market driver We continue to like the SOE reform theme in the medium term and see it as the most important driver of market performance in 2H15 as it is supported by a sustainable investment logic, covers a large number of investment targets and benefits from strong policy support. Policy catalysts expected this week While the performance of the theme did start to weaken last Friday, we noticed a fair amount of expectations for policy catalysts related to SOE reform to be issued this week during our talks with institutional investors. If, however, these reform policies remain unclear in the near term, corrections might be seen not only in the investment theme but the entire market. State-level reform plan to come out soon We believe a state-level SOE reform plan will be issued in the near future, and that the implementation of the reform pilot for the first group of central SOEs and the announcement of the second group can both be expected. Once such a state-level reform plan is accepted by the market and the second group of central SOEs for the reform pilot are announced (especially with regard to a state-owned investment company trial), we expect to see overall share price strength in the SOE reform theme, with companies affiliated to local SASACs to become popular stocks in the market later on. Pro-growth policies another key theme in 2H15 Apart from SOE reform, we believe the maintenance of stable economic growth will also be a focus of policy making in 2H15: we expect the current administration to balance between maintaining stable growth and restructuring the economy. Container Shipping: Sector to enter up cycle in 2016 Period of high sector growth ended Global container shipping volume grew at a CAGR of 9% during , vs. 3.7% for dry bulk shipping and 1.6% for oil shipping, driven by rising containerization levels and economic globalization. However, the period of high sector growth has ended as the containerization rate peaked in 2005 and as overall shipping distance has shortened due to regional economic cooperation. Industry concentration rising on liner-based operation Under the current liner-based operating model, shipping companies key competitiveness lies in their operating efficiency, service networks and trip frequency. As a result, efforts to enlarge business scale have led to a rapid increase in industry concentration. The CR8 of the global container shipping market rose to nearly 60% by the end of 2014, with the CR20 reaching as high as 86%. Cost-plus pricing to prevail We believe the container shipping units of Japan s top three shipping companies are very likely to be consolidated amid ongoing pursuits for bigger business size. In addition, sector M&A and alliances are also likely to become more common. The 2M and O3 alliances are set to further raise industry concentration, with the overall pricing mechanism to shift towards cost-plus pricing. Large ships to drive global route development After the Panama Canal is expanded, global shipping routes are set to be developed using triple-e class ships, as the increased use of large ships with capacity above 15,000 TEU has led to further declines in the costs of major trunk lines. Furthermore, regional trunk lines and branch lines will provide support to the global trunk lines. This should benefit large shipping groups and regional shipping companies with specialized business strength. Sector to enter up cycle in 2016 The arrival of a new sector up cycle hinges upon a stable competition landscape and certain changes in global trade conditions, namely: 1) easing sector supply growth amid declining new ship orders; 2) rebounding demand amid OECD economic recovery; and 3) increased imports by China. We believe the rebalancing of sector supply will finish Page 2

3 in 2016, at which point the sector will likely enter an up cycle given China s Silk Road initiative and the economic recovery in Europe. Key risks include a slower-than-expected pace of industry consolidation, irrational growth in new ship orders, and weaker-than-expected economic recoveries in OECD countries. Property: Price growth momentum strong in 1st/2nd-tier cities Transactions down slightly WoW Primary area sold in first-tier cities dropped 10% WoW last week, dragged by Beijing and Shanghai, while second-tier cities tracked picked up 2%. Among second-tier cities, Fuzhou (+161%) and Nanchang (+84%) posted the strongest WoW growth, while Dongguan suffered the most significant decline of 31%. All three key regions saw drop-offs in weekly transactions: the PRD dropped the most by 11.7%; YRD cities except for Hangzhou and Wuxi all recorded a WoW decline, while cities in the Bohai Rim were mixed. New launches rebound to month s high New project launches rebounded significantly to the month s high last week. Our index for inventories in 15 large cities edged up slightly as a result, with Shanghai and Beijing both rising. The sell-through rate in the 12 large cities tracked remained stable. Fundamentals recovery to continue 2Q15 economic data suggests that downward pressure on the economy still exists, meaning property sector and credit issuance policies should remain loose in the foreseeable future (though the pace of credit easing is likely to slow). The current property market recovery should continue on accelerated materialization of housing demand. Price growth momentum strong in 1st/2nd-tier cities Overall home prices are set to pick up on a sequential basis with the pace of growth to vary in different cities. The momentum for price growth in first-tier and key second-tier cities is relatively strong on owner-occupied and upgrading demand, whereas price growth in third and fourth-tier cities is limited by high inventories. Overall, mainstream developers are expected to see re-ratings on sustainable increases in property sales volume and prices. In addition, we also like SOE reform plays. Key risks include a slower-than-expected recovery in fundamentals, and changes in policy expectations triggered by home price growth. Investment Strategy: Further easing needed given weak China data Strong housing recovery could help US recovery US housing data improved in June. Existing home sales increased 3.2% MoM to an annualized level of 5.49m units, the highest level in eight years. Combined with the strong housing starts data released last week, we expect the US housing market to continue to recover in the second half of 2015, pointing to an upward trend in residential investment. Looking ahead, the FOMC meeting on July will become the focus for the market. In her testimony before Congress, Fed Chair Janet Yellen was more optimistic about the economic outlook. She noted increased momentum for the labor market and reduced uncertainty over the outlook. Given the recent stronger economic data, we believe the FOMC statement will reiterate that a rate hike will come this year, and that the pace of normalization is likely to be gradual. Greek crisis will not dampen euro zone economy The Greek government passed the second bundle of austerity measures demanded by creditors last week. According to the government s spokesperson, Greece will wrap up bailout talks with creditors by August 20, and receive 86bn in loans. We believe the risk of Grexit has receded in the short term. Although the crisis has knocked investor confidence in the stock market, the impact on the economy seems limited. Euro-zone manufacturing and services preliminary PMI dropped slightly in July, but is still near the highest level in a year. We believe the ECB will continue its asset purchase program to support the economy. The Grexit crisis will therefore not reverse the trend of recovery, and the euro zone economy is likely on track for a modest recovery in Low commodity prices encourage central banks to ease monetary policy Over the past few weeks, energy, precious metals and industrial metals prices have dropped sharply to the lowest level in several years. In the energy market, WTI crude oil prices dropped 20% to below $50/barrel within one month, mainly due to the nuclear deal with Iran and uncertainties about the global economic recovery. In the precious metals market, gold prices declined to below $1,100/oz, the lowest level since Mar 2010, due to diminishing safe-haven interest after the Greek crisis. In the industrial metals market, LME copper prices fell to $5,240/tonne, a six-year-low, on concern about China s economy. Low commodity prices provide space for central banks to ease monetary policy further as inflation is facing downside risk. The central banks of Canada, Sweden, Hungary and Page 3

