Dim Sum Express. A-Share Market. Hong Kong Market. Equity Research. Jan 14, 2016

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1 Equity Research Dim Sum Express Key index performance Chg (%) EPS (%) P/E Market 1D 1M YTD 15E 16E 15E 16E HSI HSCEI MXCN SHSZ SHCOMP SZCOMP INDU SPX CCMP UKX NKY Hong Kong ADRs HK ticker Company Local (HK$) Daily (%) ADR (US$) Daily (%) 1398 ICBC CHINA MOBILE PETROCHINA TENCENT CCB BANK OF CHINA HSBC CHINA LIFE PING AN SINOPEC Source: Bloomberg GF events Source: GF Securities (HK) A-Share Market Investment Strategy: Impact of Rmb devaluation by sector Based on data from other countries, no consistent pattern can be seen in stock market performance following significant devaluations in relevant local currencies. We believe the unclear mid/long-term outlook for the Chinese economy has led to weakness in the A-share market. The persistence of conflicts between reform and pro-growth efforts will more likely lead to a slow bear stock market instead of a slow bull. We advise caution in the short term and suggest watching defensive sectors such as banking, healthcare and environmental. Please see text for our analysis of how Rmb devaluation affects companies in different sectors. Property: 2015 transaction volume a new high; Dec market performance beats Both property sales volume and prices picked up in 2015 with full-year transaction volume exceeding the 2013 high. We believe the recovery in sector fundamentals was mainly attributable to continued improvements on the policy front. The property sector will remain an important economic stabilizer as the Chinese economy shifts to a lower gear amid ongoing restructuring, meaning the favorable sector policy environment will likely continue. Upcoming policy support might focus on the monetization of subsidized housing, strengthened tax/fee discounts, and rural home purchase subsidies, while further progress in the establishment of long-term regulation systems will also drive long-term sector development. Hong Kong Market Technology: Global PC shipments fell 10.4% YoY in 2015; Lenovo continues market share gains PC shipments fell 10.6% YoY in 4Q15, meaning 2015 was the fourth consecutive year with a decline in global PC shipments since the PC market peaked in Despite the industry downturn, Lenovo's global PC market share grew to 21.4% at end-2015, driven by market share gains. The company has seen particularly strong performance in the US market. PC industry consolidation and business turnaround (smartphone business to reach breakeven in early 2016) remain the two key investment stories for Lenovo. We maintain our Accumulate rating on the stock. Digital China (861 HK, Buy): Takeaways from meeting with management; reiterate Buy The spin-off of the company s distribution business has received CSRC approval and should be completed around Chinese New Year, according to management. The company is speeding up execution of its smart city projects, a segment we believe is likely to make a positive earnings contribution by We also see profitable opportunities in its agricultural informatization business. The impact of Rmb depreciation on the company s debt should ease in 2016 as it shifts towards more Rmb debt and its own funding. Reiterate Buy and TP of HK$ Luk Fook (590 HK, Hold): Disappointing 3Q; cut TP to HK$13.10 We see LF s 3QFY16 data as disappointing: 1) SSSG for China gem-set products slowed to 2%; 2) Despite a high base for HK & Macau SSS in 3QFY15, the drop in SSS was worse than we had expected. LF s share price has dropped 16% YTD and has underperformed CTF, suggesting the weak 3QFY16 data could be partly priced in. We cut our FY16/17 net profit forecasts by 18%/23%, mainly to reflect lower-than-expected SSS, and lower our TP from HK$17.00 to HK$ Alex Fan, CFA, Head of Research, SFC CE No. ADJ672 alexfan@gfgroup.com.hk Gao Yedong, Editor, SFC CE No. BAI002 yedonggao@gfgroup.com.hk

