Dim Sum Express. A-Share Market. Hong Kong Market. Equity Research. Aug 11, 2017

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1 Equity Research Dim Sum Express Top pick of the week Brilliance China (1114 HK) Buy (maintained) TP: HK$26.17 BMW Brilliance s new product cycle in 2H17 to drive JV contribution; cooperation with Renault to improve ownbrand minibus tech and design, narrowing segment losses (to be reflected from 2018). Key index performance Chg (%) EPS (%) P/E Market 1D 1M YTD 17E 18E 17E 18E HSI HSCEI MXCN SHSZ SHCOMP SZCOMP INDU SPX CCMP UKX NKY Hong Kong ADRs HK ticker Company Local (HK$) Daily (%) ADR (US$) Daily (%) 700 TENCENT ICBC CHINA MOBILE PETROCHINA CCB HSBC BANK OF CHINA PING AN CHINA LIFE SINOPEC Source: Bloomberg A-Share Market Pharmaceutical: Sector to see re-rating on improved medical insurance management, internationalization and channel consolidation End market drug sales in China grew 7.8% YoY to Rmb803.7bn in 1H17. While this pace of growth was not particularly high, some sector sub-fields, e.g. upgrades in price-insensitive drugs and the popularization of high-end medical care, achieved much higher growth than the industry average. Given the sector s steady growth prospects in the long term, we remain positive on upcoming sector share price performance, and expect to see a sector re-rating driven by improved management of state medical insurance expenditures, Chinese pharma companies business internationalization and quickening sales channel consolidation on new policy requirements. Steel: July Chinese steel and iron ore trade data review Leading indicators of property investment growth rebounded in June, while infrastructure investment growth turned positive. Amid high profit margins, steel supply should continue to increase though the magnitude of output growth should be limited. Structurally speaking, tough environmental regulation will weigh on capacity growth at smaller steel companies, while output contribution from larger companies should continue to grow. Overall, the steel market should maintain strength in Aug, with steel prices to be strong and iron ore prices to fluctuate. Sector profitability should remain high. Coal: Coking coal prices continue to rise; company valuations still attractive We expect coking coal prices to pick up further in view of the peak season in the steel sector. Without considering any coal price growth in 2H17, coking coal companies are currently trading at 12-18x P/E. An Rmb50/tonne increase in the price of clean coal is likely to enhance companies earnings by 20%. Assuming full-year coal price growth of Rmb /tonne, some of the companies are likely to see their P/E drop below 10x. In addition, sector P/B of 1.8x is one of the lowest among different sectors, just higher than banking and petro chemical. Hong Kong Market China Securities: 1H17 results preview and July data update Average daily trading volume in mainland China in 1H17 declined 17% YoY, and was down 19% if July is included. IPO volume soared 442% YoY in 1H17 and 414% YoY in 7M17. However, funds raised via equity financing in 1H17 dropped 12% YoY and 17% YoY in 7M17 as a result of lower share placement demand caused by tightened policy. We expect an increase in asset management income in 1H17. Aggregate net profit at 14 companies tracked was down 10% YoY in 1H17 (11% in 7M17). We suggest buying large, well-diversified, and undervalued China brokers. Brilliance China (1114 HK, Buy): New generation 5 Series spurs strong monthly sales rebound Brilliance China s sales of BMW models in July rose 15% YoY, or 9% MoM, an encouraging sign following two consecutive months of declines in May/June. 7M17 sales are up 17% YoY, maintaining its good sales trend. Sales of the JV s BMW 5 Series grew sharply at 59.1% MoM, spurred on by sales of the new generation of the model. However, due to disappointing sales in 2Q17, 7M17 sales are still down 15% YoY. We should see a higher level of growth during the 4Q17 peak season, which should push 2017 full-year growth into positive territory, ~8% YoY in our view. The United Lab (3933 HK, Accumulate): Share price rally supported by upstream market upcycle Shares in The United Lab have rebounded 14% week-to date on expectations that the continued recovery in the 6-APA price could have a beneficial effect on the company s FY17 results. Our belowconsensus earnings forecasts were based on our recent update with the company in July, but the strong market upcycle may lead to a better-than-expected 2H17. We estimate 5/10% increases in the 6-APA price in 2017 would lead to an EBIT that is 8/15% higher. The company should be the biggest beneficiary of an API price recovery. We believe the stock is fairly valued and await further info from its interim results. 