Dim Sum Express. A-Share Market. Hong Kong Market. Equity Research. Jun 24, 2016

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1 Equity Research 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 TENCENT PETROCHINA CCB BANK OF CHINA HSBC SINOPEC PING AN CHINA LIFE Source: Bloomberg GF events Date Event Location 24 Jun CBRE investor luncheon Hong Kong 24 Jun Haozhi Industrial co. visit Guangzhou 29 Jun Sinosoft co. visit Nanjing Source: GF Securities (HK) A-Share Market Property: 2H16 sector investment strategy We believe the YoY property market strength seen in 1H16 likely represented a short-term peak, with overall YoY sales volume growth to weaken in 2H16. We expect full-year new starts to rise 7.4% YoY, with property investment to pick up 4.9%. The real estate finance space will be worth watching. Given where the industry is standing in the current cycle, we do not see a solid foundation for mainstream property stocks to offer excess investment returns. In addition, while the valuations of these stocks have come down, they remain relatively high. We suggest waiting for a better entry point. Building Materials: Waterproof materials industry to become more concentrated The waterproof materials industry has been highly fragmented due to its low entry barriers. That said, changes in downstream players practices (i.e. preference for purchasing from large brands) are driving an industry reshuffle and a rise in the industry concentration ratio. Industry leader Oriental Yuhong Waterproof Technology ( CH) has suffered continued de-ratings since mid-2015 due to market concerns that the company has reached a growth ceiling as revenue growth turned negative last year. The return of revenue growth into positive territory will reverse such pessimism, likely leading to share price re-ratings. Hong Kong Market Luk Fook (590 HK, Hold): In line results, 1QFY17 remains weak Net profit slumped 41% YoY in 1QFY17, coming in 2% below consensus. Revenue fell 12% YoY. We revise down our FY17 core net profit forecast by 3%, mainly to reflect lower-than-expected GM for gem-set products, and forecast a 6% YoY decline for core net profit in FY17, driven by a 10%/5% SSS decline in HK & Macau/China. We believe share price upside is very limited as the current valuation is above its historical average, and as we expect weak jewelry sales to continue. We revise our TP from HK$16.40 to HK$ NetDragon (777 HK, Buy): Bigger 1Q16 loss on Promethean consolidation and seasonal factors The company recorded a higher loss in 1Q16, mainly due to the consolidation of the newly acquired Promethean business and the impact of seasonal factors on the domestic education business as well as the rising operating costs for education businesses. Revenue from online games increased 27% YoY. We remain positive on the company given healthy sales growth and improving profitability in its online game business, as well as the strong ramp-up in its online education business expected in the upcoming three quarters. 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 Property: 2H16 sector investment strategy Sales and home price growth We believe the YoY property market strength seen in 1H16 likely represented a short-term peak, with overall YoY sales volume growth to weaken in 2H16. We expect full-year GFA sold to rise 17% YoY to 1.5bn sqm and total sales value to increase 30.4% YoY to Rmb11.4trn. While home prices in medium and large cities will maintain moderate MoM growth, the pace should slow over time. We do not see any momentum for continued home price growth in third and fourth-tier cities. Property investment With the transaction of a large number of high-priced land parcels, land sales value in 300 large cities surged 40% YoY in 5M16, despite planned GFA growth of just 3%. In particular, the premium of transaction prices over auction opening prices exceeded the peak reached during , especially in the case of second-tier cities. Both property new starts and investment strengthened significantly during 1H16. We expect full-year new starts to rise 7.4% YoY to 1.66bn sqm, with property investment to pick up 4.9% to Rmb10trn. Real estate finance worth watching The asset management industry in China is facing an unprecedented opportunity as its AUM is rising rapidly amid a lack of underlying assets that offer an attractive risk-reward balance. The capitalization of premium property projects will not only increase liquidity for existing projects and help boost the operational efficiency of properties, but will also offer to the market premium investment instruments yielding stable returns. Wait for better entry point Given where the industry is standing in the current cycle, we do not see a solid foundation for mainstream property stocks to offer excess investment returns. In addition, while the valuations of these stocks have come down, they remain relatively high. We suggest waiting for a better entry point. Stock picks Looking into 2H16, we suggest watching developers with property management business and strong performance in existing projects such as Jiabao Industry & Commerce ( CH) and China World Trade Center ( CH), as well as companies which are going through business transformation and offer a high margin of safety such as Haide Industry ( CH), Guangdong Mingzhu ( CH) and Cosmos Group ( CH). Building Materials: Waterproof materials industry to become more concentrated A highly fragmented industry The waterproof materials industry has been highly fragmented due to its low entry barriers. The top 50 companies in the industry combined currently take a market share of around 20%, while companies with annual output of less than Rmb100m represent nearly 80% of market share. It is worth noting that 75% of the waterproof materials currently available in the market are counterfeit products, as the smaller producers lacking cost advantage compared with their larger-sized opponents tend to engage in price competition by producing counterfeit and substandard products. Moreover, these small companies are still able to be profitable even at extremely low capacity utilization rates as a result of the low investment barriers for setting up waterproof materials production lines, which has led to a severe overcapacity issue in the industry. Downstream changes favoring large producers That said, changes in downstream players practices are driving an industry reshuffle and a rise in the industry concentration ratio. As the property sector becomes more concentrated, large developers practices of conducting centralized procurement and forming strategic partnerships with suppliers have become the mainstream, leading to a preference for purchasing from large waterproof brands with a focus on product quality, brand compatibility and production capacity. Similarly, project tendering practices in the infrastructure development space are also moving towards a direction which is more favorable for large waterproof materials producers with a well-known brand. Larger companies becoming even stronger Large waterproof materials companies mostly have adopted both the distributor sales and direct sales models, while smaller players operate under the direct sales model due to the absence of strong branding. Even in the direct sales space, large companies are taking market shares over from smaller ones, while at the same time further enhancing their strengths in terms of branding and channels by extending their product lines and retail sales networks. Oriental Yuhong Waterproof Technology ( CH) is by far the leader of the industry, though its relatively small market share of 6% still represents considerable room for further growth. The Page 2