2 Investment Strategy: Impact of Rmb devaluation by sector Investment Strategy: No consistent pattern in stock performance following currency devaluation Based on data from other countries, no consistent pattern can be seen in stock market performance following significant devaluations in relevant local currencies. We believe the unclear outlook for the Chinese economy in the mid/long term has weighed on domestic risk appetite and led to weakness in the A-share market, and we see reform and economic restructuring, particularly supply-side reform, as the solution. The persistence of conflicts between reform and pro-growth efforts (e.g. aggressive tax reductions vs. fiscal expense expansion, overcapacity removal and maintenance of GDP growth bottom line) will more likely lead to a slow bear stock market with shirking trading volume instead of a slow bull. Meanwhile, if the government becomes truly committed to supplyside reform by giving up the GDP growth bottom line, short-term panic selling might be seen but mid/long-term market confidence will be boosted when supply-demand in traditional sectors improves and emerging sectors acquire more resources for growth. Either way, we advise caution in the short term and suggest watching defensive sectors such as banking, healthcare and environmental. Coal: Long-term positive for domestic producers as imports become less attractive Rmb depreciation will squeeze the profitability of coal imports and alleviate the pressure for domestic coal producers to lower prices. On the other hand, a cheaper Rmb will help boost Chinese coal exports, while increased exports by downstream companies amid Rmb depreciation will also drive upstream coal demand. We expect the domestic coal supply overhang to continue over the next two years, though reduced coal imports amid Rmb devaluation should help improve sector supply-demand. We like Xishan Coal and Electricity Power ( CH), Panjiang Refined Coal ( CH), Wintime Energy ( CH) and Shanxi Coal International Energy ( CH) as supply-side reform might be a key investment theme throughout Separately, companies with high exposure to exports such as Haohua Energy Resource ( CH) and Yanzhou Coal Mining ( CH) should benefit from Rmb depreciation. Building Materials: Fiberglass names to benefit from Rmb devaluation Four of the eight A-share building materials companies with an overseas revenue mix above 30% (based on 1H15 data) have a business focus on fiberglass; these four companies are Jiuding New Material ( CH), China Jushi ( CH), Zaisheng Technology ( CH) and Changhai Composite Materials ( CH). While the fiberglass industry is typically highly leveraged, three of these four companies do not face severe pressure from overseas liabilities, with the remaining company China Jushi having hedged against exchange rate risks with forex forwards. Separately, Rmb depreciation will bring a one-off earnings enhancement for overseas order backlogs in the short term, and it will make Chinese-made products more attractive and help drive business scale expansion in the mid/long term. We particularly like Changhai Composite Materials ( CH), China Jushi ( CH) and Zaisheng Technology ( CH). Textiles & Apparel: Chinese exports to become more competitive Rmb depreciation should drive export growth for domestic companies, although this impact will disappear if devaluation is also seen in other Asian currencies. Companies that purchase raw materials mainly from China and sell their products overseas will see revenue increase when settled in Rmb. However, this might be offset by the imports of cotton or cotton yarn in the case of some companies, as well as US$ debt borrowed by some companies. Some of the A-share names with the highest overseas revenue mix include Challenge Textile ( CH), Bangjie Digital Knitting ( CH) and Jasan Holding Group ( CH). Machinery: Exchange rate changes to affect company financials Slight deprecation in the Rmb against the US dollar tends not to have any material effect on companies overseas income, but its impact will mainly be seen in the increase in pre-tax profit (as recurring US$ income is changed into Rmb), appreciation in the value of US$ net assets, and fair value changes in companies foreign exchange contracts. Based on our analysis of companies overseas revenue contribution and US$ assets and liabilities, we suggest watching the positive impact of Rmb depreciation on Great Star Industrial ( CH), Yingliu Electromechanical ( CH) and Zhejiang Dingli Machinery ( CH). Airlines: Positive earnings surprise unlikely despite strong business conditions Domestic airline companies typically have a high proportion of US$ liabilities as their equipment is mainly purchased using the US dollar. In particular, the three largest domestic airlines are more sensitive to exchange rate changes than the smaller ones such as Spring Airlines ( CH) and Juneyao Airlines ( CH). Based on companies 1H15 financial data, every 1% of devaluation Page 2