4 New Zealand cut their main interest rates in July. We believe most central banks will keep their monetary policies accommodative in Weak manufacturing PMI data in China calls for policy easing China s economy performed worse than expected again in July. The flash Caixin/Markit manufacturing PMI dropped to 48.2 from 49.4 the previous month, the lowest level in 15 months. This is the fifth straight month below 50, showing five months of contraction for the manufacturing sector. Although 2Q GDP data show emerging signs of economic stabilization, the manufacturing data illustrate that the recovery is still not yet steady. We therefore believe a combination of monetary and fiscal measures will be introduced in the second half. Further IR and RRR cuts are coming, and the third round of the local government debt swap plan is likely to be granted in order to reduce financing costs for companies and support the economy. (Alex Fan, CFA, Head of Research, SFC CE No. ADJ672, alexfan@gfgroup.com.hk ) (Frankie Wan, Research Analyst, SFC CE No. AVK969, frankiewan@gfgroup.com.hk ) Yashili (1230 HK, NR): Acquisition of Dumex from Danone What s new? Mengniu (2319 HK) and Yashili (1230 HK) jointly announced last week that Danone plans to sell its 100% stake in Dumex to Yashili and that it will use the funds from the sale to purchase shares in Mengniu, through CDI (CFCO Dairy Investment, a substantial shareholder in Mengniu). Our Comments We believe Dumex s performance has remained weak this year as it is focused on offline channels online sales of infant milk formula are taking market share from traditional channels. We believe this may be the reason that Danone wants to sell the brand now. Competition in infant milk formula has been more intense than expected, with online retailers (cross-border online selling) increasingly entering into price wars. We do not expect a turnaround in the short term. We see limited synergy between Dumex and Yashili, and we do not expect Yashili to perform well this year, especially given sector headwinds. (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 ) NetDragon (777 HK, Hold): Takeaways from company visit Main focus on education business NetDragon is a leading online gaming and mobile internet company. After the disposal of 91 Wireless, one of China s largest mobile app stores in 2013, the company began to shift its focus to the online education business. NetDragon aims to build an education ecosystem for primary and secondary school education. The ecosystem will include hardware, software platform and education content. The company will start selling one of its key products, the 101 student tablet, in the second half to both schools and students. The product is a tailor-made 10-inch tablet for both teachers and students, and includes many education apps developed by NetDragon. Management indicated they may give estimates for revenue and product sales in the education business after its interim results. Substantial acquisition to accelerate development The company is in the process of acquiring the UK-listed education company Promethean for around HK$1.01bn. Promethean is a global leader in the interactive education technology market. It developed a series of education hardware products and has also recently released some interactive education software products. It sources most of its revenue from the US and UK markets. The company expects to accelerate its development in the education business with Promethean s strong technical capabilities and significant cross-selling opportunities in domestic and overseas markets. Heavy pressure on profitability during investment phase Online games remain the main source of revenue. Revenue from online games should maintain low-teen growth in 2015, driven by new PC and mobile games. The company increased its headcount by around 50% to 3,378 as of end- 1Q15 from 2,285 one year ago, in order to support R&D in its new education business. As the company will continue to invest heavily on education this year, net profit is estimated to decline by a substantial 72% in The online education business will start to generate revenue in 2H15 along with the commercial launch of the 101 student tablet. But the financial impact should be very limited given it is still at an initial stage. We believe sales volume and platform user base will be more important indicators to judge its progress in the education business. Page 4

5 Education business now valued at HK$3.8bn We believe investors main focus is on its emerging education business, rather than the gaming business. Its share price has risen 80% YTD. Excluding the value of its online games business (HK$4.3bn based on 10x FY16E P/E) and cash (HK$4.1bn), the market is currently valuing its education business at HK$3.8bn. We will track its development and await clear guidance. (Ryan Zhu, Research Analyst, SFC CE No. BDK820, ) Page 5

6 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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