3 company is set to benefit significantly from rising industry concentration given the trends discussed above, and we believe it will maintain rapid growth over the coming few years. Strong revenue growth in 4Q15 (+21% YoY) continued into 1Q16 (+26%), and we expect the company to have maintained relatively high shipment growth in 2Q16 (1Q16: +40%). The stock has suffered continued de-ratings since mid-2015 due to market concerns that the company has reached a growth ceiling as revenue growth turned negative last year. The return of revenue growth into positive territory will reverse such pessimism, likely leading to share price re-ratings. Luk Fook (590 HK, Hold): In line results, 1QFY17 remains weak In line results Net profit slumped 41% YoY to HK$959m in 1QFY17, in the middle of the 35-45% decline stated in its profit warning, and 2% below consensus. LF raised its payout ratio from 40% to 68% by giving a special dividend of HK$0.21/share, to keep full-year unchanged at HK$1.1/share. Outlook 1) FY17 YTD SSS has continued to decline due to uncertainties in the economic outlook, but we expect the decline to narrow compared to 4QFY16 (HK & Macau -28%, China -19%). Management expects 2HFY17 SSS to be better than 1HFY17 due to the low base; 2) Store plan: While LF targets 50 new store additions in China (50/50 between self-operated/licensed stores), it will continue to optimize its retail network in HK; 3) Around 1/3 of stores in HK & Macau will have their leases renewed in FY17. For the leases renewed so far, management has said there was a teen-level decline in rent. As LF will open new street stores in China in FY17, management does not expect rental expenses to drop very much; 4) Payout ratio will be maintained at 40% as special dividend is not committed; 5) Management targets its associate company, CDS, to break even in two years. Results highlights Excluding the fair value change in its CB, core net profit would have dropped by 41% YoY. Revenue fell 12% YoY driven by 20%/8% SSS declines HK & Macau/China. GM narrowed 0.9pp to 23.2%, 0.5pp below our estimate. The decline was led by a 0.7pp increase for gold products in the sales mix to 60.9%, and a 2.2pp contraction of gem-set GM due to the adjustment of retail prices in response to lower diamond prices. Opex ratio rose 2.1pp to 15.2%, mainly attributable to a 1pp/0.4pp/0.3pp increase in rental/staff/a&p expense ratios. Losses at its associate company, CDS, also widened from HK$23m to HK$81m. The proportion of revenue and profit contribution from China increased by 3pp/10pp to 28%/44%. Maintain Hold We revise down our FY17 core net profit forecast by 3%, mainly to reflect lowerthan-expected GM for gem-set products, and forecast a 6% YoY decline for core net profit in FY17, driven by a 10%/5% SSS decline in HK & Macau/China. Trading at 11.1x FY17E P/E, we believe share price upside is very limited as the current valuation is above its historical average, and as we expect weak jewelry sales to continue. We revise our TP from HK$16.40 to HK$16.50, based on 10.5x FY17E P/E (historical average) as we roll forward our valuation basis. (Albert Yip, CFA, Research Analyst, SFC CE No. ADT599, albertyip@gfgroup.com.hk ) NetDragon (777 HK, Buy): Bigger 1Q16 loss on Promethean consolidation and seasonal factors Bigger loss in 1Q16 due to Promethean consolidation and seasonal factors The company recorded a higher loss of Rmb114m in 1Q16, compared to losses of Rmb11m and Rmb98m in 1Q15 and 4Q15. The increase is mainly due to the consolidation of the newly acquired Promethean business (estimated to cause a loss of Rmb60m) and the impact of seasonal factors on the domestic education business as well as the rising operating costs for education businesses. Healthy growth in online games Revenue from online games increased 27% YoY to Rmb284m (50% of total revenue) in 1Q16, attributable to strong momentum in its new games Calibur of Spirit and Eudemons Online Pocket version. Calibur of Spirit generated gross revenue of Rmb49.3m in Feb 2016, reaching a new record high. For the full year, the company expects strong performance in online games, unpinned by 1) the launch of two mobile game products, developed based its hot PC game titles Calibur of Spirit and Eudemons in 2H16 and 2) the release of Tiger Knight on the globally known Steam platform during 2H16. Education business sales to rise in 2Q16 Revenue from its education business came in at Rmb280m in 1Q16, 95% of which came from Promethean. The company indicates that 1Q is the traditional off-season for the education business in domestic markets, due to the Chinese New Year Page 3

4 holidays and constraints in China s funding system, which delay schools buying decisions. For the peak season of 2Q and 3Q, the company expects a strong ramp-up in both its domestic and overseas education business. Our view We remain positive on NetDragon given 1) healthy sales growth and improving profitability in its online game business, 2) the strong ramp-up in its online education business expected in the upcoming three quarters. More comments to follow this afternoon s investor meeting. (Ryan Zhu, Research Analyst, SFC CE No. BDK820, zhuran@gfgroup.com.hk ) 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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