Hong Kong Exchange [0388.HK]

Hong Kong Exchange [0388.HK] We believe the proposed establishment of New Board Premium and New Board Pro will be another game changer for the HKEx after the launch of the Stock Connect in November 2014. If the establishment of the new boards is approved by the authorities, we estimate that HKEx s average daily turnover (ex-warrants) may increase by >14% initially and that the potential increase may be >30% in the medium term if the Top 10 Chinese ADRs are traded in Hong Kong. Although the share price of HKEx has come under moderate pressure recently because of weakening market sentiment, we reiterate our view that investors should treat HKEx as not just a market proxy; the huge potential of business opportunity expansion should not be overlooked. Maintain BUY with a Gordon Growth Model-based target price of HK$232.5 (40.9x 12-month-forward PER; beta at 1.38, cost of equity at 8.4%, and medium-term ROE at 20.5%). Investment Highlights New Board Premium & New Board Pro to be Another Game Changer Two key features of New Board Premium and New Board Pro. (i) Weighted voting right structures will be allowed. This paves the way for Alibaba and other companies with similar share holding structures to be listed in Hong Kong. (ii) Currently, Chinese ADR companies are not allowed to be listed in Hong Kong in the form of secondary listings. New Board Premium and New Board Pro will allow Chinese ADR companies to have secondary listings in Hong Kong. (See Figure 1 for details.) Lowers the cost of returning to Hong Kong substantially. Without New Board Premium and New Board Pro, Chinese ADR companies need to delist first and then launch an IPO in Hong Kong. After the establishment of these two new boards, Chinese ADR companies will be able to avoid the high cost of delisting and be traded in Hong Kong in the form of a secondary listing. As the example of Tencent (0700.HK) shows that Hong Kong investors are willing to pay high a PER for leading technology companies, we believe Alibaba and other leading Chinese ADRs will be willing to consider a secondary listing in Hong Kong. Huge trading volume upside for HKEx. The 3-month average daily turnover of the Top 10 most traded Chinese ADR companies is HK$30.2bn (Figure 2). If we assume about 30% of the trading volume will go back to Hong Kong, this implies that the average daily turnover of the Hong Kong market may increase by 14% (exwarrants). In the medium term, we believe the potential increase may be >30% because of the home-bias effect, as shown by some SOE ADR companies (Figure 3). New Board rules to be finalized in early 2018. The consultation for the New Board will end on August 18, 2017. If the proposal is supported by market participants, HKEx aims to finalize the New Board rules in early 2018. Year ended 31 December 2015 2016 2017E 2018E Revenue (HK$ m) 12,233 10,398 11,475 12,259 Net income (HK$ m) 7,956 5,769 6,837 7,536 Net Margin 65% 55% 60% 61% Basic EPS (HKD) 6.70 4.76 5.58 6.07 YOY Change 51% -29% 17% 9% PE (x) 29.5 41.5 35.4 32.5 PB (x) 9.3 7.8 7.2 6.7 ROAE 31.1% 18.6% 20.2% 20.4% ROAA 3% 2% 3% 3% Sources: Company, CGIS Research Hong Kong Financials Sector BUY Close: HK$197.6 (June 16, 2017) Target Price: HK$232.5 (+17.7%) Price Performance (HK$) 230 210 190 170 Market Cap US$31,197m Shares Outstanding 1,225m Auditor PricewaterhouseCoopers Free Float 94.48% 52W range 3M average daily T/O Major Shareholding Sources: Company, Bloomberg HK$170.75-211.16 Livy Lyu Research Analyst (852) 3698 6393 livylyu@chinastock.com.hk US$102.0m HKSAR Govt. (5.45%) Wong Chi Man Head of Research (852) 3698-6317 cmwong@chinastock.com.hk June 19, 2017 (HK$ million) 8000 150 0 Jun-16 Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 Jun-17 Turnover (RHS) Price (LHS) Source: Bloomberg 6000 4000 2000 1

