Industrials  Asia June 2011 

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1 Industrials  Asia June 2011 

Peer snapshot

Asia construction machinery players: peer comparison Sany Heavy Lonking Zoomlion Doosan Infracore Ticker 600031 CH 3339 HK 1157 HK 042670 KR Currency RMB HKD HKD KRW Share price* 17.00 3.87 17.28 22,000 Market cap* 129,093m 16,564m 102,529m 3,708b Market cap* (USDm) 19,916 2,217 13,166 3,424 Rating Overweight (V) Neutral Neutral (V) Overweight (V) Valuation method PE PE PE PE Target multiple 16.3x 9.5x 13.6x 10.9x Vs 5yr sector average 20% premium 30% discount No discount 20% discount 2011 EPS RMB 1.38 RMB 0.37 RMB 1.13 KRW 2,513 Target price RMB22.5 HKD4.2 HKD18.4 KRW27,000 Potential return 35% 11% 8% 23% Key businesses Product mix – Excavator 18% 16% 2% 63% – Wheel loader - 69% - - – Crane 12% - 34% - – Concrete Machinery 53% - 44% - – Others 17% 14% 19% 37% Region – Domestic 94% 95% 95% 39% – Exports 6% 5% 5% 61% Plants in China Changsha, Huayin Kunshan, Shanghai, Zhengzhou, Longyan – Location Yuanjiang, Changde Yantai, Suzhou Shanghai, Beijing Shanghai Shanghai (Wheel loader) 48,000 (Concrete) 15,060 (Excavator) 29,200 – Capacity (Excavator) 30,000 (Excavator) 8,000 (Crane) 10,100 (Wheel loader) 6,000 (Forklift) 20,000 (Excavator) 3,000 Key Component supplier Cummins, Deutz, In-house, Cummins, – Diesel Engine Cummins, Deutz Cummins, Weichai Weichai Yanma – Valve Rexroth, Kawasaki Kawasaki, Rexroth Partially in-house KYB – Pump Kawasaki Kawasaki, Rexroth Kawasaki, Rexroth In-house – Motor Nabtesco Nabtesco, Rexroth Nabtesco, Rexroth In-house – Cylinder Partially in-house Partially in-house Partially in-house Dongyang Mechatronics Sales Network – Number of dealers 42 main dealers 286 sales outlet 548 (self-owned) outlet 38 main dealers Covering all the Additional 410 third-party – Network strategy by province by province provinces dealers’ outlet Pricing – Excavator (20-25 ton) RMB 880k RMB 840k RMB 800k RMB 800-820k – Wheel loader (5 ton) - RMB 230k - RMB 230k Leasing policy – Leasing sales mix 60% 36% 34% 15% – Financial leasing receivable holder Parent company Listed company Listed company Listed company

*Priced as of 15 June 2011 Note: (V) = volatile (please see disclosure appendix) Source: Company data, Bloomberg, HSBC

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Rationale for valuation and SWOT analysis

Sany Heavy Lonking Zoomlion Doosan Infracore Market Positioning by product Segment Outlook ______Market Positioning ______Major player (No. 2 market Major player (No. 4 market Excavator Strong Marginal player Marginal player share of 11.1%) share of 10.2%) Market leader (No. 1 market Major player (No. 2 market Concrete Machinery Strong - - share of 20%) share of 19%) Major player (No. 3 market Major player (No. 2 market Crane Neutral - - share of 8%) share of 24%) Market leader (No. 1 market Wheel Loader Weak - Marginal player Marginal player share of 18%) Valuation summary PE 2011e 12.3 8.8 12.7 8.8 2012e 9.9 7.8 10.6 7.7 EPS growth 2011e 24.5 -6.3 18.0 NM 2012e 24.6 12.3 19.9 14.0 PB 2011e 5.1 2.1 2.5 2.0 2012e 3.8 1.7 2.1 1.6 ROE 2011e 51.5 27.9 21.3 27.0 2012e 45.6 25.4 21.4 23.3 Revenue growth 2011e 46.7 14.5 34.9 13.7 2012e 28.0 14.5 28.2 4.0 Net Margin 2011e 15.4 12.0 14.8 8.6 2012e 15.0 11.7 13.8 9.4

Valuation rationale Target multiple 16.3x 9.5x 13.6x 10.9x Vs 5yr sector average 20% premium 30% discount No discount 20% discount Well positioned, gaining High dependence on Diversified product line-up High exposure to share in Chinese wheel loaders Valuation rationale Moderate growth and excavator market excavator market Moderate growth and margin Low growth and margin High growth high margin margin SWOT analysis Offering diversified Strong exposure to Offering Diversified construction machinery excavator market in construction machinery products China products Top wheel loader player in China Top player in truck crane First-mover advantage in Higher exposure to Strengths market China and brand concrete machinery and Strong cost control & recognition excavator segments highest margin among State owned company: top wheel loader makers Majority shareholder is Potentially to leverage its Financial leasing offered Hunan Provincial US market exposure by parentco, not listco People's Government through Bobcat Cannot boost sales High dependency on the High dependence on Relatively high exposure through financial leasing government policy Wheel loader at 69% to crane segment Weaknesses due to high debt ratio High exposure to fossil Higher sales portion from Latecomer in fast-growing Weaker financial stability fuel price financial leasing excavator market from Bobcat acquisition Strong candidate to After market parts sales become No. 1 in foreign Aggressive sales Seeking growth from to derive stable margins dominated excavator promotion of excavators excavators Potentially to boost sales Opportunities market Potential disposal of Overseas expansion volume via financial Overseas expansion by financial leasing business through CIFA leasing building plants in ma to improve cash flows markets Recovery of US market Foreign brands entering Industry competition and into matured wheel More competitive crane High gearing ratio slowdown = potential loader market market preventing capacity pressure on strong Margin and balance sheet expansion + R&D Threats capacity expansion at risk due to high Overseas business recovery is slow (i.e Strong competition from Low brand recognition in financial leasing = Europe especially Italy) local brands in China overseas market negative operating cash Macro tightening in China Macro tightening in China Macro tightening in China flow Macro tightening in China

Source: Company data, Bloomberg, HSBC

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Investment summary

 Machinery companies have enjoyed a cyclical sector boom over the past few years in China, but growth has yet to slow before the mature stage of the industry life cycle  Aggressive industry-wide capacity expansion will likely outpace demand and weigh on overall profitability  We initiate with an Overweight (V) on Sany Heavy and Doosan Infracore, Neutral on Lonking, and Neutral (V) on Zoomlion

Cyclically off the downhill Many machinery companies have benefited from the construction machinery sector’s strong growth during the past few years in China. Property, mining and infrastructure FAI played a key role in driving industry demand. While China focuses on moving towards a consumption-driven economy over the long term, we continue to believe FAI will be the key to achieve its target GDP. Nevertheless, we believe that the construction machinery industry in China has reached the end of its growth stage, assuming it follows a four-stage industry life cycle. During the growth stage, several leaders in the industry have surfaced and become more stable, and market share gains can now be envisaged.

As the industry benefits from strong FAI, the industry is still growing faster than the rest of economy, but we expect growth to slow before the market matures. The recent spate of government-driven FAI has created opportunities for the Chinese machinery sector to develop rapidly. The boom in property and infrastructure has rewarded many firms with high profit margins and this, in turn, has encouraged existing players as well as new entrants to invest their profits in further expansion. However, the strong growth cannot be sustained indefinitely. Fast-expanding capacity the biggest concern Our biggest concern for sector is its fast-expanding production capacity. In 2010 and 2011, all producers benefited from the demand recovery, as the leading machinery companies had not increased their production capacity during the financial crisis in 2008-2009. Most Chinese construction machinery companies began aggressively expanding their excavator capacity and distribution networks from 2010, resulting in overcapacity from 2012. We think this aggressive capacity expansion could lower the overall profitability of the industry; higher competition will increasingly affect sales promotion, product prices, and margins. For example, we expect total excavator capacity to reach 412k units by 2012 (versus 197k units in 2010), 77% higher than industry demand, at 233k units. Therefore, we urge investors to be more

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selective and identify an ultimate survivor in this battlefield. Aggressive capacity expansion is likely to bring this industry from its growth stage to maturity. From a long-term perspective, even though we expect further growth in the construction machinery sector, driven by increased FAI, we believe that what is now a pure growth industry will become cyclical depending on macro policies and industry capacity.

We believe China’s relatively low urbanization will drive construction machinery demand further, as its ratio remains below 50% versus that of developed countries at above 80%. Despite the government’s push to make the Chinese economy more consumer-driven, this is a long-term change, and China’s per capital FAI is still lower than that of developed countries globally. We believe the industry will continue to see further growth; however, it is uncertain whether machinery companies can continue to enjoy higher margins without this translating into higher stock prices and stock multiples. The peak of the cycle could come either in 2011 or 2012 in terms of earnings, growth rates and share prices. Therefore, we see more room for upside selectively for companies making market share gains as opposed to companies growing below industry average.

To decide where we are in the current cycle, we should look at macroeconomic indicators as well as industry-wide capacity expansion plans, utilisation rates, and industrial conditions (PMI). All these indicators were at their bottoms in 2009 and have seen a strong recovery in 2010 and y-t-d 2011. The sector outperformed massively up to 1Q11 and since then has fallen sharply due to slowing growth; now the question is whether there is potential for further upside in the current cycle. In terms of their risk- return profiles, not every industry player looks equally attractive from a long-term perspective given the current credit tightening, plus the aggressive expansion plans of most players. After such a strong rally, many investors have also become concerned that growth will decelerate in 2H11; however, more importantly, we believe the aggressive industry expansion, in addition to sales promotion using financial leases, will be a key concern from a long-term perspective while monthly or quarterly sales volume will increase stock price volatility.

Excavator capacity expansion trend Industry life cycle

('000 unit) 500 100% China 85% 400 65% 80% 57% 300 60% 200 40% Start-up Grow th Maturity Decline 100 20% Industry Output Industry Stage Stage Stage Stage 0 0% 2010 2011E 2012E

Capacity Sales v olume Utilization rate Tim e

Source: CCMA, HSBC Source: HSBC

Where is the cash? Catch 22 In 1Q11, after offering more competitive pricing, zero-down payments, and longer repayment terms, the companies posted negative operating cash flow. This aggressive sales promotion generated higher-than- expected and above-industry growth for many companies except more conservative foreign brands such

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as Doosan Infracore, Komatsu, and Hitachi. However, we think this trend in 1Q11 will trigger problems of further competition, financial instability due to weak cash flows, and an increase in second-hand products due to potential customer defaults.

We are concerned that the next efforts to gain market share may come from lowering product pricing, as financing with zero down payments can no longer serve to differentiate peers. We gather that certain makers already began to offer discounts to their customers in May. This could mean that some companies will run into funding difficulties, as sales volume increases due to new capacity may further pressure their balance sheets; otherwise, the companies will lose market share, with a lower portion of their sales from financial leasing business.

We believe that financial leasing is not a negative factor for companies as long as the default rate is theoretically zero. In fact, this product actually can generate additional earnings from the net interest margin, and this could provide a stable earnings stream. However, a higher-than-expected rate of defaults is a downside risk for both margins and asset value. In a worst-case scenario, the company would have to mitigate liquidity risk by securing capital market funding, depending on the maturities of existing debts.

Receivable turnover trend Lonking: A/R turnover

(x ) (RMB m) Trade and other receiv ables (x) 8.0 Receiv ables under finance lease 15,000 A/R Turnov er 10.0 7.0 12,000 8.0 6.0 5.0 9,000 6.0 4.0 6,000 4.0

3.0 3,000 2.0 2007 2008 2009 2010 2011e 0 0.0 Lonking Zoomlion Sany Doosan 2007 2008 2009 2010 2011e

Source: Company data, HSBC Source: Company data, HSBC

Read-across from macro and leading indicators In general, we believe that the demand for construction machinery is highly correlated to fixed asset investment (FAI) in China, as most construction equipment is used for infrastructure, property and mining development under FAI. Infrastructure investment, including railways and highways, accounts for roughly 40% of FAI, with property investment at 30% and manufacturing capacity expansion also at roughly 30%. Under FAI, all three subsegments are important leading indicators for different product types in the machinery industry.

Despite the government’s strong stimulus package following the 2009 financial crisis, we still believe that China’s FAI will rise another 21.5% in 2011 and 19.0% in 2012. During first four months of 2011, FAI grew 25.4% y-o-y, above consensus and faster than December’s 24.5% y-o-y growth This is attributable mainly to accelerated growth in the secondary sectors (up 24.7% y-o-y), railway construction (45.3% y-o-y) and property investment (35.3% y-o-y).

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During the 12th Five-Year Plan period, the government has aimed to make the economy more consumption- driven; however, we believe FAI will continue to be an important diver for GDP growth in China and the contribution from domestic consumption will only gradually increase, causing further room for FAI sustainability. Key drivers during 12th Five-Year Plan would be continuous development of west China for regional balancing, urbanization of low-tier cities and higher industrialization.

We expect that China’s policy priority is to control any inflationary pressure as the government is seeking to balance towards more consumption driven economy. Therefore, we think there will be further tightening by the government. With multiple rate hikes and reserve requirement ratio (RRR) hikes, China’s new bank lending declined 14% y-o-y to RMB2,387bn in 1Q11, from RMB2,786bn in 2010.

The market has been concerned about continued base interest rate hikes through 2011 and multiple RRR hikes to control the inflation. Will this really have a negative impact? Yes, we think so; however, it means that growth coming from FAI will be stronger than expected and that the government will want to control the overall industry’s financing capabilities.

China FAI and annual growth China Policy rate and reserve ratio

(Rmb tn) 24% 8% 40 40% 20% 7% 30 30% 16% 20 20% 6% 12% 5% 10 10% 8%

0 0% 4% 4% 2005 2006 2007 2008 2009 2010 2011e2012e 2001 2003 2005 2007 2009 2011e FAI Total Growth (%) Policy Rate (RHS) Reserve Ratio (LHS)

Source: CEIC, HSBC Source: Bloomberg, HSBC

We prefer excavators and concrete machinery Among the various construction machinery segments, we prefer excavators and concrete machinery mainly because (1) they stand to benefit most from social housing; (2) we believe the demand for replacement by excavators (substitution demand) will continue; and (3) structural growth comes from adoption of ready-mixed concrete.

Therefore, our top pick in the sector is Sany Heavy, as the company has the highest exposure to concrete machinery and excavators, and there could be earnings upside deriving from an enhanced brand image if Sany overtake Komatsu as the No. 1 excavator player in China. Excavators It is interesting that many construction machinery companies are aggressively expanding their capacity at the moment when we believe industry supply will grow faster than industry demand. Even a new entrant such as Rongsheng Heavy Industries (shipbuilder) is planning to set up 30,000 unit excavator capacity in 2011. Besides this, the further credit tightening should lower the purchasing power affecting sales volume

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in 2H11. We think the financial leasing terms will become more favourable to customers and could be the key swing factor for sale volume with growth slowing down.

From a long-term perspective, we believe excavators will gradually replace wheel loaders as excavators are more powerful and have more functions. In developed countries, excavators are already widely used than wheel loaders. Due to rising labour cost and improving construction standard, we think excavators will outpace wheel loaders in terms of growth and eventually reach a 2:1 volume ratio (2 excavators to 1 wheel loader).

We therefore forecast excavators to grow 20% in 2011 and 15% in 2012 versus wheel loaders at 10% in 2011 and 8% in 2012. Interestingly, the excavator segment is the only area in which foreign brands still dominate the Chinese market due to the high mechanical barriers of hydraulic components. Also, reliability and durability are key factors determining market positioning of foreign brands in China. However, the strong capacity expansion on the part of major players and local brands could outpace demand and trigger an ASP war in 2012. Concrete machinery Concrete machinery should deliver better-than-expected sales growth. We expect to see growth of 22% in 2011 and 19% in 2012, driven mainly by an improving off-site concrete mix ratio in China and an improving mechanisation rate (the increasing usage of commodity concrete). Historically, the concrete machinery market has been the biggest in terms of sales and has grown more than 30% in the past 10 years.

Slowing sales could be a downside risk to industry demand, but we think the risk is fairly limited given higher usage of commodity concrete and social housing in 2011. We believe truck-mounted pumps should take away sales value from stationary pumps due mainly to higher working efficiency and mobility and easy set-up despite higher pricing. We believe this upgrade trend is likely to continue given growing demand for working efficiency and rising purchasing power as in the crane segment.

Concrete was mostly mixed on-site in the past in China. The ready mix concrete was more costly as commodity concrete was not widely used for property construction. Government implemented on-site mixing prohibition regulation as on-site mixing is not efficient and environmentally friendly. This regulation is triggering growing demand for concrete machinery and we believe this will be the key growth driver going forward in China. China market snapshot Foreign brands still dominate the excavator market in China, accounting for more than 70% of sales volume (including mini excavators). Major brands include Komatsu (Japan), Doosan Infracore (Korea), Hyundai Heavy Industries (Korea), Kobelco Construction Machinery (Japan), and Caterpillar (US). We think Japanese’s high market share is due mainly to better control of technology, quality, and durability, while Korean brands have enjoyed strong market share gains as a result of their pricing and their after- sales service strategy. However, local brands are now becoming more aggressive in terms of sales promotion and the adoption of after-sales service strategies, also leading to recent market share gains. The local brands’ market share rose from 14% in 2005 to 30% in 2010. We think this trend will continue, as we believe they are well-positioned in the market between Japan and Korea. Sany is a leading local brand

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that has shown strong market share expansion through its competitive products, financing, strong distribution channels, and attractive after-sales service system.

Still, major construction equipments are sourcing key components largely from Japan and Europe. However, local brands’ operating margins are quite impressive despite their high dependency on imported components, driven mainly by strong industry demand and pricing strategy. Therefore, despite the fact that it is in their best interest to develop key components in-house similar to Komatsu and Caterpillar, Chinese brands are not rushing to develop them near-term and enjoy the current positioning while it lasts.

Over the long term, we think Chinese machinery names will attempt to develop in-house components. However, since reliability is the key to further success, this may take longer than expected, much as in Korea. It is likely that survivors of intense competition with established brand power will adopt localised component or in-house components slowly to prevent quality and reputational risk in the future. Once the overall profitability of the industry shrinks, more and more companies will focus on developing key components to reduce costs and generate stable earnings from after-market sales.

