Dim Sum Express. A-Share Market. Hong Kong Market. Equity Research. July 20, 2018

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1 Equity Research Dim Sum Express Key index performance Chg (%) EPS (%) P/E Market 1D 1M YTD 18E 19E 18E 19E HSI HSCEI MXCN SHSZ SHCOMP SZCOMP INDU SPX CCMP UKX NKY Hong Kong ADRs HK ticker Company Local (HK$) Daily (%) ADR (US$) Daily (%) 700 TENCENT ICBC CCB PETROCHINA HSBC CHINA MOBILE PING AN BANK OF CHINA SINOPEC AIA Source: Bloomberg A-Share Market Environmental: 2H18 Outlook Stringent environmental regulation still in place; wait for financing conditions to improve The major problem in the sector currently lies in the conflict between strong demand growth and financing difficulties. The pessimistic sentiment towards financing conditions has made it difficult for the market to accept current earnings forecasts, with downward revisions in earnings forecasts possible. However, from a longer-term perspective, continued demand growth is highly visible. The resolution of financing difficulties hinge upon relevant policy adjustments. We expect the focus of pollution prevention and treatment to shift from air to water pollution with a market worth around Rmb900bn in total covering production facility upgrade & renovation, treatment of black and smelly water bodies and rural & agriculture related water treatment. Defense: 2H18 Outlook Sector likely to see rally on fundamentals turnaround and cheap valuations We maintain the views in our 2018 sector outlook report: orders will recover in 2018, and the sector will enter a three-year upcycle; the tasks of asset securitization at major military equipment company groups will be heavy in the last three years of the 13th FYP period; the benefits of sector reforms will continue to play out with major reform measures to be implemented. We believe that after the corrections over the past three years, the defense sector has returned to historically low valuation levels down from the overly high levels seen in Media: Overview of China s bestselling book market The retail book market has shown a recovering trend, with best-selling books the most eye-catching. The sales contribution from top-sellers is becoming greater: according to Openbook data, the top 1% of new books published in 2017 accounted for 51.70% of total new book sales. Some key characteristics include: fiction books tend to remain long-term bestsellers after publication, nonfiction is typically driven by short-term campaigns, and classic children s books are consistently popular. Separately, the three new models for content creation at the moment are the contract/introduction model, the cultivation/packaging model, and book publication alongside film/tv productions. Hong Kong Market Ou Yafei, Research Analyst, SFC CE No. BFN410 oyf@gf.com.cn

2 Environmental: 2H18 Outlook Stringent environmental regulation still in place; wait for financing conditions to improve Financing difficulties fueling downbeat expectations The major problem in the sector currently lies in the conflict between strong demand growth and financing difficulties. The pessimistic sentiment towards financing conditions has made it difficult for the market to accept current earnings forecasts, with downward revisions in earnings forecasts possible. However, from a longer-term perspective, environmental and ecological development is a key component of the government s three critical battles, and affects people s livelihood, meaning that continued demand growth is highly visible. The resolution of financing difficulties hinge upon relevant policy adjustments. Rmb900bn worth water treatment market to materialize at quickening speed According to decisions made at the latest Environmental Protection Conference and statements from relevant ministries, we expect the focus of pollution prevention and treatment to shift from air to water pollution with a market worth around Rmb900bn in total covering production facility upgrade & renovation, treatment of black and smelly water bodies and rural & agriculture related water treatment. From a policy making perspective, special inspections in relation to black and smelly water bodies and water sources protection have started. Relevant plans for the Yangtze River Basin, Bohai Sea, and rural & agriculture related water treatment are expected to be announced within this year. Moreover, for the PPP model, after several rounds of standardization and improvement, the model has started to deliver good development. Leading companies have stronger financing, construction and operational capabilities, and are likely to dispel market doubts about industry growth with earnings performance. Strict environmental inspections continued, market-oriented de-capacity to become the norm The latest Environmental Protection Conference has made local officials immediately responsible for environmental protection. Recently various types of inspections have strengthened, such as downstream production shutdowns, production restrictions, and renovations. In terms of regulatory policies, inspection reviews have become more common, and the geographical coverage of air treatment inspections has extended, while special campaigns for water treatment have been launched. We expect the implementation of long-term schemes including an environmental protection tax and pollution discharge permits to accelerate in 2019, so as to force smaller-scale players out of the market with an increasing environmental protection. We believe the competitive advantages of leading companies that meet emission standards to strengthen further, and that market-oriented de-capacity will become the norm. 5-year low forward P/E reflecting pessimistic sentiment; wait for improvement in financing conditions The current sector P/E (TTM) is only 22.7x, the lowest in five years. If financing conditions improve, we suggest watching the water treatment industry which has strong demand growth. Currently we suggest watching companies with sound cash flows including Longma Environmental Sanitation Equipment ( CH). With strict environmental inspections remaining in place, and the implementation of long-term mechanisms such as an environmental protection tax and pollution discharge permits, we believe the environmental cost for some industries will increase substantially, leading to market-oriented capacity reduction. Risks Continued tightening in the financing environment, declines in government fiscal revenue leading to insufficient investment in environmental protection, weaker-than-expected efforts made by local government in environmental protection. Defense: 2H18 Outlook Sector likely to see rally on fundamentals turnaround and cheap valuations Fundamentals recovering, sector entering three-year upcycle Looking back on 1H18, new orders have gradually come in after the national military reform; ABS transactions have resumed their normal course; sector reform has continued to move forward. In 1H18, especially since the start of 2Q18, sector new orders and production have grown rapidly and business conditions have recovered, with the sector likely to enter a three-year upcycle. Asset securitization at major military equipment company groups has resumed, and we think their securitization work will be heavy in the last three years of the 13th FYP period. A major military equipment company group s ownership reform plan has been approved by eight government ministries, and a few key listcos share-based incentive schemes have been introduced: the benefits of sector reforms are playing out. Page 2