Figure 1: Highlights of the proposal to set up new boards New Board Premium New Board Pro Eligibility Open to both retail and professional investors. Open to professional investors only. Basic requirements Quantitative entry requirements equivalent to those of the Main Board in force from time to time. No track record or minimum financial criteria, subject to a minimum market cap at the time of listing of HK$200m. Investor protection Secondary listings Special shareholding structure Regulatory approach Sources: HKEx, CGIS Research Figure 2: Trading volume of Top 10 most traded Chinese ADR companies Ticker Company name Sources: Bloomberg, CGIS Research Regulatory cooperation requirement under the 2013 Joint Policy Statement (JPS) would continue to apply but listings by companies listed on recognized US exchanges (NYSE and NASDAQ) will be exempted from having to provide equivalent shareholder protection standards. No restriction on secondary listings by Mainland Chinese companies. Weighted voting rights (WVR) structures permitted. A more stringent approach to initial listing requirements. Price (US$) Market cap (US$m) 2017E PER (x) 2018E PER (x) PBR (x) 3-month average daily turnover (HK$m) BABA US Equity Alibaba Group Holding Ltd 134.87 345,423 30.00 22.85 8.23 13,679 BIDU US Equity Baidu Inc 173.88 60,421 31.08 22.56 4.36 3,671 JD US Equity JD.com Inc 38.17 54,520 123.12 51.73 10.34 2,769 NTES US Equity NetEase Inc 296.97 38,980 17.64 15.54 6.37 2,757 MOMO US Equity Momo Inc 36.89 7,273 24.71 17.07 10.00 1,984 CTRP US Equity Ctrip.com International Ltd 52.94 27,171 54.05 30.31 2.49 1,693 WB US Equity Weibo Corp 71.1 15,545 45.96 29.70 19.08 1,162 SINA US Equity SINA Corp/China 85.91 6,136 31.88 21.34 2.21 921 YUMC US Equity Yum China Holdings Inc 39.88 15,327 27.60 24.60 5.94 868 EDU US Equity New Oriental Education & Technology Group Inc 74.1 11,684 40.40 31.33 7.42 692 Total 30,197 Figure 3: ADR accounted for less than 20% of the trading volume of leading SOEs Regulatory cooperation requirement under the 2013 Joint Policy Statement (JPS) would continue to apply but issuers will not be required to provide equivalent shareholder protection standards. No restriction on secondary listings by Mainland Chinese companies. WVR structures permitted. A "lighter" approach to initial listing requirements. Equivalent to % of HK 3-month average daily turnover (exwarrants) Equivalent to % of HK 3-month average daily turnover 46.6% 37.8% Ticker Company name Sources: Bloomberg, CGIS Research 3-month average daily turnover (ADR) (HK$) (A) 3-month average daily turnover (HK) (HK$) (B) 941 HK Equity China Mobile Ltd 248,234,891 1,326,127,685 18.72% 2628 HK Equity China Life Insurance Co Ltd 40,942,645 888,066,121 4.61% 857 HK Equity PetroChina Co Ltd 54,102,575 533,013,166 10.15% 386 HK Equity China Petroleum & Chemical Corp 69,011,764 522,329,760 13.21% A/B 2

Key financials P&L summary (HK$m) 2015 2016 2017E 2018E Trading fees and trading tariff 5,469 4,428 4,935 5,277 Stock exchange listing fees 1,114 1,092 1,165 1,232 Cearing and settlement fees 3,118 2,358 2,725 2,992 Depository related fees 867 857 930 980 Market data fees 803 816 840 872 Other revenue 862 847 880 905 Revenue 12,233 10,398 11,475 12,259 YoY 34% -15% 10% 7% Net investment income 1,123 696 1,032 1,286 Other income 19 22 22 22 Revenue and other income 13,375 11,116 12,529 13,566 Staff costs (2,020) (2,035) (2,125) (2,260) IT expenses (517) (500) (510) (520) Premises expenses (294) (333) (340) (345) Marketing expenses (41) (54) (58) (62) Legal and professional fees (99) (106) (120) (125) Other operating expenses (396) (427) (450) (480) EBITDA 10,085 7,661 8,926 9,774 Depreciation& amortisation (684) (771) (757) (767) Operating profit 9,401 6,890 8,168 9,007 Finance costs (114) (82) (83) (83) Share of loss of JV (9) (9) (9) (9) Profit before tax 9,278 6,799 8,076 8,915 Tax (1,347) (1,058) (1,268) (1,409) Minorities (25) (28) (29) (30) Net Profit 7,956 5,769 6,837 7,536 YoY 54.0% -27.5% 18.5% 10.2% Balance Sheet summary (HK$m) 2015 2016 2017E 2018E Cash 110,890 115,723 123,798 133,318 Financial assets 92,144 99,159 103,125 112,620 Accounts receivable 15,535 12,928 14,475 16,355 Current assets 218,571 227,810 241,398 262,293 Financial assets 57 74 75 80 Goodwill 17,872 17,812 17,850 17,820 Fixed assets 1,560 1,499 1,450 1,430 Non-current assets 19,622 19,508 19,502 19,457 Financial liabilities 64,486 61,627 62,009 65,009 Margin deposits 115,213 126,846 135,000 148,000 Accounts payable 15,270 12,246 13,455 14,719 Clearing House Fund of Participants 7,474 8,656 8,982 9,070 Current liabilities 203,976 210,688 220,933 238,420 Borrowings 3,409 3,422 3,430 3,436 Deferred tax liabilities 761 713 888 986 Non-current liabilities 4,255 4,246 4,441 4,555 Shareholders' Equity 29,816 32,266 35,380 38,598 Minorities 146 118 147 177 Sources: Company, CGIS Research estimates 3