We agree that Koreans could stay more competitive by adding wheel loaders to their product offerings, given cost reduction to further leverage the economies of scale. However, we prefer the Chinese strategy to the Korean strategy mainly for the following reasons:

1 Koreans are entering the highly competitive wheel loader market, dominated entirely by local brands

2 By contrast, the Chinese are becoming more aggressive in the excavator market by targeting to gain market share from the Koreans after they dominate the rest of construction machinery industry. Key proxies for winning the market share war In the following analysis, we identify five key factors for market share expansion in China: (1) product quality, (2) sales network, (3) financial leasing conditions, (4) pricing strategy, and (5) after-sales service. 1. Product quality Due to the use of imported components from Japan and Germany, local brands claim that they have better quality than Korean brands. So far, we believe strong after-sales service may be a way to overcome poor quality of their products. Apart from hydraulics and other key components, local brands improved the mechanical performance of their products by developing and adopting more in-house designs. Most customers of these machines are individuals in China. We think these customers believe the machines with imported components (Japan) have better quality than Korean machines, and this has been the key market strategy taken by local brands to expand their market share. Sany also has plans to localise most of its hydraulic components by licensing technology from leading companies such as KYB. This is similar to the case of Doosan Infracore, which targets to generate additional earnings from after-sales parts. 2. Sales networks This is easily comparable to car dealers, as dealers are the main sales channel for machinery products, especially excavators, in China. Moreover, dealers play important role of providing after-sales service, maintenance and financing arrangement for customers. Generally, major players have 1 distribution centre per province, which also controls other products types. The management of dealership is increasingly becoming important as they are the face of brand and product to their customers, which

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could potentially affect sales volume. We gather that the companies change dealership rights time to time depending on their performance and service quality to customers. We do not see much difference between local and Korean brands in terms of sales network, but they both have key advantages over some foreign brands such as Komatsu and Caterpillar in terms of number of dealers covering broader areas of China. 3. Financial leasing Recently, financial leasing has become an important way for local brands to increase their market share. This is increasingly used in China to purchase construction equipment. This could be easy and fast way to boost its sales given smaller down-payment with longer payment terms. Local brands are more aggressive with easier funding access versus more conservative stance by foreign brands such as Komatsu and Doosan. Therefore, local brands have more flexibility to boost sales volume but at the same time this could potentially pose high financing risk and deterioration of working capital. Among major players, Sany has the model which benefits the shareholders the most with minimum risk as the leasing is offered by its parent group. Currently above 80% of its excavator sales are financed by mortgage loans, while its dealers resume repurchase obligations for a substantial portion of the loans. 4. Pricing strategy We gather that the pricing of local brands is quite similar to that of Korean brands even though the quoted price seems a little higher. We do not expect local brands to lower their pricing far below the Koreans, as dealers in local brands are educating customers that local brands with Japanese components are better in terms of product quality and reliability. By looking at the margins of local brands, they have a relatively high margin structure compared with foreign brands despite using imported components. We think this higher margin is driven mainly by cheaper labour, better economies of scale (product variety) and RMB appreciation. Therefore, we believe local brands have more room to lower pricing and remain competitive during an industry downturn. 5. After-sales service After-sales (AS) service has been the key to local brands’ recent success. As competition heats up, construction machinery companies are offering more and more timely responses, as construction machines’ hours of operation are higher than in developed markets. We gather that excavators typically operate 20 hours per day at peak versus a maximum of eight hours per day in developed markets. Therefore, AS service, including parts supply, has grown in importance and is now one of the key factors used to choose machines by customers in China. After our visit to Sany’s headquarters, we think the company has made significant progress in its AS service quality, including shortening the response time, expanding its service network, and training dealers & engineers. We also think this differentiates Sany from its peers and the better quality service is helping them strengthen its brand image and its market positioning. Stock picks Sany is our top pick with a premium valuation Our price target of RMB22.5 is based on a PE of 16.3x applied to adjusted FY11e EPS. We have set the target multiple higher than the construction machinery sector average of 13.6x, as we think the earnings of construction machinery companies will show evidence of their emergence as market leaders versus marginal players, and we believe the market will award a premium to the future market leaders.

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We see this premium as based on two factors: (1) increasing market share for construction machinery companies and (2) relatively high operating profit margins. Sany is likely to expand its market share, as seen in the excavator segment, as it is raising its production capacity.

In terms of margins, Sany is now showing better margins due to better cost control, economies of scale, and higher product pricing. We believe this trend will lead to continued market share expansion, brand power and further bargaining power on component procurement.

On Doosan and Lonking, we believe that the discount to our target multiple can be justified by following: (1) a less diversified product offering, (2) lower margins, (3) potential liquidity risk, and (4) the highest exposure to the most mature wheel loader market for Lonking.

1. Sany Heavy: OW(V), TP RMB22.5  Initiate with Overweight (V) due to greater exposure to high-growth products  Continued market share gain in foreign dominated excavator market  Potential to become No. 1 in China with better pricing strategy, brand power and after-sales service  Top pick in the sector

2. Lonking: N, TP HKD4.2  Initiate with Neutral due to highest exposure to slowing wheel loader market  Attractive valuation among construction machinery  Strong execution capability and cost leader among the top three loader makers

3. Zoomlion: N(V), TP HKD18.4  Initiate with Neural (V) due to its high exposure to crane business and slightly demanding valuation  Current premium should diminish once Sany H gets listed in HK near future  Consensus numbers seem to be relatively high and likely to come down

4. Doosan Infracore: OW(V), TP KRW27,000  Initiate with Overweight (V) due to strong positioning in excavator market in China.  Targeting to generate high-margin from after-sales parts business by increasing in-house parts  Limited downside risk at current share price offering 23% potential return.

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Contents

Peer snapshot 2 Company section 63 Changsha Zoomlion (1157 HK) 64

Investment summary 4 Lonking (3339 HK) 71

Macro issues 13 Sany Heavy Industries (600031 CH) 79 Doosan Infracore (042670 KS) 88 Where we are in the cycle 28 Disclosure appendix 98 Industry forecasts 35 Disclaimer 100 Competitive landscape 51

Valuation and stock picks 58

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Macro issues

 Overall FAI indicates a slowdown in the construction machinery industry  Social housing under the 12th Five-Year Plan stands to benefit excavator and concrete machinery segments  Credit tightening is working, despite off-balance sheet lending

Further growth intact, but infrastructure investment in railway, highway, likely to slow down property and mining development, are very important indicators of the direction in which the China has become the biggest construction industry is going. machinery market globally. Infrastructure, property and mining industries are driving solid FAI to remain solid growth for the machinery sector. Among Generally, demand for construction machinery in construction equipment, excavators and wheel China has a high correlation with FAI, as most of loaders are the biggest markets in dollar terms, the construction equipment is used for and are seeing strong demand. These markets infrastructure, property and mining, which are have experienced 20% and 10% growth, recipients of FAI funds. Infrastructure investment, respectively, in 2011, causing further competition including railway and highway investment, between local and foreign brands. accounts for c40% of FAI, with property and manufacturing capacity at 30% each. These three We saw a rapid downturn in the overall industry are important leading indicators for different in 2009 due to the financial crisis; however, product types in the machinery industry. government policies and measures drove market recovery and led to stronger demand from 2010. Therefore, government policies, including

China major FAI policy and impact on the construction machinery sector Major FAI category Policies and trend Impact on segment Consists of railway, highway spending and urbanisation. Solid railway spending Infrastructure expected until 2012, with RMB2.8trn spending earmarked under the 12th Five-Year Negative for the sector Plan. Highway spending has come down due to massive spending during 2009-10 The credit tightening policy is putting further pressure on commodity housing, but Positive for concrete machinery Property we expect support from government’s social housing plan of 36m units during & excavators 2011-15 Slowdown expected due to limitations on coal production. The government is Mining aiming to limit production to 3.8bt by 2015; 2.8% production growth during 2011-15 Negative for wheel loaders versus 8.8% in 11th Five-Year Plan

Source: HSBC

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Despite the government’s strong stimulus package 12th Five-Year Plan to combat the 2009 financial crisis, we still The key themes of China’s 12th Five-Year Plan are believe that China’s FAI will continue to rise by income redistribution and consumption. We believe 21.5% and 19.0% in 2011 and 2012, respectively. it will manifest in more construction projects (such During the first four months of 2011, FAI as low-income housing at RMB1.3trn in 2011), expanded by 25.4% y-o-y, above consensus water supply construction investment (RMB2trn expectation and faster than December’s 24.5% y- during 2011-15) and railways (RMB2.8trn for next o-y growth, while real growth of urban FAI five years). These will give a boost to the strengthened to 18% y-o-y in January-February construction machinery sector. versus 15.7% y-o-y in December. This is driven mainly by faster growth in the secondary sectors There is no doubt that China is attempting to (up 24.7% y-o-y), railway construction (45.3% y- move to a more consumption-driven economy. o-y) and property investment (35.3% y-o-y). However, the structural change in wealth generation and real purchasing power would take Under the 12th Five-Year Plan period, the longer than expected. We believe China’s government aims to induce a more consumption- economy will remain significantly investment- driven economy; however, we believe FAI will driven for many more years, driven by west China remain an important diver for GDP growth in development projects, more social housing and China and the contribution from domestic the on-going high-speed railway and railway consumption will only gradually increase, development projects. Therefore, China’s sustaining FAI. Key drivers during the 12th Five- infrastructure should continue to grow. Year Plan would be continuous development of west China for regional balancing, urbanisation of The market is still concerned about a slowdown in growth despite strong stimulus efforts by the low-tier cities and higher industrialisation. government in 2009 and 2010. Although recent According to the National Bureau of Statistics of credit tightening may slow the pace of new China, total FAI in China increased 26.3% CAGR investments, there are still more than 100k during 2005-10, from RMB7.5trn in 2005 to infrastructure projects currently in progress and RMB24.1trn in 2010. 10m public housing units to be built in 2011. We believe these could support volume growth for the construction machinery sector.

Chinese FAI and annual growth Mining FAI and annual growth

(Rmb tn) (Rmb mn) 40 40% 1,200 60% 50% 30 30% 800 40% 20 20% 30% 400 20% 10 10% 10% 0 0% 0 0% 2005 2006 2007 2008 2009 2010 2011e2012e 2005 2006 2007 2008 2009 2010 FAI Total Growth (%) FAI - Mining Growth (%)

Source: CEIC, HSBC Source: CEIC

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Urbanisation is the key Urbanisation rate (2010) Urbanisation has been identified as the single- 100% most important factor for domestic demand 80% growth. The government is pinning hopes on accelerating urbanisation in the western regions as 60% a policy platform to gradually solve the long-term 40% economic challenges of imbalanced regional development levels and the urban-rural 20% divergence, as well as to upgrade the industry. We 0% believe property prices must be controlled to FR KR US Canada UK GR JP CH ensure that the pace of urbanisation is maintained. Source: World Bank Estimates from various academic sources as well as comments from government officials suggest Urbanisation could also propel consumption China’s urbanisation rate could rise from 47% in growth through the growing pool of urban 2010 to 65% by the end of 2030 and eventually consumers. Urban per capita consumption in 2009 reach 70-80% by 2050. Even if the 150-170m stood at RMB12,265 (USD1,800), or 3.5 times migrant workers are counted as urban residents, that of rural areas. For the top 36 cities, average the potential upside could still be 10-20ppt. consumption expenditure in 2009 was From an investment perspective, urbanisation RMB15,604 (USD2,200), or 4.5 times that of boosts both property sector and public rural areas. Further liberalisation of the urban infrastructure investments. For instance, 10-15m household registration system, Hukou, and new urban residents every year could translate reforms to land ownership transfer are the likely into 100-150m sqm of potential housing demand, regulatory changes driving urbanisation. Various assuming 10 sqm per person (the national average regional development plans and the emerging living standard for the low-income group in urban trend of industrial manufacturing base migrating areas). Regression analysis for the past two to inland and western provinces are the economic decades also suggests that around 20% of the drivers. Moreover, the public housing scheme will potential demand, or 20-30m sqm, could be also greatly facilitate the urbanisation process. realised as residential floor space sold in a year, representing 3-5% of incremental demand.

Urban population and annual growth Infrastructure FAI – Urban transportation and annual growth

(million person) (Rmb mn) 650 4% 250 80% 200 3% 60% 600 150 2% 40% 100 550 1% 50 20% 500 0% 0 0% 2005 2006 2007 2008 2009 2010 2005 2006 2007 2008 2009 2010 Urban population (person mn) Grow th (%) Urban transportation Growth (%)

Source: CEIC, HSBC Source: CEIC, HSBC

15 Industrials  Asia June 2011 

FAI – Infrastructure and annual growth FAI – Real estate and annual growth

(Rmb mn) (Rmb mn) 3,000 60% 8,000 40% 2,500 50% 6,000 30% 2,000 40% 1,500 30% 4,000 20% 1,000 20% 2,000 10% 500 10% 0 0% 0 0% 2005 2006 2007 2008 2009 2010 2005 2006 2007 2008 2009 2010 F AI - Infra Grow th (%) FAI - Real Eastate Grow th (%)

Source: CEIC Source: CEIC

Infrastructure – railway and highway Railway investment to remain solid until 2012 investment According to the Ministry of Railways, the The infrastructure investment makes up about operating distance will reach 120,000km by 2015 30% of China’s FAI and mainly consists of from the current level of 91,000 km. In addition, investments in railway, highway and urbanisation the high-speed railway (300kmph) operating of cities. Construction machinery, such as distance will reach 45,000km from the current excavators, concrete pumps and truck cranes, are level of 8,358km. Therefore, the total generally the beneficiaries of a boom in infrastructure investment over the next five years infrastructure investment. The government’s is expected to grow 41% annually, triggering total RMB4trn stimulus package has substantially railway investment of RMB2.8trn. boosted demand for such equipment in the past Procurement of equipment was strong in 2009 and two years. 2010, as railway construction began, and we The government is targeting to maintain its GDP believe the trend will continue with further growth at above 8% in 2011, after delivering railway expansion in China. However, we expect higher growth during the 11th Five-Year Plan. the growth of railway investment to decelerate after 2012. We forecast annual spending on railway infrastructure construction to reach

Infrastructure FAI – Railway Infrastructure FAI – Highway

(Rmb mn) (Rmb mn) 800 80% 1,500 50% 40% 600 60% 1,000 30% 400 40% 20% 500 200 20% 10% 0 0% 0 0% 2005 2006 2007 2008 2009 2010 2005 2006 2007 2008 2009 2010 Railway Grow th (%) Highw ay Grow th (%)

Source: CEIC Source: CEIC

16 Industrials  Asia June 2011 

RMB700bn in 2011 and 2012, which could come Overall FAI to still grow at a slower pace down to RMB400-500bn during 2013-15. Due to the base effect, we expect China’s overall FAI growth to slow to 21.5% in 2011 and 19.0% Note that the definition of high-speed railway is in 2012. We still believe railway will drive growth now lowered from a maximum speed of 350kmph and expect a slowdown in highway spending. to 300kmph. This might be because of the change in the minister of railway. The previous minister Therefore, we believe that the growth rate of had to step down because of a corruption scandal infrastructure spending may surprise the market in March this year (he reportedly took a bribe of on the downside, and we may be witnessing the more than RMB1bn). It is believed that the new peak of the current industry cycle. minister is less aggressive on high-speed railway Property – economic housing to expansion, and hence, has lowered the maximum maintain growth speed target. Property investment – mainly consisting of public Highway investment to slow down housing and urbanisation of cities – makes up Highway investment is another major driver of about 20% of China’s FAI. Construction construction machinery demand. Highway speed machinery, such as concrete machinery, cranes, construction generally requires road-rollers, wheel excavators and wheel loaders are generally loaders, excavators and concrete pumps. After beneficiaries of a boom in property investment. robust investment in both 2009 and 2010, there is high possibility that highway spending could slow. China’s social housing of 5.2m units in 2010, in order to balance wealth distribution, has supported In addition to highway spending, the government strong growth in construction machinery spending has been focusing on building a metro network, in 2010. The government is targeting to achieve mainly due to rapidly increasing traffic in major additional 10m units in 2011, out of total 36m for cities as well as for improved urban transportation. 2011-15, despite its recent tightening measures. Local governments’ financing ability will be a key factor in determining the pace of development. We believe that the newly started floor space will grow 25% in 2011, driven mainly by (1) We forecast annual spending on highway stabilising property prices, (2) the government’s construction to reach RMB6.2trn in the next five strong commitment to social housing of (36m years. We expect China’s highway investment units over the next five years), and (3) the start of growth to slow down in 2012. new projects by private developers.

Real estate investment Real estate investment – residential

(Rmb mn) (Rmb mn) 6,000 40% 4,000 40% 5,000 30% 3,000 30% 4,000 3,000 20% 2,000 20% 2,000 10% 1,000 10% 1,000 0 0% 0 0% 2005 2006 2007 2008 2009 2010 2005 2006 2007 2008 2009 2010 Real Estate investment Grow th (%) RE inv estment - Residentail Bldg. Grow th (%)

Source: CEIC Source: CEIC

17 Industrials  Asia June 2011 

Major indicators, including property floor space We forecast the demand growth form the coal started and real estate FAI, are pointing to further mining industry will gradually slow down due to strong growth in China, which could further boost limit of coal production in China. Therefore, this demand for construction machines. would have negative impact on wheel loaders sales as they have relatively higher exposure to Given the government’s target of 36m social coal mining industry at roughly 30-40%. housing, we do not see much downside risk to infrastructure investment growth. We expect By looking at the shipments, it is clear that coal China’s social housing investment to grow strong, production and wheel loader sales have high up 70% to RMB1,387bn in 2011 and a further correlation in the past. Thus, we believe that the 10% to RMB1,526bn in 2012. We believe social coal production is a good leading indicator for housing would make a bigger contribution to total wheel loader sales in the future. real estate investment in 2012. Upside risk Strong social housing investment will likely boost On the other hand, on-going industry demand of concrete machines. Concrete machines consolidation through government-driven M&A have higher exposure to property development could boost the equipment demand due mainly to than any other machines. higher machinery rate at merged mines.

Apart from concrete machines, we also expect In addition to industry consolidation, rising excavators to benefit from property construction mechanisation of the industry could be another demand. The government’s willingness to increase key factor for construction machinery market. supply volume could surprise to the upside and According to the China National Coal Machinery this should drive volume growth for excavators. Industry Association, 40% or less of medium Mining – slowdown in coal production sized mines are mechanised versus above 80% of potentially hits wheel loader market larger mines. The government is targeting to raise this ratio up to 80% for medium-size mines. The mining investments used to be key drivers of wheel loaders and excavators demand in China as construction machinery such as wheel loaders and excavators are generally beneficiaries of boom in mining industry.

RE Investment – Official RE Investment – Commercial

(Rmb mn) (Rmb mn) 200 40% 600 40% 500 150 30% 30% 400 100 20% 300 20% 200 50 10% 10% 100 0 0% 0 0% 2005 2006 2007 2008 2009 2010 2005 2006 2007 2008 2009 2010 RE investment - Official Bldg. Grow th (%) RE investment - Commercial Bldg. Grow th (%)

Source: CEIC Source: CEIC

18 Industrials  Asia June 2011 

Excavators to replace wheel loaders Coal output to slow Sarah Mak* Analyst In China, wheel loaders have generally been used (See Decarbonising China’s growth: What The Hongkong and Shanghai Banking Corporation Limited more widely than in developed markets such as China’s green goals mean for heavy industry in +852 2822 4551 [email protected] the US and Western Europe despite similar the 12th Five-Year Plan, by Nick Robins, dated *Employed by a non-US affiliate working applications. We believe this has been 3 March 2011, for full report.) of HSBC Securities (USA) Inc, driven by the government’s intention to develop and is not registered/ qualified pursuant to FINRA regulations the local wheel loader industry, where relatively Coal-fired power generators supply around 80% little technology is required. of China’s electricity and generate over 40% of the country’s GHGs. As part of the 12th Five- We think excavators will replace wheel loaders in Year Plan, the government is aiming to cut the China, following pattern similar to that of developed percentage of primary energy consumption from markets, driven by higher construction standards. coal from c70% to 63% by 2015. Therefore, mining will become the most important source of excavator demand in the future. Sector consolidation During the 11th Five-Year Plan, China set the According to HSBC’s metal and mining team, we goal of developing large coal enterprises, of forecast Chinese coal output to grow at 6-7% each which 6 to 8 with 100mt production capacity and in 2011 and 2012. 8 to 10 with 50mt capacity; together, these would contribute 50% of national coal production. This target has been lifted to 65% in the 12th Five- Year Plan, aiming for 10 large coal enterprises with 100mt capacity and 10 with 50mt capacity. In addition, the number of coal enterprises will be cut from 11,000 in 2010 to 4,000 in 2015.

The focus will be on closing mines with less than 300ktpy production capacity, and the overall target is to limit small mines’ coal production from 700mt in 2010 to 500mt by 2015, or a cut from 27% of China’s coal production in 2010 to 13% in 2015.

Chinese mining FAI and annual growth Chinese coal production

(Rmb bn) (Rmb mn) 1,200 60% 4,000 12% 1,000 50% 10% 3,000 800 40% 8% 600 30% 2,000 6% 400 20% 4% 1,000 200 10% 2% 0 0% 0 0% 2005 2006 2007 2008 2009 2010 2005 2006 2007 2008 2009 2010 FAI - Mining Grow th (%) Coal Output (Ton mn) Growth (%)

Source: CEIC Source: CEIC

19 Industrials  Asia June 2011 

Limiting coal production China thermal coal market balance/pricing The government is also aiming to limit coal 200 180 production in the next Five-Year Plan to 3.8bt by 160 2015. This implies that the scope for further 140 120 growth is only 430mt, or an annual growth rate of 100 80 c2.8% (80-100mtpa) during 2010 to 2015. This is 60 much lower than 11th Five-Year Plan, when 40 production grew on average of 232mtpy or 8.8% Jul-07 Jul-08 Jul-09 Jul-10 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 CAGR. However, this 8.8% CAGR in the 11th Newcastle Richards Bay Aus-JPY contract Five-Year Plan compares with the Plan’s target of just 3.4%, which would have delivered output of Source: McCloskey, HSBC

2.6bt compared with the actual result of 3.37bt. There are concerns on oversupply of coal in the We forecast that coal production will grow at 6% long run following the capacity expansion in the to 7% each in 2011 and 2012 and production inner parts of China, when greater rail capacity could reach 3.8bt as early as 2012. Although will also become available. We believe much higher than the government’s intended consolidation and control of resources by a few target, this rate of growth is still lower than the large state-owned enterprises will limit the past five years, as a result of slowing consumption oversupply risks. Following consolidation, the growth from China’s industrial sectors and a Chinese coal producers will have greater control rising clean energy share (see below). over supply, allowing them to adjust the supply and transport to match with the demand growth in the 12th Five-Year Plan.