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 Pharmaceutical: Sector to see re-rating on improved medical insurance management, internationalization and channel consolidation Steady LT growth prospects End market drug sales in China grew 7.8% YoY to Rmb803.7bn in 1H17. While this pace of growth was not particularly high, some sector sub-fields, e.g. upgrades in price-insensitive drugs and the popularization of high-end medical care, achieved much higher growth than the industry average. Given the sector s steady growth prospects in the long term, we remain positive on upcoming sector share price performance, and expect to see a sector re-rating driven by the following factors. State medical insurance nearing income-expenditure balance Expenditures from China s state medical insurance grew by more than 10% in both 2015 and 2016, higher than the average growth of the pharmaceutical industry. In addition, the income for the medical insurance fund has grown faster than its expenditure over the past two years thanks to expenditure control implemented in recent years Shanghai currently has a medical insurance surplus ratio of 30%. Some pharma companies benefit substantially as a number of important drugs are included in the latest version of the national reimbursement drug list. Business internationalization Several Chinese pharma companies are now capable of competing in overseas markets. An increasing number of them are seeking overseas registrations for their generic drugs or even innovative drugs, while quite a few agreements have been signed with overseas peers regarding drugs still in the research pipeline. The US FDA has started to speed up generic drug approvals. Quickening channel consolidation The Chinese government has required that by 2018 a twoinvoice system should be put in place along the drug sales value chain from pharma companies to hospitals. This should significantly drive industry consolidation. In addition, the separation of drug sales from hospitals is also worth watching despite its slow progress at the moment. Pharmacies will benefit as a result. Our stock picks In the prescription drug space, we like Changchun High & New Tech ( CH), Huadong Medicine ( CH), Livzon Pharmaceutical ( CH), Yifan Pharmaceutical ( CH), Salubris Pharmaceuticals ( CH) and Humanwell Healthcare ( CH); among OTC names, we prefer Yunnan Baiyao ( CH) and Dong-E-E-Jiao ( CH); in the drug supply chain operation space, we like China Medicine Health ( CH), Realcan Pharmaceutical ( CH) and Cachet Pharmaceutical ( CH). Steel: July Chinese steel and iron ore trade data review Steel exports to come down MoM in Aug Chinese steel exports grew 2.2% MoM but dropped 32.43% YoY to 6.96m tonnes in July. A gauge of steel new orders edged up 3.6 from June to 49.8 but remained below the 50 expansion-contraction threshold. The supply-demand balance in the domestic steel market has remained strong in Aug with steel prices staying at a high level. As such, domestic steel companies are less motivated to step up exports now. Coupled with anti-dumping and anti-subsidy investigations overseas, we expect steel exports to come down MoM in Aug. Iron ore imports to decline further Iron sand and iron ore concentrate imports fell 2.43% YoY and 8.92% MoM in July. In fact, overall iron ore demand in China remained high as steel mills resumed or expanded production amid high profit margins, with furnace utilization rising to 77.49% at the end of the month. However, overseas iron ore shipments dropped significantly, while iron ore inventories at ports edged down slightly but remained high at 142m tonnes. Looking into Aug, steel products should continue to offer relatively high profit margins, but stringent environmental regulation will remain in place. Therefore, crude steel output should pick up though the scale of growth should be limited, while iron ore demand should remain high but grow at a slower pace. Given the supply overhang and slowing downstream demand growth, we expect iron ore output and import volume to continue to decline in Aug. Supply-demand and earnings strength to be maintained While property investment growth decelerated in June, YoY growth in property area sold and new starts area (leading indicators) rebounded; we expect property investment growth to remain high in the foreseeable future. In addition, cumulative infrastructure investment growth turned positive in June. According to Mysteel.com, the average gross profit for deformed steel bars remained high at Rmb1,283/tonne in July; those for hot and cold rolled steel rose 32% and 57% MoM to Rmb1,004 and 710/tonne respectively. Improving per tonne profit will stimulate production resumption and expansion. Page 2

3 Meanwhile, capacity using qualified electric furnace will come on line shortly. Steel supply should continue to increase though the magnitude of output growth should be limited. Structurally speaking, tough environmental regulation will weigh on capacity growth at smaller steel companies, while output contribution from larger companies should continue to grow. Overall, the steel market should maintain strength in Aug, with steel prices to be strong and iron ore prices to fluctuate. Sector profitability should remain high. We like Fangda Special Steel Technology ( CH), Maanshan Iron & Steel ( CH), Angang Steel ( CH), Hesteel ( CH) and Beijing Shougang ( CH). Coal: Coking coal prices continue to rise; company valuations still attractive Heat supply season steel production cuts to affect coking coal demand The removal of outdated steel capacity has been ramped up since 2016 amid supply-side reform. A total of 65m tonnes