3 We maintain the views in our 2018 sector outlook report: orders will recover in 2018, and the sector will enter a three-year upcycle; the tasks of asset securitization at major military equipment company groups will be heavy in the last three years of the 13th FYP period; the benefits of sector reforms will continue to play out with major reform measures to be implemented. Sector valuation at historical bottom level despite solid fundamentals; sector likely to offer investment opportunities At present, the trailing P/E of the CSI defense sector index is at the historical bottom level (close to that in early Dec 2012). We believe that after the corrections over the past three years, the defense sector has returned to historically low valuation levels down from the overly high levels seen in In terms of fundamentals, sector orders are entering a three-year upcycle, while asset securitization and reforms are rapidly under way. The sector is likely to offer new investment opportunities in the near future. Investment highlights We highlight two key investment themes: Firstly, we prefer cheaply valued growth stocks, such as AVIC Electromechanical Systems ( CH), Inner Mongolia First Machinery Group ( CH), AVIC Shenyang Aircraft ( CH), and China Shipbuilding Industry Group Power ( CH). Second, we like the vessel equipment industry chain, and our stock picks are CSSC Offshore and Marine Engineering Group ( CH), China Shipbuilding Industry Group Power ( CH), and Xiangtan Electric Manufacturing ( CH). Risks Asset injection schedules and plans involve uncertainties; the progress of relevant reform policies might be slower than expected; the reform of research institutes is subject to uncertainties; and the progress of equipment R&D might be slower than expected. M&A uncertainties, uncertainties tied to military product orders, and the risk of gross margin declining. Media: Overview of China s bestselling book market Fiction remaining LT bestsellers after publication, non-fiction driven by ST campaigns, classic children s books consistently popular The retail book market has shown a recovering trend, with best-selling books the most eye-catching. The sales contribution from top-sellers is becoming greater: according to Openbook data, the top 1% of new books published in 2017 accounted for 51.70% of total new book sales. Fiction remaining LT bestsellers During Jan 2017 to May 2018, fictional books such as Higashino Keig s "Grief Grocery Store", Khaled Hosseini s "The Kite Runner" and Claire McFall s "The Ferryman" stayed among the top 10 bestsellers. Fictional books tend to remain bestsellers after being published. Non-fiction driven by ST sales campaigns The types of non-fictional books are diverse. "Genius or Psychotic( 天才在左, 疯子在右 )", "Wo Men Sa ( 我们仨 )" and "Mu Song ( 目送 )" remained on the top ten list for the longest during the abovementioned period. Non-fictional bestselling books are greatly affected by marketing events, and can reach their sales peaks more quickly. Classic children s books consistently popular and becoming serialized Kuroyanagi Tetsuko s " The Little Girl at the Window" remained among the top10 for a long time during the period, followed by Shen Shixi s "Lang Wang Meng ( 狼王梦 )" and Cao Wenxuan s "Cao Fang Zi ( 草房子 )". Classic serial themes and IPs have provided guarantee for children's book sales. Private-sector publishers more engaged in fictional books Thinkingdom Media Group ( CH), Baima Shiguang and Century Wenjing ranked as the top three publishers during the sample period, while few non-fiction and children's book brands made it to the list. Nanhai Publishing, CITIC Publishing and Zhejiang Shaonianertong Publishing were the key publishers for fiction, non-fiction and children's bestsellers respectively. Writers reputation tends to influence the formation of bestselling books. Fictional bestselling authors mainly included Higashino Keig, non-fictional Yuval Noah Harari, and children's classics Yang Hongying. From the perspective of pricing, non-fiction bestsellers tend to have higher price premiums, with an average price of Rmb48.08; children s books tend to have lower premiums, with an average price of Rmb Three new models for content creation The contract/introduction model: Signing on a well-known author is the most common way to make bestselling books, and this is mainly meant for authors who have already built a reputation; the introduction of overseas books has become an important component of fictional bestsellers. Page 3

4 The cultivation/packaging model: This involves the use of marketing and new media to create a star writer, capturing an active user base. Publication alongside Film/TV productions: This model ties the performance of the book closely with the related film/tv productions. Yangeling s Youth ( 芳华 ) saw its book sales increased to peak levels along with the film. Risks Mass book market growth losing steam; the sales of bestsellers dropping; disappointments from the development of the digital reading space; new media and forms of entertainment crowding out the time for reading. Page 4

5 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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