China thermal coal supply China thermal coal demand

1,600 18 20 1,400 15 18 1,200 12 16 1,000 9 14 800 6 600 3 12 400 0 10 8 Jul-07 Jul-08 Jul-09 Jul-10 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jul Apr Oct Jan Jun Feb Mar Aug Sep Dec Nov China thermal coal imports (RHS) May Australian (RMB/t equivalent w 17% VAT) 2007 2008 2009 Qinhuangdao Port domestic 6000kc 2010 2011

Source: China Coal Resource, McCloskey, HSBC Source: China Coal Resource, HSBC

20 Industrials  Asia June 2011 

Macro tightening PBoC’s monthly open market operation Hongbin Qu Chief Economist, Greater China (See China Inside Out: Three big myths on credit, 2,000 (RMB bn) The Hongkong and Shanghai Banking Corporation Limited by Hongbin Qu, dated 31 May 2011, for full report.) +852 2822 2025 1,000 [email protected] Policy tightening is working, despite 0 off-balance-sheet lending As a key component of its overall policy package -1,000 to check inflation, Beijing has been stepping up its -2,000 efforts to bring credit growth to a normal rate 08 09 10 11 since last October. Unlike central banks in most Liquidity injection Liquidity withdraw al Net position developed countries, the Chinese central bank has been mainly relying on quantitative tools rather Source: Wind, HSBC than interest rate hikes to remove excessiveness in  credit growth. Chief among the quantitative tools Central bank bill issuance. Unlike a are the following: developed economy, China has not yet developed a deep bond market, and the  Required reserve ratio (RRR) hikes. The central bank holds little government bonds People’s Bank of China (PBoC) has hiked the and other securities, leaving the PBoC little RRR eight times since last October. Each 50 room to sell down its security holdings to basis point (bp) hike can immediately freeze mop up liquidity. However, the PBoC has and up over RMB370bn liquidity within the will continue to issue bills (with maturity banking system, limiting banks’ capability to ranging from one month to three years) in its extend loans. This, in our view, is a more own name to withdraw liquidity from the effective tool to control credit expansion. inter-bank market.

HSBC China macro forecast summary

2006 2007 2008 2009 2010 2011e 2012e Production, demand and employment GDP growth (% y-o-y) 11.6 13.0 9.6 9.2 10.3 8.9 8.6 Fixed asset investment (nominal, % y-o-y) 24.5 25.8 26.1 30.5 24.5 21.5 19.0 Industrial production (excl. small enterprises % y-o-y) 16.2 16.0 12.9 12.9 15.7 13.2 12.5 Unemployment rate, average (%) 4.1 4.0 4.2 4.3 4.1 4.3 4.3 Money, FX & interest rates Central bank money M0, average (%) 13.2 13.6 12.4 12.1 14.9 11.0 11.0 Broad money supply M2, average (%) 18.1 17.5 16.7 26.5 23.7 17.9 15.5 Policy rate, end-year (%) 6.12 7.47 5.31 5.31 5.81 6.56 8.56 5yr yield, end-year (%) 6.48 7.74 5.76 5.76 6.16 7.00 7.00 RMB /USD, end-year 7.81 7.30 6.82 6.83 6.61 6.35 6.15 RMB /USD, average 7.96 7.60 6.94 6.83 6.72 6.48 6.25 External sector Merchandise exports (USDbn) 969 1,219 1,429 1,202 1,578 1,863 2,086 Merchandise imports (USDbn) 792 956 1,133 1,006 1,394 1,673 1,940 Net FDI (USDbn) 73 84 108 90 106 122 134 Exports (% y-o-y) 27.2 25.8 17.2 -15.9 31.4 18.0 12.0 Imports (% y-o-y) 19.9 20.8 18.5 -11.3 38.6 20.0 16.0 Public and external solvency indicators Commercial banks’ FX assets (USDbn) 200 188 181 212 245 292 292 Gross external debt (USDbn) 323 374 375 350 330 360 360 Short term external debt (% of int’l reserves) 17.2 14.4 10.8 6.3 4.2 4.1 4.8 Consolidated government balance (% GDP) -1.0 0.6 -0.4 -2.2 -2.5 -2.0 -1.7

Source: HSBC

21 Industrials  Asia June 2011 

 New loan quota system. This year, the PBoC For example, if a bank extends RMB1bn lending has introduced a more rigorous monthly loan in form of “trusted loans” to a company, the new quota system to smoothen banks’ lending loan may not be included in the bank’s new loan activity. Given that big banks account for figure, but once the company receives this sum, it more than 40% of bank lending, such monthly should immediately be reflected in its bank new loan quota is very effective in reining in account as an increase in deposits, which will still big banks’ lending. be captured by M2 money supply figures. Given Combined with gradual increases in interest rates, that growth in M2 money supply has been these quantitative tightening steps since last October slowing consistently over the last four months, it have already been filtering through, with growth in implies that off-balance-sheet lending, even if it both broad monetary aggregate and loans slowing may still rise, has not derailed the trend of meaningfully. As chart2 shows, broad money slowdown in the overall credit flowing out of the supply M2 growth has decelerated from the nearly banking system. 30% peak to average of 16% in the last two months Moreover, the China Banking Regulatory (which is in line with the year-end target of 16% Commission (CBRC) has been filling the and the long-term average growth) and lending loopholes in off-balance-sheet lending since late growth also normalised from nearly 35% y-o-y in last year. It also set a timetable for banks to bring 3Q09 to around 17% in April. old off-balance-sheet lending onto their balance That said, we believe the PBoC still needs to keep sheets, ie banks have to bring off-balance-sheet tightening in the coming months in order to check lending into bank books by the end of 2011. The inflation. Now, we expect two RRR hikes (100bp) volume of off-balance-sheet lending was reduced and one interest rate hike (25bp) in the coming to RMB1.66trn by the end of 2010 from months. All these should help to cool inflation RMB2.08trn by the end of July 2010. According meaningfully into 2H this year. to the timetable, no less than 25% of the outstanding off-balance-sheet lending should be Chart2. M2 and credit growth transferred into the books each quarter. (%yr,3mma) (%yr, 3mma) 40 40 We believe another confusion on the credit 35 35 30 30 situation comes from the PBoC’s recent release of 25 25 the “social financing aggregate” figure. It shows 20 20 that if external financing through equity and bond 15 15 markets is included, total social financing for non- 10 10 5 5 financial companies and institutions still recorded 99 00 01 02 03 04 05 06 07 08 09 10 11 RMB4.2trn in 1Q compared with RMB4.5trn in M1 M2 Loans 1Q10. On the surface, this figure implies that the policy tightening has not slowed growth in overall Source: CEIC, HSBC credit that much. However, there is a key How about banks’ off-balance-sheet lending? difference between financing through the capital Timely data for such lending is unavailable, but a market and bank credit: an increase in bank loans rise in off-balance-sheet lending will still be will lead a chain effect of loan-deposit creation reflected in the M2 money supply figures, even and, therefore, will be a self-sustained cause of though it may get around the new loan figures. credit creation, which will not be the case with the

22 Industrials  Asia June 2011 

Table 1. Total social financing _ Total financing ____ Bank lending__ __Off-balance-sheet lending _ ____ Bond ______Equity ______Others ___ RMB bn % y-o-y RMB bn % y-o-y RMB bn % y-o-y RMB bn % y-o-y RMB bn % y-o-y RMB bn % y-o-y

2003 3,420 2,999 263 55 55 51 2004 2,868 -16 2,398 -20 318 21 52 -6 66 21 60 17 2005 2,862 0 2,456 2 100 -69 200 288 34 -48 72 19 2006 4,010 40 3,280 34 425 324 84 -58 136 297 84 18 2007 5,922 48 3,920 20 1,178 177 231 174 480 252 113 34 2008 6,869 16 4,973 27 852 -28 556 141 337 -30 158 40 2009 14,082 105 10,519 112 1,577 85 1,296 133 451 34 253 60 2010 14,270 1 8,348 -21 3,840 143 1,199 -7 579 28 300 18 20101Q 4,513 n.a 2,786 n.a 1,274 n.a 268 n.a 125 n.a 0 n.a 20111Q 4,190 -7 2,387 -14 1,091 -14 455 70 156 25 0 n.a

Source: CEIC, HSBC

former. As a result, so long as policy tightening Chart 3. Actual lending rate can slow bank credit, it will likely lower growth % 100 in the overall financing soon. 80 If still not convinced that the over credit 60 conditions have become tighter amid policy 40 tightening, all you need to look at is the latest 20 changes in official and unofficial lending rates. As 0 chart3 shows, the actual lending rate is even Jan-08 Jan-09 Jan-10 Jan-11 May-08 Sep-08 May-09 Sep-09 May-10 Sep-10 higher than the benchmark rate, which has seen As Benchmark 10% below 10% above four hikes (or a total of 100bp) since last October. 10-30% above 30-100% above

As of April, 55.8% of bank loans were priced Source: CEIC, HSBC above the benchmark lending rate, while this share was 42.8% in 4Q10. The surge in the private Chart 4. Private lending rate higher than the previous tightening cycles lending rate is more significant: as shown in 20 (%) chart4, the private lending rate in Wenzhou, a prefecture city in southeast Zhejiang province and 15 one of the private companies’ hubs, jumped to an 10 average of 18.5% on an annualised basis in 5 March, according to the PBoC’s survey. This is nearly three times of the one-year benchmark 0 lending rate and also higher than the private January 2005 November 2007 March 2011 Annualised priv ate lending rate in Wenzhou lending rate in the previous two tightening cycles 1-y ear official benchmark lending rate (2004-05 and 2007-08). Source: PBoC, HSBC

23 Industrials  Asia June 2011 

Another sign of the impact of policy tightening is shows, M2 growth leads GDP growth by about that tighter credit conditions have also been three quarters; the nearly 20% M2 growth in 2H10 cooling real activity, as shown in the is consistent with over 15% nominal GDP growth in following indicators: 2Q-3Q this year, or around 9% real GDP growth, if we net off high inflation.  PMI, the monthly leading indicator, has been slowing over the past five months. The latest Nominal GDP vs credit growth flash May reading fell to a 10-month low, at 25 (%yr) (%yr) 35 51.1, from 51.8 in the previous two months, 30 or well below the series’ long-term average of 20 25 52.3 for four months. (See China: Cooling, 15 HSBC Flash China manufacturing PMI (May) 20 10 slows, 23 May 2011.) 15

 IP growth slowed unexpected to 13.4% y-o-y in 5 10 April from 14.8% y-o-y in May. Sequentially, 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 IP growth cooled to 0.9% m-o-m, seasonally GDP (Lhs) M2 (Rhs, lagged by 3 quarters)

adjusted, in April from 1.2% m-o-m, seasonally Source: CEIC, HSBC

adjusted, in March. Electricity output growth also softened to 11.7% y-o-y in April from Lending to local governments’ 14.8% y-o-y in March. financing vehicles To finance the urbanisation-led infrastructure Yes, there are increasing concerns about over- investment, local governments have been borrowing tightening and hard landings. However, we think from banks through their urban development these worries are overplayed. A popular argument corporations over the last 10 years. Growth in these of the bearish camp is that the credit crunch is so borrowings was accelerated during the global crisis, pressing that the small and medium-size when Beijing called for both local governments and enterprises (SME) got deeply hurt. The SMEs banks to speed up their infrastructure investment to indeed face difficulty with financing. Yet, it is prevent a hard landing. more of a structural issue, given that China’s financial system is largely dominated by banks How large is the debt of local governments’ that in nature favour large enterprises. Even financing vehicles (LGFV)? Official data suggests without the credit control, SMEs are always that it stood at RMB7.7trn (or 20% of 2010 GDP) concerned about difficulties with funding. We at the end of 2010. Despite the clean-up of believe the solution lies in further reform in LGFVs’ debt since then, this number is likely to China’s financial system, rather than loosening be even larger, considering the growing loans to credit control. infrastructure projects (new lending to infrastructure rose RMB1.65trn last year), driven If history is a guide, the current pace of over 17% by massive ongoing projects and huge appetite of credit growth is far from too tight. Over the decade new projects. before the financial crisis (ie 1998-2007), China’s average credit growth was less than 15% y-o-y and M2 growth averaged 16% y-o-y, which supported nearly 10% GDP growth (real terms). As chart5

24 Industrials  Asia June 2011 

Outstanding debt of local governments’ financing vehicles investment in China is much higher than the Amount As % of GDP global average. In fact, the profitability of the (RMBtrn) (2010) listed toll road companies is among the Total 7.66 19.2 Sufficient cash flows to repay 2.07 5.2 highest of all Chinese companies listed on the interests and principles stock markets. Insufficient cash flows from the 3.83 9.6 projects to repay, but have the  second source of funding Even for these infrastructure projects with Serious risk to default 1.76 4.4 insufficient cash flows, it still should be the Source: CBRC, HSBC, as of end June 2010 government’s responsibility for investing in them. In our view, it is hard to imagine that We believe nothing is wrong about the Beijing would let these projects cause a infrastructure investment because the economy systematic risk to the banking system without needs these investments. However, we believe the main problem here is that many of these long- taking any pre-emptive measures. term projects, even though they are useful, would The key issue here is what Beijing can do to not be able to generate sufficient cash flows to address this problem before it spreads over to the service the bank debt (most with a maturity of 5- banking system. We believe there are at least 10 years, which is much shorter than the payback three feasible options for Beijing (see China period of the project financed). In other words, Economic Spotlight: Time to restructure local there is a big mismatch between the payback government debt, 29 July 2010), as given below: period of projects and the maturity of their debts, leading to a risk of debt defaults. The CBRC’s  The central government issues more long- estimates suggest that around 23% of RMB7.7trn term construction bonds on behalf of local (or RMB1.8trn) run the risk of bank defaulting in governments, enabling them to repay the loan repayment. loans initially used to fund pure public work projects. As this option does not require any However, the worry that this would cause a change to the current central-local fiscal banking crisis is unwarranted in our view for the following main reasons: framework, we think it will likely be the easiest to execute. Since last year, Beijing has  Unlike public debt in south European and other already issued RMB200bn of bonds on behalf countries, the proceeds of LGFVs’ debt have of some provincial governments in support of been mostly invested in infrastructure facilities selected local projects. Moreover, compared rather than financing the government’s with the direct issuance of debt by local operational expenditure. So, the increase in the governments, central government debt debt has also resulted in an increase in the issuance should incur a lower cost of funding. government’s assets. In other words, rising debt Demand for such central government bonds has not caused deterioration in the should not be an issue, given a) the huge pool government’s balance sheets. of funds currently sitting idle in individual  Many of the projects are needed and will, deposit saving accounts (RMB27trn), and therefore, generate sufficient return to service b) the demand for such government debt the debt. From a macro perspective, China instruments that are being cultivated by accounts for 25% of global total freight growing contractual savings, such as volume, but its rail network accounts for just insurance and mutual funds in China. 6% of global total, implying the return on rail

25 Industrials  Asia June 2011 

 Beijing allows local governments to directly  Property prices have increased at a slower pace. issue bonds to service existing loans and to For new residential housing prices, sequential raise funds for new future projects. The growth in 70 big cities slowed to 0.3% m-o-m obvious advantage of this option is that each in March-April from 0.6% m-o-m in January- local government’s debt will be priced by the February. For secondary residential housing market according to its own specific set of prices, there was a more notable slowdown credit ratings, effectively imposing market compared with that for new housing: sequential discipline on the local government’s growth slowed to 0.1% m-o-m in March-April investment ventures. This option has already from 0.5% m-o-m in January-February and the been discussed at length within policy- number of cities seeing m-o-m price decline making circles, but it requires an amendment increased to 16 in March-April from 3-4 in to China’s budget law as well as much greater January-February. transparency in local governments’ books –  Property transaction volume has shrunk, something that will likely take time to likely due to: a) the shaking expectation of accomplish. Other challenging issues will also persistently rising property prices; b) the ban be evoked, such as a clearer delineation of on households purchasing multiple houses in central versus local government ownership more than 40 cities. As a result, the property rights to state assets. transaction volume dropped by around 10%  Selling state assets to raise funds to repay y-o-y in April, the first contraction in eight local loans. Local governments still own more months, but the magnitude is still far less than than 20,000 state-owned enterprises (SOE), average of 27% fall in 2H 2008. with more than 70% of them making profits. Chart6. Sequential growth and transaction volume growth Local governments also own toll roads, ports (%yr, 3mma) (%mom, 3mma) and other commercially valuable assets. 100 2 Selling these assets would help them to repay 1.5 their debts after their investments in 50 1 0.5 unprofitable infrastructure facilities. In any 0 0 case, we believe selling these assets is a must -0.5 to shift local governments away from -50 -1 business activities to public service – a key 06 07 08 09 10 11 objective for government reforms in the next Property sales v olume (Lhs) five years. Public listing of local SOEs would Property price (Rhs)

be the best way to do so, but the real challenge Source: CEIC, HSBC

here is how to manage the asset selling through other channels to prevent corruption Shrinking housing sales, tighter credit and and state assets erosion, in our view. massive supply of public housing may lead to a correction in the property markets in big cities in Property market: overheated yet still the coming years. However, this is unlikely to underleveraged cause a systematic banking problem for the After 12 months of gradually stepping up property following main reasons: cooling measures, signs have been emerging that First, China’s property market is overheated but these cooling measures have started to filter through: underleveraged, which means that both

26 Industrials  Asia June 2011 

households’ and banks’ exposure to property is Second, it is true that lending to property developers still limited. For households, even after the has also been surging over the last five years, aggressive expansion in mortgage lending over posting a serious risk if the property market crashes. the past two years (outstanding mortgage loans However, direct lending to property developers just surging to RMB6.2trn as of end 2010 from stood at RMB2.49trn as of end 1Q, or 5% of total RMB3trn as of end 2008), the share of urban outstanding bank loans. Even after indirect lending households that have mortgage loans only stood at to real estate (such as trusted loans) is included, this around 6%, by our calculation. And the ratio would still be below 10%. This is a main outstanding mortgage loans just accounted for reason why recent stress tests suggest that a 30% 13.4% of total outstanding loans. It turns out that fall in property prices would impose limited risk to the NPL ratio for mortgage loans has been falling the major banks’ balance sheets. over the past four years and was at an extremely Last but not least, China’s rapid pace of low level (0.3%) last year. urbanisation process and the household sector’s Chart7. Chinese households stay underleveraged very low leverage mean underlying demand for

8,000 (RMB bn) (%) 8 housing should remain strong in the medium to long term. With 10 million people migrating to 6,000 6 cities every year, we believe it will be hard for 4,000 4 China to see total supply of housing exceeding 2,000 2 demand in the medium term, though there may be 0 0 some mismatches between the structure of supply 00 01 02 03 04 05 06 07 08 09 10 and that of demand. All this is likely to limit the Housing mortgage loan (Lhs) risk of a major collapse in the Chinese property % of urban households hav ing mortgage loans market, at least in the next five years.