of crude steel production capacity was phased out during 2016 with a target for 50m tonnes of capacity to be removed this year. In the work plan for air pollution control in the Jingjinji and surrounding areas issued this Feb, it is required that industrial companies should implement rotational production arrangements during the heat supply season in winter, with steel production cuts to be strengthened in key cities. Assuming that steel production is reduced by 50% in relevant cities during a four-month heat supply season, we calculate that steel output will be decreased by 33m-59m tonnes, representing 2.9%-5.2% of China s total steel output in Coking coal prices rising recently Coking coal prices have picked up across the country recently as: 1) per tonne steel gross margin is now as high as Rmb1,000-1,3000; 2) coking coal output fell 14% and 10% in 2015 and 2016 respectively, with 2017 YTD output growing just 4%, while coking coal import growth has also decelerated substantially from 33% YoY in 1H17; 3) due to a 30% price increase, coking coal from Australia is now ~Rmb100/tonne more expensive than domestic coking coal after shipping costs are considered; 4) port and downstream inventories are still at medium to low levels. Coking coal prices more correlated with steel prices Based on historical data, coking coal prices are highly correlated with crude steel prices but are less related to crude steel output volume. Therefore, production cuts in the steel sector tend to lead to a rise or narrower decline in coking coal prices. Overall, the ongoing steel production cut will reduce coking coal demand by 3%-4% on an annual basis. However, its impact will be partly offset by decreased imports and low coking coal output. Positive on re-rating given coal price growth We expect coking coal prices to pick up further in view of the peak season in the steel sector. Without considering any coal price growth in 2H17, coking coal companies are currently trading at 12-18x P/E. An Rmb50/tonne increase in the price of clean coal is likely to enhance companies earnings by 20%. Assuming full-year coal price growth of Rmb /tonne, some of the companies are likely to see their P/E drop below 10x. In addition, sector P/B of 1.8x is one of the lowest among different sectors, just higher than banking and petro chemical. Our stock picks are LuAn Environmental Energy ( CH), Xishan Coal and Electricity Power ( CH), Pingdingshan Tianan Coal Mining ( CH), Yang Quan Coal ( CH), Yanzhou Coal ( CH) and Shaanxi Coal Industry ( CH). China Securities: 1H17 results preview and July data update Performance by segment in 1H17 and July: Brokerage commission income Average daily trading volume in mainland China amounted to Rmb445bn in 1H17, down 17% YoY. Including July, average daily trading volume amounted to Rmb437bn, down 19% YoY. We expect a drop in commission income for China brokers and declining commission rates. Proprietary trading income The SH-SZ 300 Index rose 11% in 1H17 and 13% in 7M17, whereas the CSI Aggregate Bond Index remained flat in both periods. We expect proprietary trading income to have increased in 1H17 for China brokers. Investment banking income IPO volume soared 442% YoY in 1H17 and 414% YoY in 7M17. However, funds raised via equity financing in 1H17 dropped 12% YoY and 17% YoY in 7M17 as a result of lower share placement demand caused by tightened policy. The amount of debt Page 3

4 financing by China securities companies dropped 33% YoY in 1H17 and 28% in 7M17. Overall, we expect income from investment banking to drop in 1H17. Asset management income Benefiting from a positive capital market environment in 1H17, we expect an increase in asset management income in 1H17 and a bigger contribution from brokers private equity businesses. Capital based business The balance of margin financing grew 3% YoY in 1H17 but was down 4% HoH (and further dropped 2% MoM in July). Financial performance by company in 1H17 and July Aggregate net profit at 14 securities companies tracked amounted to Rmb33,657m in 1H17, down 10% YoY (and 11% in 7M17). Annualized for 2017, net profit comes in at Rmb63,994m, meaning profitability across the sector may drop slightly YoY. In general, larger companies such as CITIC (6030 HK, Buy), Haitong (6837 HK, Buy), HTSC (6886 HK, Buy), China Merchants (6099 HK, NR), and Guotai Junan (2611 HK, NR) demonstrated more stable financial performance in 1H17 and 7M17. Net profit at Orient Securities (3958 HK, NR) rose 38% YoY in 1H17 due to its heavy focus on proprietary trading. Buy large, well-diversified and undervalued brokers The M&A approval procedure was improved in July to allow quicker approvals, while the importance of direct financing was reiterated at the government s National Financial Work Conference. China brokers may therefore benefit from an increase in related business. As the larger brokers generally demonstrated more stable financial performance, we suggest investing in large, well-diversified, and undervalued China brokers. For example, CITIC (6030 HK, Buy, TP:HK$20.40) is trading at ~1.2x 2017E P/B, Haitong (6837 HK, Buy, TP:HK$16.80) is trading at ~1.1x 2017E P/B, HTSC (6886 HK, Buy, TP:HK$20.50) is trading at ~1.1x 2017E P/B. (Felix Luo, Research Analyst, SFC CE No. AQF573, felixluo@gfgroup.com.hk ) Brilliance China (1114 HK, Buy): New generation 5 Series spurs strong monthly sales rebound Encouraging sales volume in July Brilliance China released July sales figures for BMW models after market close yesterday, showing that it sold 30,050 units during the month, up 15% YoY, or 9% MoM, an encouraging sign following two consecutive months of declines in May/June. 7M17 sales for the JV came in at 214,130 units, up 17% YoY, maintaining its good sales trend. 