3 in the Rmb will lead to net profit declines of Rmb600m, 460m and 670m for China Eastern Airlines ( CH), Air China ( CH) and China Southern Airlines ( CH) respectively. We expect the airlines sector to continue growing on strong domestic demand and low oil prices, though accelerating Rmb devaluation might lead to lower-than-expected sector earnings. Non-Ferrous: Rmb depreciation favorable for domestic gold prices As commodities are priced in the US dollar globally and converted into Rmb when traded in China, Rmb depreciation will push domestic metal prices higher. The economic slowdown in China (which consumes 50% of industrial metal) is weighing on industrial metal demand and prices, which we think exceeds the impact of exchange rate changes. Meanwhile, we think Rmb devaluation will be favorable for domestic gold prices as Chinese residents purchase gold for monetary value preservation, and as global gold prices are supported by production costs and geopolitical uncertainties. We suggest watching Shandong Gold Mining ( CH), Chifeng Jilong Gold Mining (600988), Western Gold ( CH), Humon Smelting ( CH) and Zhongjin Gold ( CH). Steel: Export income increase to outweigh rise in iron ore cost Assuming steel exports of 134m tonnes at US$495.48/tonne in 2016, we calculate that steel export income will increase by US$29bn when the Rmb exchange rate weakens to 7 this year; meanwhile, domestic steel production cost will increase by US$18bn due to the higher cost of iron ore imports. Rmb devaluation also means an increase in the value of foreign currency loans and deposits. Overall, the increase in steel export income brought by Rmb depreciation will exceed the accompanying rise in iron ore cost. Among listed steel companies, we highlight those with a high overseas revenue mix and low foreign currency borrowings, such as Shanxi Taigang Stainless Steel ( CH), Pangang Group Steel Vanadium & Titanium ( CH), Daye Special Steel ( CH), Yulong Steel Pipe ( CH), Changbao Steeltube ( CH), JIULI Hi-tech Metals ( CH), Fushun Special Steel ( CH), Fangda Special Steel Technology ( CH), BaoTou Steel ( CH) and Fasten ( CH). Key risks include changes in sector demand driven by volatility in the macro economy, and uncertainties surrounding the direction and scale of exchange rate changes. Property: 2015 transaction volume a new high; Dec market performance beats 2015 property transactions rose to new high in five years Property transaction was highly active in Dec: our index tracking transactions in 44 large cities picked up 18% from Nov and was up 8% YoY; the index for residential property transactions rose 11% MoM and 10% YoY. YoY transaction growth slowed significantly in 1Q15 as new project launches declined on seasonality. However, a recovery was seen in 2Q15 driven by policy loosening, with the YoY transaction growth figure peaking in Jun and monthly transactions in the 44 cities tracked surging 55% YoY. YoY transaction growth decelerated again in 3Q15 as a large amount of home purchasing demand had materialized and as market conditions weakened on rising home prices. That said, sector policy support has strengthened again since the start of 4Q15, particularly as the central government has repeatedly stressed the importance of property destocking since Nov, fueling expectations for further policy relaxation. Property transactions surprised to the upside towards the year end on a continuously loose policy environment as well as strengthened new launches and promotional efforts by developers. Monthly transaction volume set a record high in Dec. First-tier cities led 2015 transaction and home price growth Dec transaction volume across different tiers of cities rose to new monthly highs in five years. For full-year 2015, first, second and third-tier cities saw transaction growth of 30%, 16% and 22% respectively, with first-tier cities posting the biggest increase due to strong underlying demand and high sensitivity to policy changes. In