Source: CEIC, HSBC

Chart8, Mortgage loans as percentage of total loans

15 (%)

10

5

0 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Mortgage loans as % of total banking loans

Source: CEIC, HSBC

27 Industrials  Asia June 2011 

Where we are in the cycle

 Growth pace slowing despite strong Government policies  Aggressive industry capacity + sales promotion with financial leasing = the biggest concern on profitability + balance sheet  Prefers survivors with market share gain and high exposure to excavators + concrete machinery

Where are we heading? and market share can be easily envisaged. As the industry benefits from strong FAI, the growth rate Many machinery companies are enjoying strong of the industry is still faster than the rest of growth of construction machinery sector past few economy but growth should slow down eventually years in China. Obviously FAI including property, before maturity stage. mining and infrastructure played key roles to drive the industry demand. While China is We think that Government driven FAI created focusing to move towards consumption driven opportunities for Chinese machinery sector to economy in long-term, we continue to believe develop rapidly in recent times. The boom in FAI will be the key to achieve its target GDP. property and infrastructure rewarded many firms with high profit margins and this, in turn, We believe that the construction machinery accelerates existing players as well as new industry in China is currently at final phase of entrants to put in all the profits back into further growth stage under 4-stage industry life cycle. expansion and enjoy the industry growth. Under growth stage, several leaders in the industry start surfacing and becoming more stable

China FAI and annual growth Excavator capacity expansion trend

(Rmb tn) ('000 unit) 40 40% 500 100% 85% 400 80% 30 30% 65% 57% 300 60% 20 20% 200 40% 10 10% 100 20%

0 0% 0 0% 2005 2006 2007 2008 2009 2010 2011e2012e 2010 2011E 2012E FAI Total Growth (%) Capacity Sales v olume Utilization rate

Source: CEIC, HSBC Source: CCMA, HSBC

28 Industrials  Asia June 2011 

However, the strong growth cannot be sustainable machinery companies would keep enjoying higher and we think it must slow down in due course of margins, which would not translate into higher time. Also we think the aggressive industry-wide stock prices and stock multiples. The peak of the capacity expansion could outpace the demand and cycle could come either 2011 or 2012 in terms of lower the overall profitability of the industry. As a earnings, growth rates and share prices. Therefore, result, we believe the higher competition will there is more room for upside selectively for increasingly affect sales promotion, product prices companies with market share gain rather than and their margins. companies growing below industry average.

Capacity expansion: Is this China excavator market capacity expansion real? (Unit) 2010 2011e 2012e Caterpillar 13 25 40 Our biggest concern for sector is its fast- Volvo (Lingong) 9 16 20 expanding production capacity. In 2010/11, every Komatsu 30 50 60 Hitachi 19 22 25 producer was able to benefit from the demand Kobelco 18 20 23 Summimoto 4 4 5 recovery as all the leading machinery companies Doosan 23 27 32 did not increase their production capacities due to Hyundai 20 24 28 Foreign Subtotal 134 188 233 financial crisis in 2008/09. However, most of Sany 12 30 50 Yuchai 8 11 13 Chinese construction machinery companies are Liugong 7 12 18 aggressively expanding their excavator capacity Lonking 5 7 15 Sunward 6 9 12 and distribution networks from 2010, resulting Shandong Heavy 5 10 20 potentially outpacing industry demand from 2012. Domestic Subtotal 43 79 128 Major Total 178 262 345 New entrant 20 50 67 For example, we expect total capacity of Total Capacity 197 312 412 excavator to reach 412k units by 2012 from 197k Capacity growth 58% 32% Sales volume 168 203 233 units in 2010, 77% higher than industry demand at Sales Volume growth 70% 20% 15%

233k units. Therefore, we urge investors to be Source: CCMA, HSBC more selective and identify an ultimate survivor in this battlefield.

We believe the industry will continue to see further growth however, it is quite uncertain that

China construction machinery sales volume trends Industry life cycle

('000 unit) 600 60% China 500 50% 400 40% 300 30% Start-up Grow th Maturity Decline 200 20%

Industry Output Industry Stage Stage Stage Stage 100 10% 0 0% 1999 2002 2005 2008 2011E 2014E Tim e

Source: Off-highway, HSBC Source: HSBC

29 Industrials  Asia June 2011 

Cyclical growth Macro Tightening: negative impact on Aggressive capacity expansion is likely to transform machinery stocks? this industry into mature stage from growth stage in We believe that China’s policy priority is to China. From long-term perspective, , despite the fact control any inflationary pressure, as the that we should see further growth of construction government is seeking to shift the balance towards machinery driven by increase in FAI, we believe the a more consumption driven economy. Therefore, industry will eventually become more cyclical from there will likely be further tightening by the pure growth one depending macro policies & government. With multiple rate hikes and RRR industry capacity. hikes, China’s new bank lending declined 14% y- o-y to RMB2,387bn in 1Q11, from RMB2,786bn In terms of deciding where we are in current cycle, in 2010. we should also look at macro indicators as well as industry-wide capacity expansion plans, The market has been concerned with continued utilisation rate and economic indicator. (PMI) All base interest rate hikes through 2011 and multiple these indicators were at the bottom in 2009 and RRR hikes to control the inflation. Does this saw strong recovery in 2010 and y-t-d in 2011. really have negative impact? Yes, however this The sector outperformed massively so far and means that growth coming from FAI is stronger now the question is whether we see further upside than expected and government would want to in current cycle. In terms of risk-return profile, the control financing capabilities of overall industry. mot every player in the industry does look In this respect, this should be viewed that the attractive from long-term perspective given demand is still quite strong fundamentally. current credit tightening + aggressive expansion plan by most players. Credit sales: where is cash?

After strong rally, many investors also became Recently financial leasing is one of important tool concerned that growth rate would decelerate in for market share increase by local brands. This is 2H11, however, more importantly, we believe the increasingly used in China to purchase aggressive industry expansion would be key construction equipment. This could be easy and concern from long-term perspective while fast way to boost its sales given smaller down- monthly or quarterly sales volume would increase payment with longer payment terms. On the other volatility of stock prices. hand, higher sales resulting from competitive

China New loan issued and growth trends China Policy rate and reserve ratio

(RMB mn) 24% 8% 10,000 150% 20% 8,000 7% 100% 16% 6,000 50% 6% 4,000 12% 0% 5% 2,000 8%

0 -50% 4% 4% 2001 2003 2005 2007 2009 2001 2003 2005 2007 2009 2011e New loan issued Loan grow th Policy Rate (RHS) Reserve Ratio (LHS)

Source: Bloomberg Source: Bloomberg, HSBC

30 Industrials  Asia June 2011 

leasing products should increase the working- by mortgage loans, while its dealers resume capital burden for companies. The construction repurchase obligations for a substantial portion of machinery companies have delivered negative the loans. operating cash flow as the rapid increase in sales Capacity expansion + credit sales – through financial leasing and other types of worrying sign of industry downturn credits boosted account receivables significantly. In 1Q11, after offering more competitive pricing, In order to obtain cash to fund operations, the zero-down payments, and longer repayment terms, construction machinery companies generally the companies posted negative operating cash factored a portion of our receivables under finance flow. This aggressive sales promotion generated leases to banks. The cash obtained from banks higher-than-expected and above-industry growth through factoring of receivables under finance for many companies except more conservative lease was presented as cash flow from financing foreign brands such as Doosan Infracore, activities as the conditions for de-recognition of Komatsu and Hitachi. However, we think this the financial assets were not met, because trend in 1Q11 will trigger problems of further companies did not transfer substantially all the competition, financial stability with weak cash risks and rewards of ownership of the receivables flows and more second-hand products from under finance lease that were factored to banks potential customer defaults. with recourse under the factoring contract terms. We are concerned that the next efforts to gain We believe this negative operating cash flow may market share may come from lowering product expose companies to additional risks and pricing, as financing with zero down payments uncertainties. The construction machinery can no longer serve to differentiate peers. We companies generally provide customers with gather that certain makers have already began to various payment options, including credit sales, offer discounts to their customers in May. This instalment payments, financial guarantees and could mean that some companies will run into finance lease services. Among major players, funding difficulties, as sales volume increases due Sany has the model which benefits the to new capacity may further pressure their balance shareholders the most with minimum risk as the sheets; otherwise, the companies will lose market leasing is offered by its parent group. Currently share, with a lower portion of their sales from more than 80% of its excavator sales are financed financial leasing business.

Receivable turnover trend Lonking: A/R turnover

(x ) (RMB m) Trade and other receiv ables (x) 8.0 Receiv ables under finance lease 15,000 A/R Turnov er 10.0 7.0 12,000 8.0 6.0 5.0 9,000 6.0 4.0 6,000 4.0

3.0 3,000 2.0 2007 2008 2009 2010 2011e 0 0.0 Lonking Zoomlion Sany Doosan 2007 2008 2009 2010 2011e

Source: Company data, HSBC Source: Company data, HSBC

31 Industrials  Asia June 2011 

We believe that the financial leasing is not Excavator shipments growth vs Floor space started y-o-y negative factor for the company as long as default 250% 100% rate is zero theoretically. In fact, this product 200% 80% actually can generate additional earnings and this 150% 60% could be source of stable earnings stream. 100% 40% However, an increase in default risk could provide 50% 20% downside risk to both margins and asset value. In 0% 0% worst case scenario, the company must solve -50% -20% liquidity risk by securing financing depending on 2005 2006 2007 2008 2009 2010 2011 Ex cav ator Yoy (LHS) the maturities of existing debts. Floor space started y/y (RHS)

Source: CEIC, CCMA Leading indicators Despite less attractive risk-return profile, our PMI versus construction machinery near-term neutral view on the sector remains for shipment volume 2011 based on the following: (1) property As mentioned above, another interesting leading indicator, (2) Five-Year Plan and leadership indicator for construction machinery sector would change, (3) recent share price correction; and (4) be PMI (Purchasing Manager Index). PMI is an consumption driven economy not yet. indicator of economic activity. This index has Floor space newly started good correlation with the sales volume for An interesting leading indicator for construction construction sector as seen in our charts. We think machinery sector could be the floor space newly there is roughly 2-3 months lagging impact on started. The strong 2H10 floor space figure sales volume. Therefore, the movement of PMI actually translated into better-than-expected sales would change the investment sentiment of in 1Q11. Therefore, the rise in floor space newly the sector. started is a positive signal for the sector.

We can look at China’s floor space newly as good leading indicators of the machinery stock index, which is closely linked to the machinery sector overall. According to CEIC data, floor newly started rose 28% to RMB191bn in January- February 2011 versus RMB 149bn in January- February 2010.

32 Industrials  Asia June 2011 

Second hand pricing + dealer check The price gap between new and second-hand products We think that the second hand pricing could be (’000 RMB) Komatsu Sany Doosan Hyundai the key indicator showing the near-term trend of New order price 1,000 880 820 800 Second-hand price 600 400 500 450 sales volume. Obviously it is difficult to track all Price gap 40% 55% 39% 44% the different second hand pricing based various Note: Second-hand prices are based on 20-22 ton excavators built in 2008 with 3000 – 5000 hours in service brands, age of the product and size. We gather Source: HSBC that, among dealers in China, Komatsu has the highest transaction volume in the second hand Infrastructure spending market, given its product reliability while Doosan It is interesting that according to Komatsu roughly and Hyundai also have reasonable volume. 55% of excavator demand in China has strong correlation with FAI. Besides this, the mining Furthermore, dealers confirm that Sany is the sector could strong leading indicator for the sector. most aggressive in terms of sales, providing the most services in after-market service and helping Company guidance: Mixed view on clients to get cheap finance. However, it is still growth in 2011 doubtful that local brands’ product reliability still After visiting various companies, we conclude can not be compared with foreign brands such as that most of construction machinery companies Komatsu. We are hearing that there are some are forecasting that the market demand will grow machines by Komatsu from the 90s, which are 15-20% in 2011, while only Sany Heavy believes still operating, whereas local brands’ products that the market will grow at 40% in 2011. Many have not been around and tested for that long. of these companies underestimated 2010 recovery and were not able to prepare the capacity Dealers are carefully anticipating a slower year in expansion just in time for the recovery. Therefore, terms of sales volume as there are less potential looking at 1Q11 demand, we think construction customers at exhibitions and machinery shows equipment demand should grow 15% in 2011. this year.

Excavator shipment y-o-y change vs PMI y-o-y change Wheel loader shipment y-o-y change vs PMI y-o-y change

200% 60% 200% 60%

100% 30% 100% 30%

0% 0% 0% 0%

-100% -30% -100% -30% 2006 2007 2008 2009 2010 2011 2006 2007 2008 2009 2010 2011 Ex cav ator shipment yoy PMI y oy Wheel loader shipment y oy PMI y oy

Source: Bloomberg, HSBC Source: Bloomberg, HSBC

33 Industrials  Asia June 2011 

Urbanization rate (2010) China’s per capital FAI

100% (Rmb) 2,000 40% 80% 1,500 30% 60% 1,000 20% 40% 500 10% 20% 0 0% 0% 2004 2005 2006 2007 2008 2009 2010 FR KR US Canada UK GR JP CH F AI per capita (Rmb) Grow th (%)

Source: World Bank Source: CEIC

Conclusion We believe China’s relatively low urbanization process will drive construction machinery demand Overall, we agree that the sector growth would further as its ratio still sits at below 50% versus not be as strong as 2010 but we believe the developed countries at above 80%. Moreover, growth of overall industry remain solid in 2011. despite the government’s push to become more The production capacity (capex), property consumer driven economy, this is long-term investment, mining expansion and infrastructure change and still China’s per capital FAI is still have proven to be among the most reliable lower than developed countries globally. indicator for identifying turning points of the Again, the aggressive capacity expansion + sales Chinese machinery cycle. The combinations of promotion via financial leasing could pose the these indicators signal directional trends of future biggest threat to the industry as we believe it is capex and GDP trends in China. inevitable to see the deterioration of margins and We believe that China’s construction machinery working capital in the future. industry is still in a growth phase, but could transform to more cyclical nature due to overcapacity by industry. Still, despite worrying signals of the sector, we believe the long-term secular growth story for the industry remains intact.

34 Industrials  Asia June 2011 

Industry forecasts

 Expecting further growth in 2011 at slower pace  Prefer excavators and concrete machinery over wheel loaders & crane segments  Aggressive capacity expansion by 2012 could trigger ASP war

Final stage of strong growth Reflecting macro/policy positives and negatives, the volume growth will continue in 2011 despite After a strong recovery in 2010, machinery government’s tightening measure in our view. We growth slowed in 2011 due mostly to macro forecast machinery market to grow 15% in 2011 tightening measures. We also expect to see a versus above 60% in 2010 (base effect). slower pace of growth going forward despite solid growth in 2011 and 2012. Among different equipments, we think excavator However, we believe that demand may surprise the will rise more than industry average at 20% while market on the upside given strong 1Q sales and wheel loader slows down significantly to 10% weaker expectations by the market. This may be growth in 2011. We think excavators will replace similar to that seen in 2010 where actual demand wheel loaders in China, following similar pattern was stronger than initial market expectation. as developed market, driven by higher construction standards. Therefore, local Potential negatives are weakening highway companies with market share gain in excavator investment, slowdown in property investment, and market will become the industry leader not only limits to coal production. Positives are (1) social from scale perspective but also in terms of housing at 10m units in 2011, (2) coal mining technology. This could be the most important industry consolidation, (3) more time required to source of growth in the future. move to consumption driven economy.

China Construction Machinery Industry Overview 2008 2009 2010 2011e 2012e Sales volume Excavator 77,845 98,949 168,209 202,524 232,902 Crane 27,683 33,398 43,553 49,389 55,316 Wheel loader 164,953 143,292 216,597 238,257 257,317 Concrete Machinery* 24,551 36,858 60,376 73,758 87,516 Overall 295,032 312,497 488,735 563,927 633,051 Sales growth Excavator 17% 27% 70% 20% 15% Crane 35% 21% 30% 13% 12% Wheel loader 4% -13% 51% 10% 8% Concrete Machinery* 15% 50% 64% 22% 19% Overall growth 10% 6% 56% 15% 12%

Source: CCMA, HSBC

35 Industrials  Asia June 2011 

The construction machinery is highly correlated Excavators with FAI, which consist of infrastructure, property Demand drivers: (1) property development, (2) and mining investment. Different equipments infrastructure, and (3) energy and such as wheel loader, excavators and crane have industrial projects. different application and exposure to above investment area. Usage: to lift equipment or materials to various heights. Types: truck, all-terrain, rough-terrain, China construction machinery downstream demand truck-mounted, crawler and tower cranes 60% (depending on varying degrees of lifting capacity 50% and mobility). 40% 30% Excavator market grew 70% on the back of strong 20% stimulus package by Chinese government in 2010. 10% Excavator sales growth should slow down to 20% 0% in 2011, mainly driven by high base effect and Ex cavator Crane Wheel loader Concrete Machinery weaker infrastructure. However, the continued Infra structure Property Mining demand from social housing project and replacement demand on wheel loaders should Source: CCMA support growth in 2011. We also forecast excavator sales to grow further by 15% in 2012,

however, the strong capacity expansion by major players and local brands potentially outpace the demand and trigger ASP war in 2012.

It is interesting that many construction machinery companies are aggressively expanding their capacity at the moment where we believe the industry supply will grow faster than industry demand. Even a new entrant such as Rongsheng

China Excavator sales volume and trend

(Unit) 50,000 300% 250% 40,000 200% 30,000 150% 100% 20,000 50% 0% 10,000 -50% 0 -100% Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Excavator sales volume Sales grow th

Source: CCMA

36 Industrials  Asia June 2011 

Heavy Industries (shipbuilder) is planning to set growth of wheel loaders and eventually reach the up 30,000 unit excavator capacity in 2011. volume ratio of 2:1 (2 excavators: 1 wheel loader).

Excavator capacity expansion trend Wheel Loader to excavator Ratio

('000 unit) (x ) Ex cav ators continue to replace Wheel loader 500 100% > Wheel loader to Ex cav ator sales trend has 85% 4.0 declined below 2.0x 400 65% 80% 57% 3.0 300 60% 200 40% 2.0 100 20% 1.0 0 0% 2010 2011E 2012E 0.0 Capacity Sales v olume Utilization rate 2006 2007 2008 2009 2010 2011

Source: CCMA, HSBC Source: CCMA

In addition, the further credit tightening should Therefore we forecast excavators to grow 20% lower the purchasing power affecting sales and 15% in 2011 & 2012 respectively versus volume in 2H11. We think the financial leasing wheel loaders at 10% and 8%. terms will become more favourable to customers Interestingly, excavator segment is the only area and could be the key swing factor for sale volume where foreign brands are still dominating in with growth slow down. Chinese market due to high mechanical barriers of From long-term perspective, we believe hydraulic components. Also, the reliability and excavators will gradually replace wheel loaders as durability are the key factor deciding market excavators are more powerful and have more positioning for foreign brands in China. functions. In developed countries, excavators are Komatsu and Doosan have been the leading already widely used than wheel loaders. Due to players in excavator market in China. Hyundai raising labour cost and improving construction Heavy and local brand Sany are increasing their standard, we think excavators will outpace the

Market share trend of Major Excavator makers in China

18%

15%

12%

9%

6%

3%

0% Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Doosan Hy undai Komatsu Hitachi Kobelko Caterpillar Sany Lonking Zoomlion

Source: CCMA

37 Industrials  Asia June 2011 

Annual excavator sales and growth 2011 y-t-d China Excavator Market Share Trend Others 27% 400 70% 80% Komatsu 69% 61% Zoomlion 60% 13% 300 44% 40% 1% Lonking 27% 30% 40% 200 17% 20% 3% Sany Caterpillar 11% 100 4% 0% -8% 7% 0 -20% Kobelko Hy undai 2003 2005 2007 2009 2011e 8% Hitac hi 11% Doosan China Ex c av ator output y-o-y growth 9% 10% Source: CCMA, HSBC Source: CCMA

market share with more aggressive sales As the demand is increasing rapidly over wheel promotion in 2011. In terms of pricing and loaders, larger tonnage excavators are gaining strategy, Japanese and US makers are classified as market share relative to smaller-size excavators. top tier group with highest pricing and quality We are seeing the strongest demand on mid- while Koreans have more ‘value for money’ tonnage (20-30t) accounting roughly 40-50% of image with lower pricing. Local brands offer total sales. similar quoted pricing as Koreans however In terms of profitability of excavator, we believe according to our channel checks, the pricing is that the high margin profile should continue in lower than Koreans in real transaction. 2011 with strong industry demand and limited Among local brands, Sany is outstanding in terms capacity. As we see increasing competition from of market share and the company is targeting to local brands due to aggressive industry-wide become No. 1 excavator player in China for the capacity expansion, we expect the profitability of first time by local brand with aggressive excavator market to come down in 2012. marketing strategy and improving product quality. However, we believe local brands with lower pricing at the moment have more room to appeal Until Apr 2011, Sany is ranked No. 2 by to customers despite severe competition from achieving 11.1% market share, slightly below No. foreign brands. 1 at 12.6%. Sany’s market positioning is between Japanese and Koreans where the company’s pricing strategy is higher than Koreans while they mostly use Japanese component and they claim their product quality is not far behind Japanese.