Key financials Cash Flow summary (HK$m) 2015 2016 2017E 2018E Profit before tax 9,278 6,799 8,076 8,915 Depreciation& amortisation 684 771 757 767 Net working capital adjustment (293) (321) (487) (626) Net cash from operations 8,321 6,164 7,519 8,125 Capex (710) (620) (746) (717) Others 290 (2,715) (2,198) (3,980) Net cash from investing (420) (3,335) (2,944) (4,697) Dividends paid (3,017) (3,329) (3,077) (3,391) Net cash from financing (3,224) (3,586) (3,368) (3,708) Free cash flow 7,611 5,544 6,773 7,408 Net cash/(debt) 9,335 5,864 7,063 6,777 Net Gearing n.a. n.a. n.a. n.a. Gross gearing 11% 11% 10% 9% Ratios 2015 2016 2017E 2018E EBITDA margin 82% 74% 78% 80% Net margin 65% 55% 60% 61% ROAE 31% 19% 20% 20% ROAA 3% 2% 3% 3% PE (x) 29.5 41.5 35.4 32.5 PB (x) 9.3 7.8 7.2 6.7 EV/EBITDA 23.0 30.7 26.2 24.0 Basic EPS (HKD) 6.70 4.76 5.58 6.07 Diluted EPS (HKD) 6.67 4.75 5.56 6.06 DPS (HKD) 5.94 4.25 4.97 5.40 Dividend yield 3% 2% 3% 3% BVPS (HKD) 90% 90% 90% 90% 21.2 25.4 27.3 29.4 Segment Income Contribution Cash 28% 26% 26% 26% Equity and financial derivatives 18% 20% 20% 19% Commodities 14% 15% 15% 15% Clearing 36% 35% 35% 35% Platform and infrastructure 4% 5% 5% 5% Key assumptions 2015 2016 2017E 2018E ADT of equity products (HK$bn) 79.9 50.2 59.0 65.0 ADT of DWs, CBBCs &warrants (HK$bn) 25.7 16.7 19.0 20.0 Total Cash Segment ADT (HK$bn) 105.6 66.9 78.0 85.0 ADT of northbound( bn) 6.4 4.7 6.5 9.5 ADT of southbound(hk$bn) 3.4 3.6 8.0 11.0 Southbound Contribution 3.2% 5.4% 10.3% 12.9% Number of newly listed (main board) 104 81 85 90 Number of newly listed (GEM) 34 45 39 42 ADT of DWs, CBBCs &warrants (HK$bn) 25.7 16.7 19.0 20.0 ADnumber of derivative contracts 393,948 463,722 500,000 530,000 ADnumber of stock options contracts 374,346 297,903 340,000 360,000 ADvolume of metals contracts (LME) 670,189 618,627 680,000 720,000 Sources: Company, CGIS Research estimates 4

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Explanation on Equity Ratings BUY SELL HOLD : : share price will increase by >20% within 12 months in absolute terms share price will decrease by >20% within 12 months in absolute terms : no clear catalyst, and downgraded from BUY pending clearer signal to reinstate BUY or further downgrade to outright SELL Copyright Reserved No part of this material may be reproduced or redistributed without the prior written consent of China Galaxy International Securities (Hong Kong) Co., Limited. China Galaxy International Securities (Hong Kong) Co. Limited, CE No.AXM459 Room 3501-3507, 35/F, Cosco Tower, Grand Millennium Plaza, 183 Queen s Road Central, Sheung Wan, Hong Kong. General line: 3698-6888. 5