addition, MoM home price growth in first-tier cities widened in Dec, while second and third-tier cities demonstrated mild rebounds from Nov. YTD home price growth was mixed, with first-tier cities rising 16% and second/third-tier cities sliding 0.43%/0.87%. Residential property inventories in most cities eased at a high level as a result of increased transactions. Favorable policy environment to continue Both property sales volume and prices picked up in 2015 with full-year transaction volume exceeding the high reached in We believe the continued recovery in sector fundamentals during the year was mainly attributable to continued improvements on the policy front. The property sector will remain an important economic stabilizer as the Chinese economy shifts to a lower gear amid ongoing restructuring, meaning the favorable sector policy environment will likely continue. Upcoming policy support might focus on the Page 3

4 monetization of subsidized housing, strengthened tax/fee discounts, and rural home purchase subsidies, while further progress in the establishment of long-term regulation systems will also drive healthy, stable sector development over the long term. 1Q16 stock picks We are positive on stocks related to property finance, business transformation and SOE reform for 1Q16, and suggest watching Jiabao Industry & Commerce ( CH), Haide Industry ( CH), Guangdong Mingzhu ( CH), Vantone Real Estate ( CH), Cosmos Group ( CH), Zhejiang Guangsha ( CH), Metro Land ( CH) and Tianjin Songjiang ( CH). Technology: Global PC shipments fell 10.4% YoY in 2015; Lenovo continues market share gains Global PC shipments down for fourth consecutive year PC shipments fell 10.6% YoY in 4Q15, meaning 2015 was the fourth consecutive year with a decline in global PC shipments since the PC market peaked in 2011 smartphones and tablets (the ipad was launched in 2010) have replaced PCs in meeting consumers digital needs. Lenovo continues to gain market share Despite the industry downturn, Lenovo's global PC market share grew to 21.4% at end-2015, up 1.4pp compared to the year before, driven by market share gains. In particular, Lenovo delivered strong performance in the US market during 4Q15, where its PC shipments rose 21% YoY, compared to a 4.3% YoY overall decline in the US market during the period, according to IDC. Industry consolidation and business turnaround PC industry consolidation and business turnaround (smartphone business to reach breakeven in early 2016) remain the two key investment stories for Lenovo (992 HK, Accumulate). The stock is trading at 10.3x 2017E P/E (FYE Mar 31, 2017), based on our estimates. We maintain our Accumulate rating. (Joseph Ho, CFA, Research Analyst, SFC CE No. AFP308, josephho@gfgroup.com.hk ) Digital China (861 HK, Buy): Takeaways from meeting with management; reiterate Buy Sale of spun-off business to be completed in 1Q16 The spin-off of the company s distribution business has already received approval from the CSRC and is now going through the registration process with the Administration for Industry and Commerce. According to management, the transaction should be completed around Chinese New Year, and will be followed by the payment of a special dividend (HK$3.2 per share) at the end of Feb. Smart City business reached its 2015 target By the end of 2015, the company had put its smart city service platform into operation in over 20 cities, and signed smart city project contracts with around 50 cities in total, beating its target of 16 and 42 cities, respectively. The company is speeding up the execution of its smart city projects, and expects 100 platforms to be brought into operation by the end of We believe this new segment is likely to make a positive earnings contribution by 2017, thanks to business scale expansion and the introduction of a new ToC business model. Large profitable opportunities in agricultural informatization The company s agricultural informatization business, Beijing Sino-Agri Sinda Information Technology, mainly focuses on the confirmation of agricultural land rights and related IT systems, a market which could be worth Rmb40bn. According to the valuation adjustment mechanism included in the acquisition agreement, this wholly-owned subsidiary has promised to achieve net profit of