38 Industrials  Asia June 2011 

China Excavator Downstream demand Annual China Excavator Market Share Trend

Others 100% Infra 10% 80% structure 45% 60% 40% Mining

20% 20% 0% 2008 2009 2010 2011 YTD Property Doosan Hyundai Komatsu Hitachi 25% Caterpillar Sany Others

Source: CCMA, HSBC, as of 2010 Source: CCMA

2011 y-t-d Excavator sales volume breakdown by size Excavator annual sales volume breakdown by size

100% 20t - 24.9t 25t - 29.9t 80% 33% 9% 60%

30t < 40% 13t - 20t 13% 20% 8% 0%

6t - 13t 6t > 2007 2008 2009 2010 21% 16% < 6t 6t - 13t 13t - 20t 20t - 24.9t 25t - 29.9t > 30t

Source: CCMA Source: CCMA

2011 y-t-d Excavator sales volume breakdown by region Excavator annual sales volume breakdown by region

100% 29% 30% West C hina 80% 33% 31% 31% East China 60% 31% 30% 30% 29% 40% 40%

20% 40% 37% 40% 39%

Central 0% China 2008 2009 2010 2011 YTD 29% East China Central China West China

Source: CCMA Source: CCMA

39 Industrials  Asia June 2011 

Excavator volume by region

High volume, High growth > None High volume, Moderate growth 5,000 units or more > None 3,000 - 5,000 units Moderate volume, High growth 3,000 units or less > Guizhou, Liaoling, Xinjiang

Source: CCMA, HSBC

Excavator volume growth by region

Below-average growth market > High volume: Sichuan, Jiangsu Shandong, Anhui > Moderate volume: Hebei, Hellongjiang, Hunan, Jiangx i, Yunnan, Zhejiang > Low volume: Hebei, Helongjiang 90% or more Zhejiang, Jiangx i, Guangx i, Hunan 50% - 90% units Low v olume market on the rise 3,000 units or less > Hainan, Tibet, Qinghai

Source: CCMA, HSBC

40 Industrials  Asia June 2011 

Wheel loaders The biggest driver for this segment could be the mining industry relative to other equipment. Since Demand drivers: (1) infrastructure (40-50%), (2) we do not see strong growth opportunities from mining (10-20%) and (3) property development mining sector due to output limit, we favour (30-40%) excavator over wheel loaders. Usage: used to load materials into various types We think wheel loader market is already maturity of vehicles and the most popular earth-moving stage where the profitability should decline and machinery in China industry consolidation should emerge. The Wheel loader should see lower than industry leading players such as Lonking and Luigong average growth at 10% in 2011 and this should continue to gain market share, mainly equipment will be gradually replaced by driven by more brand power, more distribution excavators with higher construction standard. We channels and better service. forecast that wheel loaders sales to grow at 10% In this regard, only positive driver for wheel in 2011 and 8% in 2012 from its average growth loader would be the replacement demand resulting of 14.6% during 2008-2010. While we expect from relatively short cycle period at less than 5 export to grow above 30%, higher than Chinese years. This should support the base demand for market growth, the export only accounts 7% of wheel loader in China despite the segment has total shipments in 2010. already faced the maturity stage of the cycle.

While we think the 5-ton model remains the best- In terms of profitability, the margin profile of selling model among wheel loaders, competition wheel loader in China has been one of the weakest is bound to increase, profitability will eventually due to low entry barrier and severe competition. decline, and the industry will consolidate given Korean brands such as Doosan and Hyundai are (1) declining mining demand and (2) replacement also entering into already matured wheel loader needs (substitution by excavators). Lonking, market in 2011, creating further pricing war. Liugong and Xiagong are wheel loader leaders in Therefore, without strong cost management, it China accounting for more than 50% market share. will be difficult for leading players to achieve better margins going forward.

Monthly wheel loader output and growth

(Unit) 50,000 250% 200% 40,000 150% 30,000 100%

20,000 50% 0% 10,000 -50% 0 -100% Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 China Wheelloader output China Wheelloader output grow th

Source: CCMA

41 Industrials  Asia June 2011 

Annual wheel loader sales and growth 2011 y-t-d China wheel loader market share trend

('000 Unit) Others Liugong 400 60% 25% 16% 51% 300 40% 20% 200 10% 20% Doosan Lonking 1% 18% 100 4% 0% -13% XCMG 0 -20% 8% 2007 2008 2009 2010 2011e 2012e Lingong Xiagong China Wheelloader Sales Volume y -o-y growth 15% 17%

In terms of pricing, Liugong has the highest pricing slightly above Lonking. According to our channel checks, leading players generally had pricing power in the past but replacement demand by excavator and severe competition does not protect margin profiles of market leaders any more, in our view.

Monthly wheel loader market share trend

25%

20%

15%

10%

5% Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11

Liugong Xaigong Lonking Lingong

Source: CCMA

42 Industrials  Asia June 2011 

China wheel loader downstream demand Annual China wheel loader market share trend

Infra 100% structure 80% Others 45% 5% 60% 40% 20% 0% 2008 2009 2010 2011 YTD Mining Property Liugong Lonking Xiagong Lingong 35% 15% XCMG Doosan Others

Source: CCMA, HSBC Source: CCMA

2011 y-t-d wheel loader sales volume breakdown by size China wheel loader export volume trend

+6ton 20,000 10% 1% 8% 0-2ton 15,000 5% 6% 10,000 4% 5ton 3ton 5,000 68% 2% 25% 0 0% 2008 2009 2010 3-4ton 1% Wheel Loader Ex port Volume % of total demand

Source: CCMA Source: CCMA

2011 y-t-d wheel loader sales volume breakdown by region Wheel loader annual sales volume breakdown by region

100% 33% 36% 37% 32% West China 80% 32% 60% 25% 24% 22% 23% East China 40% 45% 20% 42% 41% 42% 45% Central 0% China 2008 2009 2010 2011 YTD 23% East China Central China West China

Source: CCMA Source: CCMA

43 Industrials  Asia June 2011 

Loader volume, by region

High volume, High growth > None High volume, Moderate growth 5,000 units or more > Shanghai, Guangxi 3,000 - 5,000 units Moderate volume, High growth 3,000 units or less > Zhejiang

Source: CCMA

Loader volume growth, by region

Below-average growth market > High volume: Hebei, Guangxi > Moderate volume: Inner M ogolia, Guangdong, Yunnan, Xinjiang > Low volume: 16 provinces, including Tianjin, Heilongjiang, Jiangsu, Shandong, Anhui, Jiangxi, 90% or more Sichuan, H unan, H ubei, H enan etc. 50% - 90% units Low volume market on the rise 3,000 units or less > Beijing

Source: CCMA

44 Industrials  Asia June 2011 

Crane China crane annual sales volume (Unit) Demand drivers: (1) property development, (2) 70,000 40% infrastructure, and (3) energy and 60,000 35% 30% industrial projects. 50,000 30% 40,000 20% 21% 20% Usage: To lift equipment or materials to various 30,000 15% heights. Types: truck, all-terrain, rough-terrain, 20,000 10% truck-mounted, crawler and tower cranes 10,000 0 0% (depending on varying degrees of lifting capacity 2007 2008 2009 2010 2011e 2012e and mobility). China Crane Sales y-o-y growth

We forecast that crane to grow at 13% in 2011 Source: CCMA, HSBC and 12% in 2012, lower than its average growth of CAGR 35% past 6 years. Historically, the In terms of the crane segment’s profitability, we strong sales were coming from upgrading product believe there could be upside in China if the mix and improving ASP. We expect growth to upgrade toward higher-tonnage and upper-end slow down in 2011 and 2012 as commodity products accelerates rapidly. Therefore, we again housing and infrastructure spending are coming prefer excavators to other construction equipment, off from high base in 2010. In order for crane as we think that the improving construction segment to deliver positive long-term growth we standard should boost excavator sales volume think the demand should pick up from industrial higher than the industry average. and energy projects. Therefore, wind power and nuclear power capacity expansion could be the XCMG and Zoomlion have been the dominating key drivers for significant demand upside. players in China’s construction crane sector, with a combined market share of more than 50% as a Truck crane has been the key driver for crane result of complete product line-ups. Sany has been segment growth in the past due mainly to wide more aggressive on crawler cranes, with more range of loading capacity and relatively attractive than 100% growth in 1Q11. These top three pricing. We think this upgrading trend will boost players account for dominate the crane sector with higher-tonnage crane product, similar to the trend more than 70% market share, indicating slower seen in developed market. sector growth.

Monthly China Crane sales and growth 2011 YTD China Crane Market Share Trend

(Unit) Zoomlion 10,000 200% Others 24% 8,000 150% 15% 100% 6,000 Liugong 50% 4,000 4% 0% 2,000 -50% Sany 0 -100% 8% 2008 2009 2010 2011 XCMG Crane sales volume Sales grow th 49%

Source: CCMA Source: CCMA

45 Industrials  Asia June 2011 

China Crane downstream Demand Annual China Crane Market Share Trend

100%

Others 80% Infra 19% 60% structure 49% 40% Mining 20% 3% 0% 2008 2009 2010 2011 YTD Property 29% Liugong Sany XCMG Zoomlion Others

Source: CCMA Source: CCMA

2011 y-t-d Crane sales volume breakdown by product Crane annual sales volume breakdown by product)

100% Truck 80% mounted Crane 60% 13% 40% Truck 20% Crane Crawler 0% 84% Crane 2008 2009 2010 2011 YTD 3% Truck Crane Truck-mounted Crane Craw ler Crane

Source: CCMA Source: CCMA

2011 y-t-d China Truck Crane Market share 2011 y-t-d China Crawler Crane Market share

Liugong Liugong Others 5% 0.2% 35% Sany XCMG 9% 49% Sany 14% Others 9% XCMG Zoomlion Zoomlion 26% 28% 25%

Source: CCMA Source: CCMA

46 Industrials  Asia June 2011 

Concrete machinery demand for working efficiency and rising purchasing power similar to crane segment. Demand drivers: (1) property, (2) infrastructure, and (3) mechanisation rate. In terms of profitability of concrete machinery segment, we believe that the high margin profile Usage: equipment used by the entire chain of should continue with dominant positioning by two concrete (ready-mix) production, transportation, major players Sany and Zoomlion. We believe and pumping including (1) bulk cement trucks, (2) there could be upside potential to margin profile concrete mixing stations, (3) concrete mixing in China driven by the localisation of components trucks, and (4) truck-mounted concrete pumps and and ASP hike on truck-mounted pumps (Sany and stationary concrete pump. Zoomlion products are still 20-40% cheaper than Concrete machinery should deliver better than foreign brands, such as Putzmeister and Schwing) expected sales growth. We expect to see 22% in Sany and Zoomlion have been the dominant 2011 and 19% growth in 2012, mainly driven by players in China’s concrete machinery sector with improving off-site concrete mix ratio in China and combine market share at around 40% as a result of improving mechanisation rate (the increasing complete product line-ups. We believe Sany and usage of commodity concrete). Historically the Zoomlion’s current dominant position will size of this concrete machinery market has been continue, forming duopoly environment in the biggest market by sales value and has shown competitive Chinese market. strong growth of above 30% in past 10 years. Ready mix concrete application We believe that the downside risk on concrete Concrete was mostly mixed on-site in the past in machinery is fairly protected given strong support China. The ready mix concrete was more costly as from continued commodity concrete ratio and commodity concrete was not widely used for social housing projects in 2011. property construction. Government implemented on-site mixing prohibition regulation as on-site We believe truck-mounted pumps should take mixing is not efficient and environmentally away sales value from stationary pumps due friendly. This regulation is triggering growing mainly to higher working efficiency & mobility demand for concrete machinery and we believe and easy set-up despite higher pricing. We believe this will be the key growth driver going forward this upgrade trend is likely to continue on growing in China.

Annual Concrete Machinery sales and growth trend Concrete Machinery market share

('000 unit) Sany 19% 40 100% Others 92% 59% 71% 30 50% 31% 50% 40% 20 9% 11% 0% Zoomlion 10 15% -29% 18% 0 -50% 2001 2003 2005 2007 2009 Fangy uan Xingma Concrete Machinery Volume y -o-y growth 17% 15% Source: CCMA Source: CCMA, as of 2009

47 Industrials  Asia June 2011 

China Concrete Machinery downstream Demand Annual China Concrete Machinery Market Share Trend

100% Property 80% 30% 60% 40% 20% Infra 0% Structure Others 2006 2007 2008 2009 60% 10%

Sany Zoomlion Xingma Fangy uan Others

Source: CCMA Source: CCMA

Concrete Machinery sales volume breakdown by product Concrete Machinery annual sales volume breakdown by product Concrete 100% mixing plant 80% 12% 60% Truck Truck mounted mounted 40%

mixer pump 20% 61% 13% 0% Trailer 2006 2007 2008 2009 mounted Truck mounted pump Trailer mounted pump pump Truck mounted mix er Concrete mix ing plant 14% Source: CCMA Source: CCMA

China Truck-mounted Concrete Pump Sales Commodity Concrete as % of Total Concrete

100% Zoomlion Putzmeister 38% 7% 80% Xugong Global average 53% 60% 3% Others 40% 2% 20% Sany Heav y 0% 50% China U.K. Australia Japan U.S.

Source: CCMA Source: CCMA

48 Industrials  Asia June 2011 

US market: Recovery on the construction spending activity with high way correlation in the past. However, during financial crisis, production has fallen more than Demand recovery from rental construction spending activity and we believe the channels gap should become narrower in our view. In this The many investors are concerned with the regard, we think the pent-up demand resulting potential double-dip in US housing however the from tight financing should disappear and drive upside surprise could come from where rental the market recovery in 2011. fleets in the US are approaching five years old. This could potentially drive the replacement DII (formerly known as Bobcat) also confirm at demand and equipment makers sound more 1Q11 earnings conference that the cycle seems to upbeat compared with last year. have bottomed out and revenue came back to pre- financial crisis level in US, due mainly to strong Industry experts indicate that the demand may rise replacement demand from large rental companies. 30% y-o-y in 2011 as the utilisation from rental The company believe that there could further upside companies continues to climb. Doosan Infracore is in demand if the demand from smaller rental likely to be major beneficiary of this recovery as it companies recovers with relatively better financing. has quite high exposure in US through Bobcat. In addition to Bobcat’s forecast, global We saw the better than expected US sales of construction machinery companies including construction equipments in 1Q11 as there was Komatsu, Caterpillar and Volvo group, carefully strong demand recovery form rental channels. forecasting that the US market may expand as This strong recovery was mainly driven by much as 30% in 2011. Komatsu is forecasting that replacement demand from rental companies and sales of excavators and wheel loaders in the U.S. this could be viewed where these companies are and Canada may rise to about 40,000 units in expecting better housing market going forward. 2011 from about 30,000 units in 2010. (peak at However, we will have to see how long this 72,000 units in 2006) replacement demand will last with deterioration of US housing market. Many industry experts are also expecting continued improvement and see the market have It is interesting to see the trend between bottomed out as increase in equipment utilization, construction equipment production data and

US Monthly Housing Permit / Starts SAAR US Monthly construction spending

('000 unit) (USD bn) 2,500 1,400 1,200 2,000 1,000 1,500 800 1,000 600 400 500 200 0 0 1992 1995 1998 2001 2004 2007 2010 1993199619992002200520082011 Housing starts Housing permit Total Residential

Source: US Census Source: US Census

49 Industrials  Asia June 2011 

Construction equipment production vs Total construction US Federal Funds target rate spending in North America

('000 unit) (USD bn) 10% 300 1,200 250 8% 900 200 6% 150 600 100 300 4% 50 0 0 2% 1993 1997 2001 2005 2009 0% Construction Equipment Production in NA (LHS) Total Construction Spending (RHS) 1985 1990 1995 2000 2005 2010

Source: Off-highway, US Census Source: Bloomberg

parts sales, and distributors replacing aging rental fleets. Besides this, orders and prices for used equipments are rising too. As rental companies are replacing old equipments without growing their fleets though, we think this could be the beginning of a recovery in US market.

50 Industrials  Asia June 2011 

Competitive landscape

 Just matter of time before locals catch up with foreign brands in the excavator market  Pricing war to lower overall profitability given excess capacity expansion versus slower demand growth  Market share wins the game

Excavator battle between According to our channel check in China, Sany’s local and foreign brands excavator pricing is lower than Komatsu but higher than Doosan Infracore. A dealer claims that Foreign brands still dominate the excavator Sany’s product is quite competitive as it is cheaper market in China, accounting for more than 70% of than the Japanese while using Japanese core parts, sales volume (including mini excavators). Major making customers believe that the quality of the brands include Komatsu (Japan), Doosan product is not far behind the Japanese. The pricing Infracore (Korea), Hyundai Heavy Industries is roughly 10% higher than Korean brands (using (Korea), Kobelco Construction Machinery (Japan), Korean parts) because dealers and customers and Caterpillar (US). We think the leading market believe excavators using Japanese-parts have share of Japanese companies is due mainly to better product quality, in our view. better control technology, quality, and durability, while Korean brands are enjoying strong market Apart from the excavator market, local companies share with their pricing as well as after-sales have already been dominating the market in other service strategy. segments of the construction machinery industry, such as wheel-loaders, crane and concrete pumps. However, local brands have recently become Therefore, it could be just a matter of time before more aggressive in terms of sales promotion and they catch foreign brands in the excavator segment. after-sales service strategy to capture the market share. The market share of local companies has Key components for major construction risen from 14% in 2005 to 30% in 2010. We think equipment is sourced from Japan and Europe. this trend will continue as we believe they are However, the operating margins of local brands well-positioned in the market between the are are impressive despite the high dependency on Japanese and Korean companies. Sany is a imported components, mainly driven by strong leading candidate with strong market share industry demand and pricing strategy. Therefore, expansion through its competitive product, despite the fact that it is in their best interest to financing, strong distribution channels and develop key components in-house similar to attractive after-sales service system. Komatsu and Caterpillar, Chinese brands are not

51 Industrials  Asia June 2011 

rushing to develop them near-term and are excavator segment. Key components, including enjoying their current position while it lasts. hydraulics, MCV (main control valve), cylinders, pumps and motors, are highly dependent on From a long-term perspective, we think Chinese foreign imports. The market has been machinery names will attempt to develop in-house underestimating Chinese market share gain as the components. However, given that reliability is the simple assembly of imported components cannot key to future success, it would take longer than improve the quality of their machines. expected, which is a similar case to Korean players. It is likely that those companies with Korean players generally use Korea-made established brand power that can meet the components for their excavators in China. For challenge of intense competition will adopt example, Doosan and Hyundai Heavy both use localised parts or in-house components slowly in Korea-made engines and some hydraulic order to avoid any damage to quality or reputation components, but not all. According to our channel risk in the future. In addition, once the overall check with local dealers, they promote their profitability of the industry shrinks, more and Chinese products where quality is similar to more companies will focus on development of key Japanese given imported Japanese components components to reduce costs and generate stable while the pricing is cheaper by 10-15%. Hyundai earnings from after-market sales. and Doosan’s pricing are at a discount to the Japanese, but similar to Chinese local brands. We Chinese weakness becomes their think the Chinese are targeting to gain market strength share from Korean players, due mainly to similar Generally, the technology has been the major pricing and market positioning but better quality difference between local brands and foreign according to local dealers (maybe only based brands in the machinery sector, especially the

Product line-up comparison Sany Heavy Zoomlion Lonking Komatsu HCM Caterpillar Doosan Hyundai Bloomberg ticker 600031CH 000157CH 3339 HK 6301 JP 6501 JP CAT US 042670 KS 009540 KS 2010 revenue (USDm) 4,998 4,757 1,776 21,566 9,054 42,588 3,736 19,385 Concrete machinery Truck-mounted concrete pumps ̻ ̻ Stationary concrete pumps ̻ ̻ Concrete-mixing trucks ̻ ̻ Concrete-mixing stations ̻ ̻ Construction crane Truck crane ̻ ̻ ̻ Crawler crane ̻ ̻ ̻ Tower crane ̻ Earth-moving machinery Excavator ̻ ̻ ̻ ̻ ̻ ̻ ̻ ̻ Wheel loader ̻ ̻ ̻ ̻ ̻ ̻ Bull dozer ̻ ̻ ̻ Road machinery Road roller ̻ ̻ ̻ ̻ ̻ Grader ̻ ̻ ̻ ̻ ̻ Other machinery Dump trucks ̻ ̻ ̻ Forklift ̻ ̻ ̻ ̻ ̻ ̻

Note: The revenue of Hyundai is only from Construction machinery division. Source: Bloomberg, HSBC

52 Industrials  Asia June 2011 

reputation). So far, the selling point of the 1. Product quality Chinese is imported components = better quality, Due to the usage of imported components from and they are making strong progress in terms of Japan and Germany, local brands claim that they market share gain in China. have better quality than at least Korean brands. So Strategy far, we believe strong after-sales (AS) service could be the factor that outshines the poor quality We prefer the strategy of the Chinese players to of their products. Apart from hydraulics and other that of the Koreans mainly for the following key components, local brands improved reasons: mechanical performance of their products by  Koreans are entering into the highly developing and adopting more in-house designs. competitive wheel loader market dominated Most customers of these machines are individuals by all local brands in China. We think these customers believe the  Conversely, the Chinese are becoming more machines with imported components (Japan) have aggressive in the excavator market by better quality compared with Koreans, and that targeting to gain market share from the was key market strategy by local brands in order Koreans after they dominate the rest of the to expand market share. construction machinery industry. In terms of hydraulic components, most excavator However, we agree that the Koreans could be makers import key hydraulics equipment, more competitive by adding wheel loaders to their including valves, pumps and motors. Both Korean product offerings given cost reduction to further and Chinese brands import these components leverage the economies of scale. from Japan, while some parts are produced in- house for mini-size excavators. For cylinders, Market share wins the game Chinese and Korean brands use their local We analyse key factors for market share expansion components, which are relatively easy to produce. in China. These factors are (1) product quality, (2) A leading company such as Komatsu has in-house sales network, (3) financial leasing conditions, (4) component production and generates stable pricing strategy and (5) after-sales service. earnings (20% margin) from its strong after- market parts sales.