5 Series sales up MoM Sales of the JV s BMW 5 Series grew sharply at 59.1% MoM to 8,393 units in July, spurred on by sales of the new generation of the model. However, due to disappointing sales in 2Q17, 7M17 sales are still down 15% YoY to 67,583 units. In our view, the monthly growth for the model is encouraging and the strong market demand should continue to drive up the model s sales in 2H17. We should see a higher level of growth during the 4Q17 peak season, which should push 2017 full-year growth into positive territory, ~8% YoY in our view. 3 Series rebounded steadily amid weak sales season The company sold 9,910 3 Series units in July, rebounding 7.6% MoM after a considerable 29.4% monthly decline in June. The model s 7M17 sales reached 72,983 units, up 26.3% YoY, hitting a record growth high after 1Q17. We think average monthly sales of the model will be at the 10,000+ level in 2H17, meaning ~30% YoY growth for the model in X1 SUV sales fluctuating 7,451 X1 SUVs were sold in July, up 28.1% YoY but down 7.6% MoM. The model saw its second monthly drop after a historical sales high in May. 7M17 sales increased by 1.2x YoY to 50,178 units, reflected rising demand compared to the weak growth for peer models such as the Mercedes-Benz GLA and the Audi Q3. We are confident in growth from the X1 given the considerable growth in China s SUV market and its more spacious interior than rival models. Maintain Buy and TP of HK$26.17 Overall, as the JV is the important earnings pillar for the company, its considerable profit growth on the back of the sales rebound this year should lead to 63% YoY NI growth. The stock is now trading at 12x 2018E EPS of Rmb1.61, undervalued in our view. We maintain our Buy rating and target price of HK$26.17, based on 14x 2018E P/E, its historical average. (Alex Fan, CFA, Head of Research, SFC CE No. ADJ672, alexfan@gfgroup.com.hk ) (Chongjing Deng, Research Analyst, SFC CE No. BEY953, dengchongjing@gfgroup.com.hk ) Page 4

5 The United Lab (3933 HK, Accumulate): Share price rally supported by upstream market upcycle What s new? Shares in The United Lab have rebounded 14% week-to date on expectations that the continued recovery in the 6-APA price could have a beneficial effect on the company s FY17 results. Our below-consensus earnings forecasts were based on our recent update with the company in July, but the strong market upcycle may lead to a better-than-expected 2H17. We estimate 5/10% increases in the 6-APA price in 2017 would lead to an EBIT that is 8/15% higher. 6-APA price resumed its upward trend in July Due to supply constraints from tighter pollution requirements, the market price of 6-APA, an intermediate product for penicillin, has experienced an upward cycle since end According to Wind, the after-tax 6-APA price rose from Rmb145/kg in Oct 2016 to Rmb190/kg in July 2017, a 31% increase despite the low season. In the previous cycle during , the 6-APA price took about 9-12 months to go from its low to peak price. As such, we believe the price will likely remain high in the coming months. TUL the biggest beneficiary of API price recovery Given the monopolistic nature of the 6-APA market, companies have great bargaining power and the price transfer is passed through to end customers in the healthcare and agriculture sectors with stable demand. Based on our scenario analysis, we would expect TUL s EBIT margin in 2017 to further improve from 6% to 10%/15% if the 6-APA price were to increase by 5%/10% from the base level of Rmb150/kg, if we assume channel inventory is at normal level. Positive read-across from Tonghua Dongbao s ( CH) 1H17 results Its sales of insulin products increased by 25% to Rmb910m, above market estimates, and it saw accelerated sales growth in 2Q17. For TUL, our last discussion with the company revealed that insulin sales volume growth in 1H17 was slightly behind its 40% YoY target for the year, but that it should see increased volume uptake from 4Q17 after the introduction of the new insurance list. Further update after interim results in late Aug We provided a 1H17 preview last month; the company mentioned that the benefit from the recent API price increase would be limited to 1H17. However, as more contracts will be based on a higher market price, the margin recovery will become more evident in 2H17. Currently trading at 22/19x 2017/18 P/E based on our estimated 19% FY17-19 EPS CAGR, we believe the stock is fairly valued and await further info from its interim results. (Natalie Chiu, Research Analyst, SFC CE No. AVH029, nataliechiu@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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