around Rmb66.7m and Rmb100m in 2015 and 2016, respectively. Impact of Rmb depreciation to ease in 2016 Total interest-bearing foreign loans amount to HK$3,369m, including HK$2,562m in USD, HK$505m in EUR, and HK$300m in HK$. A foreign exchange loss of around HK$130m is expected in 2015 due to Rmb depreciation. Assuming its foreign debt position remains unchanged, each further 1% depreciation in the Rmb could lead to a foreign exchange loss of around HK$33m. However, we believe this risk is likely to ease in 2016 as the company is trying to shift from foreign debt to more Rmb debt and its own funding. After the sale of the distribution business and the special dividend payment, the company s cash position should rise by HK$1,171m. Page 4

5 Reiterate Buy With the impact of Rmb depreciation factored in, we expect net profit from continuing operations to come in at HK$295m, 405m and 558m in 2015/16/17, representing a three-year CAGR of 22%. Excluding the announced special dividend of HK$3.2 per share, the company s remaining business is valued at around HK$5.3bn, representing 12.7x 2016E P/E. Given its solid outlook and undemanding valuation for the remaining business, we reiterate our Buy rating and our SOTP target price of HK$ Downside risks Decelerating economic growth might affect demand in the domestic IT industry; slower-than-expected progress in its smart city businesses; rising credit risk in the company s financial services business. (Ryan Zhu, Research Analyst, SFC CE No. BDK820, zhuran@gfgroup.com.hk ) Luk Fook (590 HK, Hold): Disappointing 3Q; cut TP to HK$13.10 Maintain Hold but cut TP to HK$13.10 We see LF s 3QFY16 data as disappointing: 1) SSSG for China gem-set products slowed to 2% (vs 23% in 1QFY16 and 13% in 2QFY16); 2) Despite a high base for HK & Macau SSS in 3QFY15, the drop in SSS from -19% in 1QFY16 to -26% in 3QFY16 was worse than we had expected. LF s share price has dropped 16% YTD and has underperformed CTF (1929 HK, Underperform; -9%) and CSS (116 HK, Hold; -4%), suggesting the weak 3QFY16 data could be partly priced in. We cut our FY16/17 net profit forecasts by 18%/23%, mainly to reflect lower-than-expected SSS. We now estimate a 40% decline in core net profit in FY16 (vs -39% in 1HFY16). We lower our TP from HK$17.00 to HK$13.10, based on 8x FY16E P/E. Both HK & Macau and China SSS worse than 1Q HK & Macau SSS dropped 26% in 3QFY16, which was below the 19% decline in 1QFY16, mainly due to the high base in 3QFY15 (-6% SSS). Despite SSS dropping >20% in Dec 2014, HK SSS still saw a double-digit YoY decline in Dec 2015 due to sluggish consumer sentiment and Rmb depreciation. In China, SSS fell 10% in 3QFY16, weaker than the flat SSS in 1QFY16. LF s SSS in both China and HK & Macau underperformed CTF and CSS in 3QFY16. China gem-set SSS weakened noticeably SSSG for China gem-set products slowed noticeably from 23% in 1QFY16 to 2% in 3QFY16, with a double-digit decline for ASP. HK & Macau gem-set products SSS also dropped from -19% in 1QFY16 to-27% in 3QFY16. ASP continued to decline by double-digits. Overall, gem-set product SSS dropped from -18% in 1QFY16 to -26% in 3QFY16. Rental trend HK rental reversion still saw positive growth in 3QFY16, led by a rental increase from stores in residential areas. Management expects a negative rental reversion in FY17/18. GM trend Management said GM by product remained stable in 3QFY16. The product mix for gold and gem-set products in its retail business was also stable YoY as both these products saw a similar SSS. Outlook 1) The SSS trend so far in Jan has been a bit better than in Dec thanks to the earlier CNY holiday in Management targets a QoQ SSS improvement in 4QFY16, and remains cautious in the near-term but believes a bottoming for SSS is not far away. 2) HK & Macau store plan: LF will continue to optimize its store network while keeping a relatively stable number of stores. 3) China store expansion in FY16: Management now aims to add new stores, compared to previous guidance of 80 new stores. The revamping of department stores has led to the closure of certain stores. (Albert Yip, CFA, Research Analyst, SFC CE No. ADT599, albertyip@gfgroup.com.hk ) 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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