Supplier of key components Valves Motors Pumps Cylinders Diesel Engine Komastu In-house (Japan) In-house(Japan), In-house (Japan) In-house (China) In-House, Cummins Nabtesco(China) Hitachi In-house, KYB, In-house, KYB, In-house, KYB, KYB Isuzu Motors, Cummins Kawasaki Nachi-Fujikoshi Kawasaki Caterpillar In-house, Kawasaki In-house, Nabtesco In-house, Kawasaki In-house, KYB In-house, Mitsubishi Hyundai KYB, Kawasaki Korean Local Korean Local In-house In-house, Cummins Doosan KYB, Kawasaki In-house, Nabtesco In-house, Kawasaki Dongyang In-house, Cummins, Mechatronics Yanma Sany Rexroth, Kawasaki Nabtesco Kawasaki Patially in-house Cummins, Deutz Lonking Kawasaki, Rexroth Nabtesco, Rexroth Kawasaki, Rexroth Patially in-house Cummins, Weichai Zoomlion Patially in-house Nabtesco, Rexroth Kawasaki, Rexroth Patially in-house Cummins, Deutz, Weichai

Source: Company data, HSBC

53 Industrials  Asia June 2011 

Sany also has plans to localise most of hydraulic Sales network and strategy comparison components by licensing technology from leading # of Strategy dealers companies such as KYB. This is also similar case for Doosan Infracore which targets to generate Hitachi 50 27 under Hitachi(Shanghai) – China production 28 under Elle Construction Machinery ˀ additional earnings from AS parts. Imports 5 dealers are shared by both of the subsidiaries 2. Sales networks Komatsu 32 One per province by local Chinese investor Caterpillar 4 4 major dealers covering each region: Lei Similar to selling cars, dealers are the main sales Shing Hong, WesTrac, Sime Darby, ECI -Metro Hyundai 36 36 dealers for excavator and 27 dealers for channel for machinery products, especially wheel loader excavators, in China. Besides this, dealers play Doosan 38 38 exclusive dealers under 9 overseas offices Sany 42 42 dealers by province the important role of providing after-sales service, Lonking 286 Total 286 dealers covering all the province maintenance and financing arrangement for Zoomlion 548 548 self-owned shop and 410 dealer shop Source: Company data customers. Generally, major players have one distribution centre per province, which also 3. Financial leasing controls other products types. The management of a dealership is increasingly becoming important Financial leasing has become an important tool to as they are the face of a brand and a product to gain market share for local brands. This is their customers, which could potentially affect increasingly used in China to purchase sales volume. According to our channel check, the construction equipment and can be an easy and companies change dealership rights from time to fast way to boost sales given smaller down- time depending on their performance and service payment with longer payment terms. On the other quality to customers. We do not see much hand, higher sales resulting from competitive difference between local and Korean brands in leasing products should increase the working- terms of sales network, but they both have key capital burden for companies. Sometimes, dealers advantages over some foreign brands, such as are more aggressive recommending leasing Komatsu and Caterpillar, in terms of the number products because they earn a higher margin for of dealers covering broader areas of China. bearing most of the default risk. Also, some dealers are offering some promotional gifts to Sany has 37 excavator dealers in each province, attract more customers. providing sales, spare parts, AS service and In this field, local brands are more aggressive financing arrangements for customers. Sany uses providing easier funding access versus a more dealers for only excavator products, therefore conservative stance by foreign brands such as dealership management would be the key to success in the highly competitive excavator market. Komatsu and Doosan. Therefore, local brands have more flexibility to boost sales volume, but at the same time this could potentially pose high financing risk and deterioration of working capital.

Among major players, Sany has the model which benefits the shareholders the most with minimum risk as the leasing is offered by its parent group. Currently more than 80% of its excavator sales are financed by mortgage loans, while its dealers

54 Industrials  Asia June 2011 

resume repurchase obligations for a substantial and a longer track record in the market. Until we portion of the loans see higher residual value of local brands with product reliability and durability, foreign brands Financial Leasing policy comparison will continue to attract high-end customers. Provider % of sales Interest rate Komastu In-house 30% 7.5% 5. After-sales service Hitachi In-house 30% - After-sales service has been the key to the recent Caterpillar In-house 30% - Hyundai Affiliate 40% - success of local brands. As the competition heats Doosan Affiliate 15% 8.5 – 9.5% Sany Parent Co. 60% 6 – 8% up, construction machinery companies are Lonking In-house 36% 7.5 – 8% offering more and more timely service response as Zoomlion In-house 34% - the operating hours of construction machines are Source: Company data greater than in developed markets. According to

4. Pricing strategy industry channels, the operating hours of According to our channel check, the pricing of excavators is roughly 20-hours/day at peak versus local brands are quite similar to Korean brands max 8-hours/day in developed markets. Therefore, despite the quoted price seemingly a little higher. after-sales service, including parts supply, has We do not expect local brands to lower pricing far become a key deciding factor in choice of below Koreans as dealers of local brands are machine by customers in China. educating customers that local brands with With the rapid growth of units in operation in Japanese components are better in terms of China, we believe that after-sales service, product quality and reliability. including parts supply, could be another major source of earnings for companies. For example, New order price and second-hand price comparison Komatsu generates roughly 20% of earnings from New excavator Second-hand Residual (20-25 ton) Excavator Value after-sales service globally, with an operating Komastu RMB 1m RMB 600k 60% profit margin above 20%. With a naturally shorter Hitachi RMB 1m - - life cycle in China, parts turnover could be much Caterpillar RMB 1m and more - - Hyundai RMB 780-800k RMB 450k 57% higher than in developed markets, which can Doosan RMB 800-820k RMB 500k 62% cushion downside risk to earnings of machinery Sany RMB 880k RMB 400k 45% Lonking RMB 840k - - companies in an industry downturn. Zoomlion RMB 800k - -

Note: Second-hand price is based on 20-22 ton models built in 2007-08 After our visit to Sany headquarters, we think the Source: Company data, HSBC company has made significant progress in its after-sales service quality, including shorter By looking at the margins of local brands, they service response time, service network expansion, have relatively high margin structure compared and training of dealers & engineers. We also think with foreign brands despite using imported this differentiates Sany from its peers, with its components. We think the higher margin is better quality service strengthening its brand mainly driven by cheaper labour, better image and market positioning. economies of scale (product variety) and RMB appreciation. Therefore we believe local brands Most makers offer 24-hour response times with have more room to lower pricing and stay GPS tracking systems. In terms of warranty, local competitive during the industry downturn. In brands have started offering a 1-year unlimited terms of second-hand pricing, foreign brands still hours warranty due to higher machine usage plus have higher residual value due to higher pricing increased confidence in their product quality.

55 Industrials  Asia June 2011 

After-sales service policy comparison Respond time # AS shop Warrant Remarks Komastu 24 hours 35 1yr or 3,000 hours 35 service center with 24 hours response time, providing free regular check-ups and GPS tracking system providing operational status and analysis Hitachi 24 hours 200 - more than 200 AS centers in China, providing check service for machine’s operational status and information by Global e-Service system Caterpillar 24 hours Dealers - 4 Main dealers are fully responsible for the after sales service. Hyundai 24 hours Dealers 2yrs or 3,000 hours At least one service center in every province, providing also provide 6 regular maintenance check ups within the first 3,000 hours . Training program for repainman in Korea. Doosan 12 hours Dealers 2yrs or 3,000 hours Service centers are located within 130km, providing free quality check for the first 12,000 hours and GPS tracking system Sany 24 hours Dealers 1yr unlimited hours Service centers at capital of every province with 24 hour response time, providing remote machine status checking service by Satellite system. Lonking 24 hours Dealers 18month unlimited AS service is mainly handled by dealers. If any delays, the company or 3,000 hours deduct dealers' commission. Zoomlion 24 hours 524 (self-owned) - 524 self-owned service center and 339 service center operated by 3rd- 339 (3rd party) party dealers, located in 300 cities covering all the provinces and autonomous regions in China

Source: Company data, HSBC

56 

China construction machinery sector competitive landscape 2011 June Asia Industrials

Doosan Hyundai Sany Lonking Zoomlion Komatsu Hitachi Caterpillar

Product

Concrete machinery, Concrete machinery, Major product Excavator Excavator Wheel loader Excavator, wheel loader Excavator Excavator, wheel loader excavator cranes ASP – excavator (20-25ton) RMB 800-820k RMB 780-800k RMB 880k RMB 840k RMB 800k RMB 1m RMB 1m RMB 1m ASP – wheel loader (5ton) RMB 230k RMB 230k - RMB 230k - - - - R&D expenses as % of sales 2.0% 0.5% 6.0% NA NA 3.20% Not available Not available Zhengzhou, Longyan Changsha, Huayin Changsha, Kunshan, Xuzhou, Suzhou, Plants Location Yantai, Suzhou Beijing, Changzhou Shanghai Yuanjiang, Changde Changzhou, Jining Hefei Shanghai, Beijing Qingzhou Shanghai Concrete 15,000 Excavator 29,200 Wheel loader 40,000 Capacity Excavator 18,000 Excavator 30,000 Crane 10,100 Excavator – 50,000 Excavator – 22,000 Excavator – 25,000 Wheel loader 6,000 Excavator 8,000 Excavator 3,000

Components In-house, KYB, In-house, KYB, Kawasaki, Rexroth, Kawasaki, Rexroth, In-house, Kawasaki, Source of hydraulic parts Kawasaki, KYB, Rexroth In-house, Nabtesco In-house, KYB, Kawasaki Kawasaki, Nabtesco Kawasaki, Korea Local Nabtesco Nabtesco Nabtesco, KYB In-house, Cummins, Source of engine In-house, Cummins Cummins, Deutz Cummins, Weichai Cummins, Deutz, Weichai In-house, Cummins In-house, Isuzu Motors In-house, Mitsubishi Yanma

AS strategy 18months unlimited or Warrant period 2 years or 3,000 hours 2 Years or 3,000 hours 1 year unlimited hours - 1 year or 3,000 hours - - 3,000 hours

More than 200 AS Service centers at capital AS mainly handled by 524 self-owned service Service centers are At least on in every centers in China of every province dealers centers 35 service centers 4 Main dealers are fully located in 130km province Check service for # of AS shop and service Remote machine status If any delay, the company 339 service center Free regular check-ups responsible for the after Free quality check within 6 regular maintenance machine’s operational checking service by deduct dealers' operated by 3rd-party and GPS tracking system sales service. 12,000 hours check-ups in 3,000hours status and information by Satellite system commission. dealers Global e-Service system

AS respond time 12 hours 24 hours 24 hours 24 hours 24 hours 24 hours 24 hours 24 hours Leasing strategy Leasing interest rate 8.5 – 9.5% - 6 – 8% 7.5 – 8% - 7.50% - - Financial leasing sales mix 15% 40% 60% 36% 34% 30% 30% 30% Holder of financial leasing Affiliate – Doosan Affiliate – Hyundai Parent company In-house In-house In-house In-house In-house receivables Financial Leasing Financial Leasing – Sany Group

Sales strategy # of dealers 38 36 42 286 548 32 50 4

27 dealers under Hitachi (Shanghai) 4 major dealers covering – China production each region: 36 dealers for excavator 38 exclusive dealers Total 286 dealers 548 self-owned shop and One per province by local 28 dealers under Elle Lei Shing Hong, Dealer network model and 27 dealers for wheel 42 dealers by province under 9 overseas office covering all the province 410 dealer shop Chinese investor Construction Machinery WesTrac, loader

- Imports  Sime Darby, 5 dealers are shared by ECI -Metro both of the subsidiaries

Source: Company data, HSBC



57

Industrials  Asia June 2011 

Valuation and stock picks

 Applying PE valuation to China construction machinery names  Market share gainer deserves premium with diversified product offerings  Sany is our top pick in the sector

We believe the PE valuation method is the most Sany is our top pick, with a premium appropriate to reflect industry and earnings growth valuation of construction machinery in China. Therefore we Our price target of RMB22.5 is based on a PE of use PE to value the construction machinery 16.3x applied to adjusted FY11e EPS. While we companies including Sany A, Zoomlion, Lonking have set the target multiple higher than the and Doosan Infarcore under our coverage. Among construction machinery sector average at 16.3x, our coverage, our top pick in the sector is Sany we see no justification for awarding a large Heavy due mainly to (1) greater exposure to high- premium at this point. However, we think the growth products, (2) continued gains in market earnings at construction machinery names likely share, and (3) strong brand power to overtake to show signs of divergence into market leaders foreign players in China. Based on our earnings from marginal players and thus we believe the estimates, the stock is currently trading at 12.3x market will award a premium to the share price of 2011 PE. We believe the recent correction market leaders in the future. provides good buying opportunity.

China construction machinery sector PE trend

(x ) 30.0

+1SD (2007-2011): 20.2x 20.0 Average (2007-2011): 13.6x

10.0 -1SD (2007-2011): 7.1x

0.0 2007 2008 2009 2010 2011

Sector PE Av erage +1 SD -1 SD

Note: Sector Market capitalizations and Net incomes include Zoomlion, Lonking, Sany Heavy, XCMG, XGMA, Liugong, Shantui and Taiyuan Source: Bloomberg, HSBC

58 Industrials  Asia June 2011 

We think two main rationales for such a premium (2) relatively high operating profit margin. are (1) increasing market share for construction Regarding the market share increase, Sany is likely machinery and (2) a relatively high operating to expand its market share, as seen under excavator profit margin. Regarding the market share segment, as they are also raising the increase, Sany is likely to expand its market share, production capacity. as seen under excavator segment, as they are also In terms of valuation, we believe the stock is trading raising the production capacity. at slight premium to peers. The company plans an Sany is now showing better margins due to H-share listing in 2011. improved cost control, economies of scale, and 2. Lonking: N, TP HKD4.2 higher product pricing. We believe this trend will  Initiate with Neutral due to highest exposure continue with its market share expansion, brand to slowing wheel loader market power and further bargaining power on  component procurement. Attractive valuation among construction machinery On Doosan and Lonking, we believe that the  Strong execution capability and cost leader discount to our target multiple can be justified by among the top three loader makers the following: (1) less diversified product offering, (2) lower margins, (3) potential liquidity risk, and We initiate on Lonking with a Neutral rating and a (4) highest exposure to the most matured wheel target price of HKD4.2 based on PE valuation. loader market for Lonking. We drive our target price of HKD4.2 by applying 9.5x PE on 2011e earnings. For Lonking, we use a Stock picks target multiple of 9.5x 2011e EPS by applying 1. Sany Heavy: OW(V), TP RMB22.5 30% discount to historical industry average at  Initiate with Overweight (V) due to greater 13.6x given company’s higher exposure to wheel exposure to high-growth products loaders. We also believe our 30% discount can be  Continued market share gain in foreign justified given slower growth from wheel loader dominated excavator market and lower entry barrier in wheel loader segment which has long-term concern of Lonking’s future  Potential to become No. 1 in China with growth potential and profitability. Historically the better pricing strategy, brand power and after- stock was trading between PE ranges of 7-13x. sales service  Top pick in the sector 3. Zoomlion: N(V), TP HKD18.4  Initiate with Neutral (V) due to its high We initiate on Sany Heavy with an Overweight (V) exposure to crane business and slightly rating and a target price of RMB22.5 based on PE demanding valuation valuation. We drive our target price of RMB22.5 by  Current premium should diminish once Sany applying 16.3x PE on 2011e earnings. For Sany, we H gets listed in HK near future use a target multiple of 16.3x 2011e EPS, 20%  higher than historical industry average at 13.6x Consensus numbers seem to be relatively high given company’s strong growth momentum above and likely to come down industry average and high ROEs. Besides this, the We initiate on Zoomlion Heavy with a Neutral (V) main rationale for premium are (1) increasing rating and a target price of HKD18.4 based on PE market share for construction machinery and valuation. We derive our target price of HKD18.4

59 Industrials  Asia June 2011 

by applying a 13.6x PE to 2011e earnings. For We initiate on Doosan Infracore with an Zoomlion, we use a target multiple of 13.6x 2011e Overweight (V) rating and a target price of EPS based on historical industry average given the KRW27,000 based on PE valuation. We derive company’s short track record of listing. We also our target price of KRW27,000 by applying 10.9x cross-check with historical PE of Zoomlion A- PE on 2011e earnings. For Doosan, we use a shares, a similar multiple to the sector average. target multiple of 10.9x 2011e EPS, a 20% discount to the China construction machinery In terms of valuation, we believe the stock is sector but 10% higher than the Korea market at trading at a premium to peers and the A-shares. 10x, given the company’s strong exposure to the Sany Heavy plans a listing in HK in 2011. global construction machinery industry. 4. Doosan Infracore: OW(V), TP KRW27,000

 Initiate with Overweight (V) due to strong positioning in excavator market in China.  Targeting to generate high-margin from after- sales parts business by increasing in-house parts  Limited downside risk at current share price offering 23% potential return.

60 

Construction Machinery global peer comparison June 2011 June Asia Industrials

Price* Mkt cap Rating ______PE (x)______PB (x) ______EV/EBITDA (x)__ ___EPS growth (%) ______ROE (%) _____ EBITDA growth (%) __OP Margin (%) __ Company Ticker (Local) (USDm) 2011e 2012e 2011e 2012e 2011e 2012e 2011e2012e 2011e 2012e 2011e 2012e 2011e 2012e

Korea Doosan Infracore 042670 KS 22,000 3,424 OW 8.8 7.7 2.0 1.6 8.3 7.2 1,006.2 14.0 27.0 23.3 6.5 4.2 11.7 11.8 Hyundai Heavy 009540 KS 465,500 32,666 OW 10.4 9.7 2.0 1.7 8.0 7.8 -9.4 7.2 21.9 19.2 6.9 -2.2 14.7 14.0 Korea average 9.6 8.2 2.1 1.6 8.2 7.2 497.5 18.3 24.6 22.9 7.2 7.1 13.3 13.7

HK / China Zoomlion 1157 HK 17.3 13,166 N 12.7 10.6 2.5 2.1 9.8 8.3 18.0 19.9 21.3 21.4 35.1 17.6 18.1 16.7 Lonking 3339 HK 3.9 2,126 N 8.8 7.8 2.1 1.7 6.7 6.0 -6.3 12.3 27.9 25.4 -3.2 8.9 16.0 15.2 Sany Heavy Industry 600031 CH 17.0 19,916 OW 12.3 9.9 5.1 3.8 12.7 10.0 24.5 24.6 51.5 45.6 38.8 25.6 19.2 18.7 XCMG Constr. Machine 000425 CH 23.6 7,523 NR 13.1 10.4 3.2 2.5 11.4 8.8 12.4 26.2 22.9 25.2 19.3 29.6 13.5 14.1 Xiamen XGMA Machinery 600815 CH 14.4 1,732 NR 13.0 10.1 3.0 2.3 12.7 9.8 30.0 29.1 24.9 26.1 33.9 29.5 8.0 8.8 Guangxi Liugong Machinery 000528 CH 21.1 3,654 NR 11.7 9.5 2.3 2.0 9.5 7.9 13.5 23.2 20.2 19.1 21.3 20.9 11.4 11.5 Shantui Constr. Machinery 000680 CH 17.8 2,082 NR 10.5 8.2 2.6 2.0 10.7 8.4 52.7 27.6 25.5 25.6 49.7 27.5 8.8 9.0 Taiyuan Heavy 600169 CH 9.9 2,458 NR 18.8 14.0 2.5 2.1 NA NA 14.9 34.4 16.6 17.8 NA NA 10.1 11.4 HK / China average 12.6 10.0 2.9 2.3 10.5 8.4 20.2 24.7 26.4 25.8 28.1 22.8 13.2 13.2

Japan Komatsu 6301 JP 2,372 29,352 NR 11.3 10.0 2.1 1.8 6.9 6.2 34.4 13.8 20.1 19.3 27.3 11.9 14.4 15.3 Kubota 6326 JP 689 10,978 NR 14.5 12.5 1.3 1.2 8.3 7.3 10.3 16.0 9.5 10.7 18.7 13.4 10.1 11.0 Hitachi Constr. Machinery 6305 JP 1,719 4,582 NR 16.7 12.4 1.1 1.1 6.9 5.9 95.8 35.3 6.3 8.1 15.6 16.0 6.8 7.8 Japan average 14.2 11.6 1.5 1.4 7.4 6.5 46.8 21.7 12.0 12.7 20.5 13.7 10.4 11.4

Europe / US Caterpillar CAT US 97.9 63,090 NR 14.1 10.8 4.7 3.8 9.9 7.7 62.3 30.6 38.2 42.3 41.9 26.2 12.5 14.2 John Deere DE US 82.0 34,416 NR 12.8 11.0 4.3 3.3 12.7 10.8 45.1 17.1 36.4 36.5 24.5 14.1 12.9 13.7 Terex TEX US 26.3 2,879 NR 35.5 11.2 1.3 1.2 10.0 5.3 -77.5 216.6 4.7 12.5 946.2 89.5 4.0 7.7 Volvo VOLVB SS 104.5 34,856 NR 11.8 9.2 2.5 2.1 5.7 4.6 65.2 28.2 23.1 25.2 29.3 17.7 9.1 10.2 Europe / US average 18.5 10.5 3.2 2.6 9.6 7.1 23.8 73.1 25.6 29.1 260.5 36.9 9.6 11.4

Global average 13.9 10.2 2.6 2.1 9.4 7.6 81.9 34.8 23.5 23.9 82.2 22.7 11.9 12.5

*Priced as of 15 June 2010 Source: Bloomberg, HSBC

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Industrials  Asia June 2011 

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62 Industrials  Asia June 2011 

Company section

63 Industrials  Asia June 2011 

Changsha Zoomlion (1157 HK)

 Macro slowdown and margin contraction indicates near-term headwinds for Zoomlion  Higher exposure to Europe and demanding valuation  Initiate Neutral (V) with target price of HKD18.4 based on PE multiple 13.6x, in line with 5-year historical sector average

Initiate N(V) with more equipment in China and has a strong presence competition in crane market especially in the truck crane market with No. 2 market share. However, we believe the company We initiate on Zoomlion Heavy Industry with a will face more severe competition from its local Neutral (V) rating with target price of HKD18.4 peers as many other players such as Liugong are due to (1) a more competitive crane market in increasing capacity more aggressively. Besides China, (2) a slow recovery in Europe, and this, Zoomlion has an aggressive target of strong (3) slower growth in cranes due to delayed revenue growth (50% and 100% revenue growth nuclear projects. Zoomlion’s previous premium for truck and crawler cranes respectively) and we appears to be diminishing. Sany Heavy plans a will have to see if the company can achieve this listing in Hong Kong in 2001. target under higher competition and the slowing Zoomlion offers diversified construction macro environment.

Zoomlion: Revenue breakdown Zoomlion: Gross profit breakdown

Crane Crane 34% E&S 32% E&S 6% R&P 6% R&P 4% 5%

Ex cav ator Ex cav ator 2% Concrete Concrete 2% Financial machinery machinery Financial lease 44% Others 45% lease 3% Others 7% 7% 3%

*E&S = Environment & Sanitation Machinery; R&P = Road construction & Pile foundation *Others include Material handling machinery and systems and other business Source: Company data Source: Company data

64 Industrials  Asia June 2011 

We derive our target price of HKD18.4 by time to see huge earnings contribution from CIFA applying 13.6x PE to 2011e earnings. For given slower than expected global economic Zoomlion, we use a target multiple of 13.6x to recovery in Europe. CIFA delivered a loss of 2011e EPS based on the historical industry RMB107m in FY08 and RMB248m in FY09 and average given the company’s short track record of should recover to positive earnings territory in listing. We also cross-check the historical PE of 2010. CIFA accounted for roughly 5% of total Zoomlion’s A-share, which is at a similar multiple revenue in 2010, mostly for Italy and Western to the sector average. Europe and we expect its contribution remain flat at 5-6% of total. In terms of valuation, we believe the stock used to be trading at premium to peers and the A-shares, Zoomlion: Sales breakdown by region but its previous premium is diminishing. Sany 100% 8% 9% 5% Heavy plans a listing in Hong Kong in 2001. 20% 80%

Overseas contribution is not 60% 92% 92% 95% meaningful 40% 80%

Similar to some other Chinese companies, 20% Zoomlion has strong track record in M&A so far 0% through various acquisitions from 2003. The 2007 2008 2009 2010 company acquired Puyuan Group and Zhongbiao Dom es tic Ov erseas Group expanding into the crane business. In addition to the above acquisition, Zoomlion took Source: Company data over Shaanxi Xin Huanggong and Huatai, further Severe competition from crane diversifying its machinery business into segment earthmoving and material-handling machinery in 2008. Following its corporate strategy, the The crane business has been one of Zoomlion’s company also expanded into the overseas market strongest contributors to earnings, as the company by acquiring a 60% stake in Compagnia Italiana is the second player in China after Xugong. These Forme Acciao Spa (CIFA), an Italian concrete 2 companies have combined market share over machinery maker, for EUR162m. 80% in 2010. However, given its high profitability, we believe the company will face more severe Zoomlion has been seeking synergy with CIFA competition from its local peers as many other after acquisition through sharing R&D, players such as Liugong are increasing capacity distribution channels and component more aggressively. In this regard, we expect either standardization. However, we believe it will take profitability or market share of Zoomlion in the

Zoomlion: Acquisition History Target company Business Acquisition year Acquired stake Puyuan Group Construction cranes 2003 100% Zhongbiao Group Environmental & Sanitation machinery 2003 100% Shanxi Xin Huanggong Earth-moving machinery 2008 100% Hunan Axles Axles 2008 85% Huatai Group Material-handling machinery 2008 82% CIFA Concrete machinery 2008 60% Xinchen Hydraulics Hydraulic parts 2008 75%

Source: Company data

65 Industrials  Asia June 2011 

crane segment to decline. Sany and Liugong are use of leasing and credit sales caused higher the new entrants in the crane market. Liugong is receivables and weaker operating cash flow, developing high-end cranes and increasing its leading to higher bad debt reserve potentially. capacity aggressively while Sany is entering into Once the company generates positive free cash the crane business through acquisition of Sany flow and starts making a solid return through Auto in 2010. Therefore, we forecast that its sales further market share gains in highly competitive will grow 25% in 2011, less than the company’s machinery industries, the stock will gain strong targeted 50%, and expect gross profit margin to momentum, in our view come down 26% versus 28% in 2010. Earnings forecasts Cash cycle not turning yet We expect revenue to grow 35% in 2011 and 28% After going through major capex and acquisitions, in 2012, due mainly its market positioning in the Zoomlion is targeting strong growth going crane segment and pricing power. However, we forward. We note that the company has grown think that the growth should come down rapidly over the last few years; however for it to compared with the company’s target of 50% in step up to the next level via aggressive capacity crawler crane business as there may be severe expansion, we need more visibility on its market competition from other local names. share increase and higher earnings contribution Zomlion has been able to deliver better from its overseas affiliate before we would turn profitability than the industry, including No. 1 more positive on the stock. crane player XCMG, due mainly to better cost Despite its strong 1Q11 earnings, we are control and efficient marketing, despite highly concerned that the company delivered negative concentrated market structure. However, we operating cash flow of RMB1.3bn as receivable expect its GPM to be 29.5% and 28.1% in 2011 surged 60% from 2010 to RMB11.1bn while and 2012 respectively. We forecast margins to inventory rose RMB1.1bn to RMB9.1bn and decline due to cost hike and higher competition prepayments increased 82%. With more severe despite better economies of scale. competition, we believe financial leasing and In terms of net profit, we assume a tax rate of credit sales played a key role for further revenue 15% as the company was classified as a business and earnings growth in 1Q11. However, greater with innovative technology, despite the fact that

Zoomlion: Crane business GPM trend Zoomlion: Operating cash flow trend

(RMBm) (RMBm) 15,000 30.0% 1,000

28.0% 500 10,000 26.0% 0 24.0% 5,000 -500 22.0% -1,000 0 20.0% 2007 2008 2009 2010 2011e -1,500 Crane Sales (LHS) GPM (RHS) 2007 2008 2009 2010 1Q11

Source: Company data, HSBC Source: Company data

66 Industrials  Asia June 2011 

this was expired in 2010. Zoomlion is again Under HSBC’s research model, the Neutral rating applying for further extension of special tax rate. band for volatile China stocks is 0-20% potential return. Our target price implies a potential return Overall earnings – HSBC versus the of 8.2%, including dividend yield, which is within Street the Neutral band. Our net profit estimate for 2011 is 10% below market consensus given the lower margin Still has chance to be world player assumption due to increased sales promotion and We believe Zoomlion is a leading construction- intense competition. Moreover, our sales estimate machinery player in China together with Sany is 6% lower than market consensus. We think the Heavy. The company now has a strong presence Street’s expectations are high from strong 1Q11 in the crane and concrete segments and is looking earnings and strong company guidance for 2011. to enter other segments such as excavators more aggressively. The company has diversified its Valuation and risks product line-ups through various acquisitions. We initiate on Zoomlion Heavy with a Neutral Zoomlion: Valuation summary (V) rating and a target price of HKD18.4 based on Target multiple (x) 13.6 PE valuation. We derive our target price of Sector PE (x) 13.6 HKD18.4 by applying 13.6x PE to 2011e earnings. Discount (%) 0% 2011 EPS (HKD) 1.35 For Zoomlion, we use a target multiple of 13.6x 2011 EPS (RMB) 1.13 2011e EPS based on historical industry average HKD/RMB 1.20 given the company’s short track record of listing. Target price (HKD) 18.4 Current price (HKD) 17.3 We also cross-check with the historical PE of Potential return (%) (incl. div. yield) 8.2%

Zoomlion A-shares, a multiple similar to the Source: Bloomberg, HSBC sector average.

In terms of valuation, we believe the stock is trading at a premium to peers and A-shares. Sany Heavy plans a listing in Hong Kong in 2011.

Risks to our rating and estimates include (1) higher-than-expected excavator growth, (2) better-than-expected margins, (3) lower FX losses, and (4) macro tightening.

Zoomlion: HSBC estimates vs consensus ______HSBC ______Consensus ______Diff(%)______(RMBm) 2011e 2012e 2011e 2012e 2011e 2012e Sales 43,419 55,666 46,297 59,233 -6.2% -6.0% Operating profit 7,846 9,272 8,568 11,341 -8.4% -18.2% OP margin 18.1% 16.7% 18.5% 19.1% -0.4%p -2.5%p Net profit 6,411 7,687 7,159 9,422 -10.4% -18.4% NP margin 14.8% 13.8% 15.5% 15.9% -0.7%p -2.1%p

Source: Bloomberg, HSBC

67 Industrials  Asia June 2011 

Company background

Established in 1992 and listed on the Shenzhen Stock Exchange in October 2000 and on the Hong Kong Stock Exchange in December 2010, Changsha Zoomlion Heavy Industry Science & Technology Development Co., Ltd is China’s leading manufacturer of construction machinery equipment and among China’s first “Group of Innovative Enterprises.” Zoomlion is mainly specialized in the R&D and manufacturing of advanced technologies and equipment for national key infrastructure construction projects, including construction, energy engineering, environment engineering and transportation engineering projects.

Zoomlion: Shareholder structure Zoomlion market share trends

State-ow ned HKSCC Nominees 30% 17% 16% 25% Good Ex cel 20% 6% 15% Changsha Hesheng 5% 10% 5% Changsha Yifang 3% 0% Others Real Smart 2007 2008 2009 2010 2011YTD 51% 3% Ex cav ator Crane Concrete Machinery

Source: Company data Source: CCMA

Zoomlion: PE chart Zoomlion: PB chart

(HKD) (HKD) 6.0 15.0x 6.0 4.0x

12.0x 3.2x 4.0 4.0 9.0x 2.4x

6.0x 1.6x 2.0 2.0 3.0x 0.8x

0.0 0.0 2009 2010 2011 2009 2010 2011

Note: Based on 1yr forward trailing PE Note: Based on 1yr forward trailing PB Source: Bloomberg, HSBC Source: Bloomberg, HSBC

68 Industrials  Asia June 2011 

Zoomlion: Shareholder structure

State-owned Assets Changsha Supervision an d Changsha Hesheng Administration Good Excel Yifang Science Real Smart HKSCC Other Science and Commission of Hunan Group and Technology International Nominees Shareholders Technology Provincial People’s Investment Investment Government

16.8% 6.3% 5.2% 3.3% 2.4% 16.5% 49.6%

Changsha Zoomlion Heavy Industry

100% 100% 100% 100%66.8% 100% 75.6% 82% 84.9%

Shaanxi Zoomlion Hunan Hunan Zoomlion Zoomlion Hunan Teli Zoomlion Hunan Hunan Financing Zoomlion Zoomlion Material Earth Hydraulic H.K. Zoomlion Zoomlion and Internation Special Handling Working Pressure Holding Hardware Axle Leasing al Trade Vehicle Equipment Machinery (PRC) (HK) (PRC) (PRC) (Beijing) (PRC) (PRC) (PRC) (PRC)

72.3%

Hunan Zoomlion Crawling Crane Ltd. 27.7% (PRC)

Source: Company data

Zoomlion: Production site

Huayin > Excavator > Road Machienry Shanghai Shanxi > Rotary drilling rig

Changde > Crane, Axle, etc.

Yuanjiang Hunan > Concrete Machinery Changsha > Concrete Machinery > City Sanitation Machinery

Source: Company data

69 Industrials  Asia June 2011  

Financials & valuation: Changsha Zoomlion Heavy Neutral (V)

Financial statements Valuation data Year to 12/2010a 12/2011e 12/2012e 12/2013e Year to 12/2010a 12/2011e 12/2012e 12/2013e Profit & loss summary (RMBm) EV/sales 0.4 0.3 0.2 0.1 EV/EBITDA 2.1 1.5 1.2 0.6 Revenue 32,193 43,419 55,666 62,576 EV/IC 0.9 0.8 0.7 0.4 EBITDA 6,182 8,351 9,823 11,836 PE* 15.0 12.7 10.6 8.7 Depreciation & amortisation -415 -505 -552 -608 P/Book value 2.6 2.6 2.1 1.8 Operating profit/EBIT 5,767 7,846 9,272 11,229 FCF yield (%) -10.9 8.1 14.7 34.8 Net interest -365 -317 -242 -152 Dividend yield (%) 1.8 1.5 1.8 2.3 PBT 5,416 7,543 9,043 11,090 HSBC PBT 5,416 7,543 9,043 11,090 *Based on HSBC EPS (diluted) Taxation -828 -1,131 -1,357 -1,664 Net profit 4,588 6,411 7,687 9,427 HSBC net profit 4,666 6,542 7,844 9,619 Issuer information Cash flow summary (RMBm) Share price (HKD) 17.28 Target price (HKD) 18.40 Potent'l return (%) 8.2 Cash flow from operations 451 3,089 4,070 7,313 Reuters (Equity) 1157.HK Bloomberg (Equity) 1157 HK Capex -1,173 -1,200 -1,300 -1,400 Market cap (USDm) 2,442 Market cap (HKDm) 19,008 Cash flow from investment -1,833 -1,073 -1,173 -1,273 Free float (%) 67 Enterprise value (RMBm) 12,439 Dividends -1,297 -1,282 -1,537 -1,885 Country Hong Kong Sector Machinery Change in net debt -13,696 -289 -990 -3,876 Analyst Paul Choi Contact +822 3706 8758 FCF equity -1,717 1,268 2,303 5,454

Balance sheet summary (RMBm) Price relative

Intangible fixed assets 3,163 3,093 3,033 2,979 24 24 Tangible fixed assets 5,254 6,019 6,827 7,673 23 23 Current assets 43,670 52,393 61,549 69,284 22 22 Cash & others 18,758 17,047 15,038 15,913 21 21 20 20 Total assets 63,042 76,072 89,918 100,669 19 19 Operating liabilities 19,339 29,098 39,624 45,624 18 18 Gross debt 15,797 13,797 10,797 7,797 17 17 Net debt -2,961 -3,250 -4,241 -8,116 16 16 Shareholders funds 27,376 32,636 38,942 46,676 15 15 14 14 Invested capital 13,990 15,359 16,748 18,399 2009 2010 2011 2012 Changsha Zoomlion Heavy Rel to HANG SENG INDEX

Ratio, growth and per share analysis Source: HSBC

Year to 12/2010a 12/2011e 12/2012e 12/2013e Note: Priced at close of 15 June 2011 Y-o-y % change Revenue 55.1 34.9 28.2 12.4 EBITDA 79.1 35.1 17.6 20.5 Operating profit 84.7 36.0 18.2 21.1 PBT 91.5 39.3 19.9 22.6 HSBC EPS 63.5 18.0 19.9 22.6 Ratios (%) Revenue/IC (x) 2.4 3.0 3.5 3.6 ROIC 36.6 46.2 49.8 55.0 ROE 26.8 21.8 21.9 22.5 ROA 10.3 9.8 9.6 10.1 EBITDA margin 19.2 19.2 17.6 18.9 Operating profit margin 17.9 18.1 16.7 17.9 EBITDA/net interest (x) 16.9 26.3 40.6 77.8 Net debt/equity -10.8 -9.9 -10.9 -17.4 Net debt/EBITDA (x) -0.5 -0.4 -0.4 -0.7

Per share data (RMB) EPS Rep (diluted) 0.94 1.11 1.33 1.63 HSBC EPS (diluted) 0.96 1.13 1.35 1.66 DPS 0.27 0.22 0.27 0.33 Book value 5.61 5.63 6.72 8.05

70 Industrials  Asia June 2011 

Lonking (3339 HK)

 Attractive valuation appealing but growth slowing down  Downside risk to earnings and balance sheet with cash flow burden from credit sales, not returning to shareholders  Initiate Neutral with target price of HKD4.2 based on PE multiple of 9.5x, 30% discount to 5-year sector average

Initiate N with liquidity risk can successfully capture market share in despite attractive valuation excavators and deliver further growth before we change our investment stance. We initiate on Lonking at a Neutral rating with target price of HKD4.2 due to its higher exposure Lonking has been one of the market leaders (No. to the matured wheel loader market and slowing 1 market share in 2010) in the wheel loader growth despite relatively attractive valuation segment in China and is targeting to increase its compared with other Chinese construction market share in the excavator market. However, machinery names. We believe that its attractive we believe the company will face more severe valuation already reflects slower growth relative competition from its local peers as many other its peers by the Street. Moreover, the company players such as Sany are increasing capacity on increased its sales based on credit and financial excavators more aggressively. In addition, leasing in 1Q11, where we believe the company Lonking’s growth should slow down as the wheel may face deteriorating working capital and cash loader segment is already at a mature market stage, flows. This could potentially lead to further price where we forecast 10% and 8% growth in 2011 cut and earnings downside risk from bad debt and 2012 respectively. from credit sales. We will have to see if Lonking

Lonking: Revenue breakdown Wheel loader industry demand vs market share

Ex cav ators ('000 Unit) 16% 300 19% Road 18% 200 Rollers 4% 17% Wheel Fork Lifts 100 Loaders 16% 5% 69% Others 0 15% 6% 2007 2008 2009 2010

Wheelloader industry demand Lonking m/s

Source: Company data Source: Company data, HSBC

71 Industrials  Asia June 2011 

Increasing risk from financial Aggressive expansion + sales leasing sales promotion = sign of industry downturn Potential earnings and balance sheet We believe industry growth will slow down and a downside pricing war will lower overall industry profitability. Both local and foreign brands are targeting to Financial leasing has become an important tool for local brands to increase market share. It has increase market share as well as capacity; for example Lonking’s new plant will be on-line from been no exception for Lonking. The company provides in-house financial leasing service to June or July. In 1Q11, after offering more competitive pricing, zero-down payments, and customers. Lonking has been increasing its financial leasing sales ratio from 7% in 2007 to longer repayment terms, the companies posted negative operating cash flow. This aggressive sales above 40% in 2010. Due to increased financial leasing sales, the operating cash flow of Lonking promotion generated higher than expected and above industry growth for many companies, except has not improved relative to its sales growth. the more conservative foreign brands such as On the other hand, higher sales resulting from Doosan Infracore, Komatsu and Hitachi. competitive leasing products should increase the We are concerned that the next efforts to gain working-capital burden for companies. Among market share may come from lowering product major players, Sany has the model which benefits pricing, as financing with zero down payments the shareholders the most with minimum risk as can no longer serve to differentiate peers. We the leasing is offered by its parent group. gather that certain makers have already began to The greater use of leasing caused higher offer discounts to their customers in May. receivables and weaker operating cash flow; and could pose downside risk to earnings and balance In the case of Lonking, the company achieved sheet through higher bad debts. Once the sales growth in excavators of 88% y-o-y versus company generates positive free cash flow and the industry at 59% in 1Q11, taking market share starts making a solid return through further market away from most dominant foreign brands in China. This was interpreted that local brands were better share gain in highly competitive machinery industries, we expect the stock to gain strong positioned with strong marketing strategy, including after-sales service, pricing and financial momentum, in our view. terms. However, we think this trend in 1Q11 will

Financial lease sales mix comparison Lonking: Capacity expansion plan

70% (Unit) 100,000 60% 50% 80,000

40% 60,000 30% 40,000 20% 20,000 10% 0 0% 2010 2011e 2012e Lonking Zoomlion Sany Doosan Wheeloaders Excavators Road rollers Fork lifts

Source: Company data, HSBC Source: Company data, HSBC

72 Industrials  Asia June 2011 

trigger problems of further competition, financial We believe that financial leasing is not a negative stability with weak cash flows and more second- factor for the company as long as the default rate hand products from potential customer defaults. is theoretically zero. In fact, this product could contribute additional earnings and be a stable Deteriorating working capital earnings stream. However, an increase in default According to companies and dealers in China, the risk is a downside risk to both margins and asset machines’ operating ratio is declining slowly as value. In the worst case scenario, the company some projects, including social housing by local must solve liquidity risk by securing financing governments, are being delayed, while inventory depending on the maturities of existing debts. level is on the rise as well. Moreover, according to component suppliers, some construction machinery Slowing growth in 2011 and 2012 makers are currently facing liquidity issues, such Lonking is targeting a 25% sales CAGR for the that they are likely to need short-term funding to next five years. The company is targeting growth cover payment for the machines they already built in the wheel loader segment by maintaining and sold on credit. Therefore, negative cash flow market share while capturing market share rapidly resulting from sales growth + credit sales as well as given its cheaper ASP, better after-sales service capex on additional capacity is a likely threat to strategy, extensive distribution channel and both earnings and balance sheets of companies. attractive financial leasing terms. However, we Therefore, we believe there could be further believe growth will slow down in 2011 from a downside risk to sales volume and earnings of these high base in 2010, as we are the least bullish on companies near-term. the wheel loader segment, which accounts for Lonking recently issued USD350m 8.5% senior 69% of Lonking revenue. notes due 2016. The proceeds from this issue will Lonking has been guiding sales targets on 2011 as be mainly used to repay the existing debt and follows: wheel loaders 47,480 units; excavators expansion. However, this issue will not likely 7,860; forklifts 20,250 units; and road rollers cover all of the company’s needs, as the further 2,660 units. If the company achieves its target sales volume increase from new capacity would units of production, it is expected to post 20% put further pressure on the company’s balance growth in sales and 4% growth in earnings versus sheet; otherwise the company would see market its strong growth of 120% in 2010. share loss from lower financial leasing.

Lonking: Receivables and turnover Lonking: Sales breakdown by product

(RMB m) Trade and other receiv ables (x) 100% Receiv ables under finance lease 15,000 A/R Turnov er 10.0 80% 12,000 8.0 60%

9,000 6.0 40%

6,000 4.0 20%

3,000 2.0 0% 2008 2009 2010 2011e 0 0.0 Wheeloaders Ex cav ators Road rollers 2007 2008 2009 2010 2011e Fork lifts Others

Source: Company data, HSBC Source: Company data, HSBC

73 Industrials  Asia June 2011 

Growth driver: excavator? Earnings forecasts We believe excavators will be the major growth We expect revenue to grow 14% in 2011 and 15% driver for Lonking from 2011 as wheel loaders are in 2012, due mainly to the relatively low industry at a mature stage of the business cycle. For 2011, growth of the wheel loader market. We expect sales we prefer the excavator market among volume of wheel loaders to be stable given construction machinery segments in China. We Lonking’s market positioning and pricing power. believe Lonking will continue to gain market However, we think the stronger growth could come share, however, we are concerned with not only from the excavator market, reflecting stronger industry capacity expansion but also the increased industry growth. We forecast that Lonking’s number of new entrants, which potentially lowers excavator sales will grow at 46% and 32% in 2011 overall profitability of the excavator industry. and 2012 respectively, resulting from capacity expansion and increased financial leasing service. Besides this, from a long-term perspective, we However, we are concerned with the profitability of believe excavators will gradually replace wheel excavators due to aggressive sales promotion and loaders as excavators are more powerful and have strong industry-wide capacity expansion, where more functions. In developed countries, Lonking may have to face a pricing war against excavators are already more widely used than other major peers in the market. wheel loaders. Due to rising labour cost and improving construction standards, we think Lonking has been able to deliver solid excavators will outpace the growth of wheel profitability driven by industry recovery and its loaders and eventually reach a volume ratio of 2:1 market position in the wheel loader industry. (2 excavators to 1 wheel loader). Therefore, Lonking has shown it has efficient marketing and potential growth from excavators may cannibalise better cost control, despite a highly concentrated Lonking’s higher profitable wheel loader sales in market structure. However, we expect its GPM to the future. be 27% in 2011 and 26% in 2012 due to cost increase from labour and higher competition

despite better economies of scale.

In terms of net profit, we assume a tax rate of 15- 25% as the company has been enjoying a three- year tax-free and a two-year half-tax policy.

Lonking: Excavator capacity expansion vs Sales forecast Wheel loader to excavator sales

(Unit) (x ) Ex cav ators continue to replace Wheel loader 10,000 80% 4.0 > Wheel loader to Ex cav ator sales trend has declined below 2.0x 8,000 60% 6,000 3.0 40% 4,000 2.0 2,000 20% 0 0% 1.0

2009 2010 2011e 0.0 Ex cav ator Capac ity Ex cav ator Sales Utilization rate 2006 2007 2008 2009 2010 2011

Source: CCMA

74 Industrials  Asia June 2011 

However, this favourable policy will expire by Risks include (1) higher-than-expected excavator March 2012. growth, (2) better-than-expected margin, (3) lower FX loss, (4) macro tightening. Overall earnings – HSBC versus the Street Under HSBC’s research model, the Neutral rating Our operating profit margin estimate for 2011 is band for non-volatile China stocks is a 5-15% 16.0%, well below market consensus of 17.9% potential return. Our target price implies a given higher competition in wheel loader market potential return of 10.9%, including dividend in 2H11 and increasing sales promotion in the yield, which is within the Neutral band. excavator market. We believe the Street is overly Lonking: Valuation summary optimistic about margins from strong excavator Target multiple (x) 9.5 growth in 1Q11. Our sales forecast is 3% lower Sector PE (x) 13.6 Discount (%) 30% than market consensus due to slow down in the 2011 EPS (HKD) 0.44 wheel loader market. 2011 EPS (RMB) 0.37 HKD/RMB 1.20 Valuation and risks Target Price (HKD) 4.2 Current price (HKD) 3.9 We initiate on Lonking with a Neutral rating and a Potential return (%) (incl. div. yield) 11% Source: Bloomberg, HSBC estimates target price of HKD4.2 based on PE valuation. We derive our target price of HKD4.2 by applying

9.5x PE on 2011e earnings. For Lonking, we use a target multiple of 9.5x 2011e EPS by applying a 30% discount to the historical industry average of 13.6x, given the company’s higher exposure to wheel loaders. Our 30% discount is justified by slower growth from wheel loaders and lower entry barriers in the wheel loader segment, which is a long-term concern of Lonking’s future growth potential and profitability. Historically, the stock traded between PE ranges of 7-13x.

Lonking: HSBC estimates vs consensus ______HSBC ______Consensus ______Diff(%)______(RMBm) 2011e 2012e 2011e 2012e 2011e 2012e Sales 13,761 15,758 14,171 16,615 -2.9% -5.2% Operating profit 2,198 2,395 2,534 2,866 -13.3% -16.4% OP margin 16.0% 15.2% 17.9% 17.2% -1.9%p -2.1%p Net profit 1,648 1,851 1,906 2,189 -13.5% -15.4% NP margin 12.0% 11.7% 13.4% 13.2% -1.5%p -1.4%p

Source: Bloomberg, HSBC

75 Industrials  Asia June 2011 

Company background Lonking designs, manufactures, and sells wheel Founded in 1993, Lonking Holdings Limited is loaders, excavators, road rollers, motor graders, one of the largest construction machinery and forklifts. The company also develops and manufacturers in China. It has 19 wholly owned produces core components, including gearboxes, subsidiaries and four production bases located in torque converters, axles, hydraulic components, Fujian, Shanghai, Jiangxi and Henan, covering gear pipes, and driver shafts, among others. In over 3m sqm. 2010, more than 40,000 units of Lonking wheel loaders were sold, covering a domestic market share of over 18%, ranking top in the industry.

Lonking: Shareholder structure Lonking: Market share trends

6% 20% China 5% 19% Longgong Others Group 4% 18% 45% Holdings 3% 17% 31% 2% 16% 1% 15%

Li San Yim 0% 14% 24% 2008 2009 2010 2011YTD Ex cav ator (LHS) Wheel loader (RHS)

Source: Company data Source: CCMA

Lonking: PE chart Lonking: PB chart

(HKD) (HKD) 24 15.8x 24 3.2x

22 14.6x 22 2.9x

20 13.4x 20 2.6x 12.2x 18 18 2.3x

16 16 11.0x 2.0x 14 14 Dec-10 Feb-11 Apr-11 Dec-10 Feb-11 Apr-11

*Based on 1-year forward trailing PE *Based on 1-year forward trailing PB Source: Bloomberg, HSBC Source: Bloomberg, HSBC

76 Industrials  Asia June 2011 

Lonking: Shareholder structure

Mr. Li San Yim Ms. Ngai Ngan Ying

55% 45%

China Longgong Group Holdings Limited H Shares Shareholders

30.7% 24.4% 44.9% Longking Holdings Limited

100% 100%

China Dragon Development Holdings Limited China Dragon Investment Holdings Limited

100% 100% 100% 100%100% 100% 100% 100% 100%

Longgong Longgong Longgong Longgong Longgong Monarch Refined Longgong (Shanghai) (Shanghai) (Fujian) (Fujian) (China) (Shanghai) Hydraulics (Shanghai) Fujian Excavator Axle & Casting & Hydraulics Machinery Machinery Machinery Machinery Manufacturing Transmission Forging Machinery Sales

100% 100% 99% 100% 99.9% 100% 100% 100% 100% 100% Longgong Longgong Fujian Longgong Monarch Longgong Longgong Longgong Longgong (Shanghai) (Shanghai) Longgong Longgong Longyan (Jiangxi) (Shanghai) Shanghai (Shanghai) (Fujian) (Fujian) Road Road (Datong) Fujian Longgong Gear Co., Forklift Co., Machinery Financing Axle & International 1% Machinery Machinery Machinery Excavator Machinery Ltd. Ltd. Co., Ltd. Leasing Transmission Trade Manufacturing Manufacturing Components

Source: Company data as of end 2010

Lonking: Production site

Zhengzhou > Wheelloader > Harvestor Shanghai > Wheelloader & Components > Excavator Henan > Forklift, Road roller > Hydraulic Components Jiangxi Jiangxi > Wheelloader Components Fujian Longyan > Wheelloader > Wheelloader Components > Axles, etc.

Source: Company data

77 Industrials  Asia June 2011  

Financials & valuation: Lonking Neutral

Financial statements Valuation data Year to 12/2010a 12/2011e 12/2012e 12/2013e Year to 12/2010a 12/2011e 12/2012e 12/2013e Profit & loss summary (RMBm) EV/sales 1.3 1.2 1.0 0.9 EV/EBITDA 6.2 6.7 6.0 5.6 Revenue 12,020 13,761 15,758 17,237 EV/IC 3.4 2.4 2.2 1.9 EBITDA 2,560 2,478 2,699 2,810 PE* 8.2 8.8 7.8 8.1 Depreciation & amortisation -208 -279 -304 -331 P/Book value 2.6 2.1 1.7 1.5 Operating profit/EBIT 2,352 2,198 2,395 2,479 FCF yield (%) -7.3 -3.1 5.9 3.9 Net interest -196 -186 -136 -86 Dividend yield (%) 2.3 2.4 2.7 2.6 PBT 2,142 1,999 2,245 2,380 HSBC PBT 2,142 1,999 2,245 2,380 *Based on HSBC EPS (diluted) Taxation -376 -351 -394 -595 Net profit 1,766 1,648 1,851 1,785 HSBC net profit 1,725 1,615 1,814 1,749 Issuer information Cash flow summary (RMBm) Share price (HKD) 3.87 Target price (HKD) 4.20 Potent'l return (%) 10.9 Cash flow from operations -221 361 1,631 1,455 Reuters (Equity) 3339.HK Bloomberg (Equity) 3339 HK Capex -509 -600 -600 -600 Market cap (USDm) 2,126 Market cap (HKDm) 16,564 Cash flow from investment -620 -600 -600 -600 Free float (%) 45 Enterprise value (RMBm) 16,708 Dividends -315 -330 -370 -357 Country Hong Kong Sector Machinery Change in net debt 1,989 788 -491 -379 Analyst Paul Choi Contact +822 3706 8758 FCF equity -1,013 -433 818 535

Balance sheet summary (RMBm) Price relative

Intangible fixed assets 0 0 0 0 8 8 Tangible fixed assets 3,229 3,550 3,845 4,114 7 7 Current assets 7,520 8,076 9,389 10,548 6 6 Cash & others 306 -981 -990 -1,112 5 5 Total assets 13,463 14,679 16,677 18,393 4 4 Operating liabilities 5,730 5,667 6,684 7,472 3 3 Gross debt 2,443 1,943 1,443 943 2 2 Net debt 2,136 2,924 2,433 2,054 1 1 Shareholders funds 5,240 6,558 8,039 9,466 0 0 Invested capital 4,712 6,940 7,541 8,301 2009 2010 2011 2012 Lonking Rel to HANG SENG INDEX

Ratio, growth and per share analysis Source: HSBC

Year to 12/2010a 12/2011e 12/2012e 12/2013e Note: Priced at close of 15 June 2011 Y-o-y % change Revenue 74.2 14.5 14.5 9.4 EBITDA 124.3 -3.2 8.9 4.1 Operating profit 134.8 -6.5 8.9 3.5 PBT 136.5 -6.7 12.3 6.0 HSBC EPS 123.6 -6.3 12.3 -3.6 Ratios (%) Revenue/IC (x) 3.0 2.4 2.2 2.2 ROIC 49.2 31.2 27.4 23.5 ROE 38.2 27.4 24.9 20.0 ROA 16.7 13.0 12.7 10.7 EBITDA margin 21.3 18.0 17.1 16.3 Operating profit margin 19.6 16.0 15.2 14.4 EBITDA/net interest (x) 13.1 13.3 19.9 32.7 Net debt/equity 40.8 44.6 30.3 21.7 Net debt/EBITDA (x) 0.8 1.2 0.9 0.7 CF from operations/net debt 12.4 67.0 70.8 Per share data (RMB) EPS Rep (diluted) 0.41 0.39 0.43 0.42 HSBC EPS (diluted) 0.39 0.37 0.41 0.40 DPS 0.07 0.08 0.09 0.08 Book value 1.22 1.53 1.88 2.21

78 Industrials  Asia June 2011 

Sany Heavy Industries (600031 CH)

 Potential to become ultimate survivor in highly competitive construction machinery market in China  Likely to achieve above industry growth to expand market share further  Initiate at Overweight (V) with target price of RMB22.5 based on 20% premium to industry average of 13.6x PE

Initiate OW (V) – becoming a strong interest once Sany Heavy is listed in Hong winner in China Kong in 2011. We initiate Sany Heavy Industry at Overweight Sany Heavy offers diversified construction with a target price RMB22.5 due to (1) strong equipment in China and it has a strong presence growth momentum from the foreign-dominated across all the major segments. Sany’s sales on excavator market, (2) increasing market share concrete machinery, truck cranes and excavators from various sub-segments, (3) better customer grew higher than the industry average and the management and after-market sales service and company became one of leaders among local (4) right positioning in terms of product quality brands. We believe that based on strong sales and pricing strategy. We believe the stock growth, market share expansion will continue to deserves a premium over its peers and will attract drive the stock despite the overall slowdown in

Sany Heavy: Revenue breakdown Sany Heavy: Gross profit breakdown

Others Ex cav ator Others Ex cav ator 12% 18% 13% 15%

Crane Crane 12% 10%

Road Road Machines Concrete Machines Concrete 4% Machines 4% Machines 59% 53%

Source: Company data Source: Company data

79 Paul Choi* Analyst The Hongkong and Shanghai Banking Corporation Limited, Seoul Securities Branch +822 3706 8758 [email protected]

Paul joined HSBC in April 2010 as an industrial analyst from a hedge fund in Hong Kong where he worked as a portfolio analyst. Prior to that, he worked with a major US investment bank as an analyst covering Korean tech and industrial companies.

Brian Cho* Regional Head of Industrials Research The Hongkong and Shanghai Banking Corporation Limited, Seoul Securities Branch +822 3706 8750 [email protected]

Brian Cho is Head of Korea Research and Head of Asia-Pacific Industrials Research. He joined HSBC in 2009 from a major US investment bank where he was Team Leader for Korea Industrials and Deputy Head of Korea Research. Prior to that Brian worked with several local brokerage houses, analysing Korean shipbuilding, machinery, engineering & construction, and steel stocks. He was ranked No. 2 in 2008 FT/StarMine Awards for “Best Construction & Engineering Analyst”. Brian holds a Bachelor of Science degree and a Master of Business Administration degree from Drexel University, US.

Jinkyu Ryu* Associate The Hongkong and Shanghai Banking Corporation Limited, Seoul Securities Branch +822 3706 8783 [email protected]

Jinkyu joined HSBC in May 2010 as an associate covering several industrial related sectors. He holds a BA from Seoul National University.

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations.