Hong Kong Equity | Automobile Company in-depth

Zhongsheng Holding 中升控股 (881 HK) ACCUMULATE

Riding on the luxury cars boom Share Price Target Price Zhongsheng is a leading auto dealer focusing on luxury brands including , HK$22.55 HK$25.40 Mercedes-Benz, BMW (“ABB”) and in China. The group becomes the largest dealer of Lexus (with ~22% market shares) and the second largest dealer of Mercedes-Benz (with ~10% market shares) in China. The continuous rising of China / Automobile / Auto Dealers disposable income results in a consumption upgrade, which will drive Zhongsheng’s sales growth. Due to the rapid expansion of luxury brands network, 30 April 2018 we expect Zhongsheng to record an impressive earnings growth in 2018E. Initiate ACCUMULATE with TP of HK$25.4 and a 13% upside potential from here. Alison Ho (SFC CE:BHL697)  More room to grow luxury car business: The top 8 luxury car brands sales rose by (852) 3519 1291 17.7% yoy in China in 2017, which outperformed the industry growth of 3%. The upbeat [email protected] of luxury cars demand is likely to continue in the coming future on the back of rising number of young drivers and increasing disposable income in China. Zhongsheng’s luxury cars sales accounted for 66% of new car sales in 2017, which is lower than its Latest Key Data peers (Zhengtong = 88%, Yongda=79%) due to a relative high contribution from Total shares outstanding (mn) 2,267 sales (17%) to its new car sales. Given the rapid expansion of its luxury brands’ network, Market capitalization (HK$mn) 51,122 we believe the group has more room to grow its luxury car sales going forwards. Enterprise value (HK$mn) 69,907 12M daily turnover (HK$mn) 66.6  New models of ABB fuels Zhongsheng’s demand: ABB will launch a variety of new 12M volatility (%) 37% models in 2018. Especially for Audi, it will enter into a new product cycle and introduces PEG FY16-18E (x) 0.6 16 new models this year. Besides, Benz and BMW will also launch the hot models such ROE avg FY16-18E (%) 21 as long wheelbase GLC, 525Li, X3, etc. We expect that Zhongsheng will enjoy the boom P/B FY18E (x) 2.1 in 2018E. Net debt/equity FY18E (%) 78

 See robust gross profit margin ahead: Zhongsheng intends to focus their expansion on ABB and Lexus network in the future. Mercedes-Benz and Lexus accounted for 30.6% Performance (%) and 11% of the group’s new car sales and they had GPMs of 6% and 5.3% (other luxury 1M YTD 12M brands’ GPM = ~4%), respectively in 2017. The high contribution and GPMs of these two Absolute 3 26 107 brands can strengthen Zhongsheng’s competitiveness. The fast expansion of ABB + Relative to HSI 4 25 84 Lexus network is likely to support the margins growth of Zhongsheng in the future.  Remain a high borrowing level: In order to expand luxury brands network and sustain Major Shareholders (%) inventory level, we believe it’s hard for Zhongsheng to reduce their borrowing level in Huang Yi 57.7 the short terms. Jardine Matheson 20.0 Capital Research & Management Co.  Initiate with an accumulate rating. Zhongsheng is the leading luxury car dealership and 1.9

is well positioned to capture the fast-growing luxury car opportunities. We initiate Accumulate rating with target price of HK$25.4, suggesting 13% upside potential. Our Auditor target price is based on the valuation of DCF methodologies with WACC of 8.5% and Ernst & Young terminal growth of 3%. This implies a forward (FY18E) P/E of 11.4x and forward (FY18E) P/B of 2.4x. Investment Summary Price Chart FY-end Dec 2016 2017 2018E 2019E 2020E Turnover (HK$mn) Price (HK$)

Turnover (RMB mn) 71,599 86,290 100,474 113,687 126,673 400 Zhongsheng Hldg. 25.0

Chg (%) 21 21 16 13 11 HSI 350 Net Profit (RMB mn) 1,860 3,350 4,000 4,726 5,445 20.0 Chg (%) 304 80 19 18 15 300

EPS (RMB ) 0.867 1.517 1.811 2.140 2.465 250 15.0 Chg (%) 304 75 19 18 15 200 P/E (x) 21.0 12.0 10.1 8.5 7.4

P/B (x) 10.0 3.6 2.6 2.1 1.8 1.5 150 P/OCF (x) 8.7 7.7 7.6 6.3 5.4 100 EV/EBITDA (x) 11.6 8.2 6.8 5.9 5.2 5.0 50 DPS (RMB) 0.267 0.295 0.453 0.535 0.616 Yield (%) 1.5 1.6 2.5 2.9 3.4 0 0.0 Source: Company data, Bloomberg, Orient Securities (Hong Kong) 17-Apr 17-Jul 17-Oct 18-Jan 18-Apr Source: Bloomberg, Orient Securities (Hong Kong)

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Hong Kong Equity | Automobile Company in-depth

Sustained momentum for luxury car market

Vehicles sales grow slowly but steady Figure 1: Accumulated sales volume of The sales volume of vehicles crept up 2.8% yoy, to 718 million units in Q1 2018, vehicles in China according to China Association of Automobile Manufacturers (CAAM). Due to no tax Mn Accumulated sales volume of reduction for the passenger cars with engine capacity of 1.6L and below, we saw that the Units vehicles % YOY growth(%) buyers have little incentive to buy a new car and the vehicle sales is likely to grow slowly 35 50 in 2018. 30 40 25 20 30 15 20 Luxury car brands enjoy buoyant sales 10 5 10 Although the passenger car sales in China only edged up by 1% yoy to 24.71 mn units in 0 0

2017, the sales volume of China’s top 8 luxury car brands rose by 17% yoy to 2.4 mn units,

2010 2011 2012 2013 2014 2015 2016 2017

2009 mainly attributable to the consumption upgrade and growing number of wealthy 2018Q1 individuals. In particular, Audi, BMW and Mercedes-Benz (“ABB”) are the most popular Source: Wind data, Orient Securities (Hong Kong) luxury brands, which accounted for 74% of top 8 China luxury cars sales in 2017. Apart from that, the second-tiers luxury brands such as Cadillac, Land Rover, Lexus, Volvo and Lincoln delivered an impressive growth in 2017, especially for Cadillac and Lincoln, which achieved growth of 50% and 66% respectively. Due to growing brand recognition, we believe the luxury car sales remain buoyant going forwards.

Audi to rebound strongly in 2018 After the settlement of a dispute with dealers in May/2017, Audi’s sales accelerated in 2H2017(+13.8% yoy in 2H2017 vs -12.2% yoy in 1H2017) and its 2017 sales finally rose by 1.1% yoy to 597,866 units in China and surpassed Mercedes-Benz and BMW to become the best-selling luxury brand. Audi is going to launch 16 new models, we thus forecast

that it will maintain a sales momentum in 2018.

BMW - continuous expansion in China BMW was top 2 luxury car seller in China in 2017, which sales volume rose by 15.1% yoy to 594,388 units in 2017. Thanks to the launch of 525Li, 530L and X3, we believe BMW will achieve a strong growth in the upcoming year.

Mercedes-Benz - the fastest growing company among ABB in 2017 Mercedes-Benz ranked No. 3 among luxury car sellers, which sales volume rose by 25.9% yoy to 587,868 units (exclude Smart-branded cars) in 2017, it grew at a CAGR of 24.4% during the period 2012-2017 and became the fastest growing brand among ABB. Figure 2: Luxury car sales in 2017

Units 2016 sales volume (LHS) 2017 sales volume (LHS) 2017 YOY Growth (RHS) 700,000 597,866 594,388 587,868 70% 600,000 60% 500,000 50% 400,000 40% 146,399 132,864 300,000 175,489 30% 200,000 114,410 20% 54,124 100,000 10% 0 0% Audi BMW Mercedes-Benz Cadillac Land Rover Lexus Volvo Lincoln

Country of Germany U.S. Britian Japan Swedan U.S. origin Source: Internet data, Orient Securities (Hong Kong)

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Audi, Mercedes-Benz and BMW’s prices

We made a comparison of prices of Audi, Mercedes-Benz and BMW:

Figure 3: Prices of Audi, Mercedes-Benz and BMW Domestic Brands Type Model Price (Thousand RMB) Comments Made Above 150 200 250 300 350 400 450 500 550 600 650 700 750 800 850 900 950 1000 A4L, A6L and Q5 accounted for 1000 64% of Audi’s sales in 2017: A4L A1 Audi’s A4L, BMW’s 3-series and Benz’s C class have similar and A6L are mid-size sedans A3  performances and price ranges which cost between RMB292,800 A4L  and RMB698,000. A4L and A6L A5 accounted for 19% and 24% of Sedan Audi’s overall sales, respectively, A6L  Audi in 2017. Another star model- Q5 A7 (SUV) costs RMB399,600 to A8 RMB519,200, which accounted Q3  for 21% of audi’s sales in 2017. SUV Q5  Audi will launch A6Mix this year Q7 and it may further boost its sales. A class C Class and E Class dominated B class Mercedes-Benz’s sales: The C class  mid-size sedan models - C class Sedan CLS class  and E class dominate Benz’s sales, Mercedes E class  their prices range is from RMB312,800 to RMB634,800. Benz S class Over 100,000 units of long- GLA  wheelbase version of C-Class GLC  Saloon were sold in China and SUV GLE more than doubled E-Class GLS Saloon sold in 2017. 1 series  2 series  3 series and 5 series are BMW’s The performances and price stars models: The prices range of Sedan 3 series  ranges of 5-series, Audi’s A6L 3 series and 5 series is from 5 series  and Benz ’s E class are similar. RMB 288,000-RMB665,900, they 7 series accounted for 21.7% and 22.4% BMW X1  of BMW sales in China in 2017 X3 respectively. Due to the launch of X4 525Li and 530Le in 2018, we SUV expect that BMW will maintain its X5 sales momentum in 2018. X6

Source: Internet data, Orient Securities (Hong Kong)

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Mercedes-Benz optimizes product mix to attract young buyers

Wide range of models to fulfil customer’s need Daimler AG announced that Mercedes-Benz China’s sales (include smart cars) rose by 26.8% to 619,000 units in 2017. Mercedes-Benz achieved an impressive growth in past five years, which jumped by 15%, 23%, 37%, 22% and 27% yoy in 2013, 2014, 2015, 2016

and 2017, mainly due to its positive brand image, high prestige, safety and high performance. Similar to Audi and BMW, Mercedes-Benz sells a wide range of models including SUV, ultra-luxury cars such as Maybach and AMG and entry-level cars to fulfil customer’s needs, we believe it not only attracts the younger consumers, but also increase the loyalty of older buyers.

To increase domestic made products to strengthen sales In order to strengthen the sales in China, Mercedes-Benz keeps launching new and upgraded models in the past 5 years. We observed that most of Chinese buyers prefer longer, wider and higher vehicles, thus Mercedes-Benz’s Chinese Joint Venture - Automotive Co., Ltd (BBAC) produced the tailor-made vehicles including long- wheelbase version of C-Class and E-Class to satisfy Chinese customers’ need, the

proportion of domestic made vehicles hence rose from 48% in 2012 to 68% in 2017. Looking forward, BBAC plans to establish one more production plant to produce high-quality luxury vehicles, we expect the proportion of domestic made vehicles to increase continuously. Due to more sole models manufacturing by BBAC, it would stimulate the sales of Mercedes-Benz and the dealers of Mercedes-Benz will also benefit from it.

Figure 4: Mercedes-Benz + Smart cars sales volume in China Figure 5: Mercedes-Benz Network

Thousand No. of Stores Units Domestic made Imported Stores at year beginning Newly added 700 600 37 600 500 27 55 500 196 400 106 400 171 150 300 79 300 502 529 55 447 147 423 200 200 123 41 341 108 317 262 100 250 100 207 100 116 146 166 0 0 2012 2013 2014 2015 2016 2017 2011 2012 2013 2014 2015 2016 2017

Source: Daimler AG , Orient Securities (Hong Kong) Source: Daimler AG , Orient Securities (Hong Kong)

Zhongsheng benefits from Mercedes-Benz’s expansion strategy Although 566 Mercedes Benz 4S stores went into operation in China in 2017, the pace for network expansion was slowing down. We found that more than 50 Mercedes-Benz stores were added annually in 2012-2015, but only 27/37 stores were opened in 2016/2017. As China is one of the important markets for Mercedes-Benz, the strategies

including raising R&D costs, providing credits services to customers, models upgrade and launching the tailor-made models will be adopted by Mercedes-Benz to secure its market shares in China. We believe it will accelerate the expansion pace. Since Zhongsheng is Mercedes-Benz’s 2nd largest dealership, we estimate that they can obtain more authorizations from Mercedes-Benz for 4S stores opening going forwards.

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The launch of new car models and localization of ABB

Audi – The launch of 16 models to improve competitiveness in 2018 Figure 6: Top 8 luxury brands sales Audi plans to launch 16 new car models in 2018. In particular, 6 models including Q2L contribution (Domestic), Q8 and A4 Avant would be newly added. Q2L is a small long-wheelbase SUV and Q8 is a large high performance SUV, both of them are Audi’s popular models. In Volvo Lincoln Lexus 5% 2% addition, 5 new generations and 5 facelift models would be introduced this year, A8L is Land 6% Audi one of upgrade models with high technology including partial autonomous driving Rover 25% 6% functions to allow the car to monitor the driving environment. Another upgrade hot Cadillac 7% model is Q5L(Domestic), which installs a large size interior to meet Chinese customers’ needs. The improvement of product mix may foster Audi’s sales growth in 2018. Merced BMW es-Benz Mercedes-Benz – Introduction of long wheelbase GLC to meet Chinese taste 24% 25% Mercedes-Benz accounted for 24% of China’s top 8 luxury car brands sales in 2017. The group will introduce 10 new models including long-awaited new generation of A-Class,

Source: Auto Gasgoo, Orient Securities (Hong Kong) CLS and long wheelbase GLC in 2018. The new A-Class has a new face, more powerful engines, MBUX infotainment system and roomier interior which can compete with Audi A3 and BMW 1-series. Besides, new CLS has installed autonomous emergency braking, lane-keep assist, speed limit assist and the pre-safe occupant protection system. In addition, long wheelbase GLC, only offers in China, whose wheelbase has grown by 10 cm, indicating that more foot space and it is easy for passengers to entry and exit. Offering customers a choice of both regular and long wheelbase hot models can improve users’ experience, which can strengthen Mercedes-Benz product mix and support their revenue growth in the coming future.

Figure 7: 2018 New Cars Launch A8L Q2L Q5L Q8 A7 A4 Avant

Audi

A-class CLS G-class GLC long wheelbase GLE - Mercedes Benz

X2 X3 X7 M5 i8 Roadster

BMW

Source: Internet, Orient Securities (Hong Kong)

BMW – an expected strong growth driven by 525Li and localized X3 The new BMW X2 and domestic made X3 models will be launched in 2018. X3 is one of the bestselling models in BMW, which accounted for ~5% of China BMW’s sales in 2017. With an improvement of the workmanship, material and technology (new generation iDrive system and semi-automatic driving technology configuration) coupled with a relative low price comparing with import X3, we expect localized X3 sales volume to increase significantly. In addition, 525Li and 530Le are hot models for BMW and they are likely to become the growth drivers for BMW in 2018.

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ZhongSheng Group – Diversified portfolio of luxury brands

Zhongsheng - No. 2 largest auto dealers in China

Zhongsheng Holding (881 HK) is one of the leading 4S auto dealers in China and it ranked

No. 2 in 2016 “China Top 100 Dealer Groups” list, according to CADA. The group was

listed in HKEX in 2010. Up to 2017, Zhongsheng opened 286 4S dealership stores and

distributes luxury car brands including Mercedes-Benz, Audi, Jaguar & Land Rover, Volvo

and BMW/MINI and mid-to-high end car brands including Toyota, , Volkswagen,

Chrysler and . Besides, Zhongsheng also expands its sales in after-sales services,

second-hand automobiles, car insurance and car financial businesses.

Figure 8 : Milestones for Zhongsheng

In 2010, the group listed in HKEX. In 1999, Zhongsheng The IPO price was HKD10. became Audi’s Listed in HK dealership. Up to now, the group reaches a market share of 4.5% in Audi’s China sales. 2012 2010 2009 2005 In 2012, Zhongsheng became Jaguar & 1999 In 2009, the group became Mercedes- Land Rover (“JLR”)’s Benz’s dealership. dealership. 1998 Recently, it is the 2nd Zhongsheng is the largest first company to get Mercedes-Benz’s the dealership right dealership in China. from Toyota.

Source: Company data, Orient Securities (Hong Kong)

Toyota’s largest dealership in China In 1998, Zhongsheng was the first company to get the dealership rights from Toyota and Nissan. Recently, the group becomes Toyota’s largest dealership in China and reaches the market shares of c.6%. In 2017, Toyota sales (FAW Toyota + GAC Toyota sold 1.19mn units) accounted for c.4.8% of China passenger cars sales. Thanks to a high volume of Toyota sold, we forecast that Zhongsheng can churn out stable cash flows from Toyota sales.

Zhongsheng is Lexus’s largest dealership in China In 2005, Zhongsheng was one of the first authorized dealerships for Lexus in China. The group operates over 30 Lexus 4S stores in China and it grabbed a c.22% market shares in Lexus sales in 2017. With a high market shares, we believe they can gain a greater bargaining power than other dealers.

nd Mercedes-Benz’s 2 largest dealership in China Zhongsheng got the dealership right from Mercedes-Benz in 2009. Nowadays, it is the nd Mercedes-Benz’s 2 largest dealership with c.10% market shares in China. The close relationship with Mercedes-Benz would be easier for Zhongsheng to have more 4S stores authorization from Mercedes-Benz.

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Extensive network coverage in China Figure 9: No. of stores operation Premium and ultra premium brands Concentrate on luxury brands expansion to enhance revenue and GP growth stores Up to 2017, Zhongsheng opened 286 dealership stores in more than 24 provinces. In Middle brands stores order to increase the profit margins, it mainly focuses on luxury brands expansion. The Stores total number of luxury brands stores rose from 57 in 2013 to 151 in 2017, which was 200 growing at a CAGR of 27.6% during 2013-2017. On the other hand, the number of

150 mid-to-high end brands stores grew at slow rate from 113 in 2013 to 135 in 2017, growing at a CAGR of 4.5% between 2013 and 2017. Zhongsheng guided that they will 100 continue to concentrate on luxury brand network expansion, we believe buoyant 50 consumer spending can bolster Zhongsheng’s revenue and gross profit growth. 0

Head to ABB, Volvo and Lexus Source: Company data, Orient Securities (Hong Kong) Thanks to the high brands recognition in China, the sales volumes of Audi,

Mercedes-Benz and BMW rose by 1.1%, 15.1% and 25.9% yoy in 2017, far higher than

industry growth of 3%. In order to capture opportunities in ABB’s fast growth trend,

Zhongsheng plans to open 15 new stores and mainly focuses on ABB, Lexus and Volvo

this year. We believe the group can benefit from the strong cycle of ABB in 2018-19E.

Focus on tier-1 and tier-2 cities to maintain competitiveness

Zhongsheng’s 4S stores mainly located in coastal province such as Shandong, Jiangsu,

Zhejiang and Guangdong, primarily due to the higher purchasing power of those cities.

Zhongsheng guided that it will locate their stores strategically in tier-1/tier-2 cities, the

big appetite for luxury goods of those cities’ customers is likely to boost Zhongsheng’s

luxury car sales.

Figure 10: Stores location of Zhongsheng

Liaoning - 47 Zhongsheng locates their Shandong - 30 stores strategically in Jiangsu - 22 tier-1/tier-2 cities due to high purchasing Sichuan - 13 Zhejiang - 19 power of those cities.

Fujian - 18

Yunnan - 27 Guangdong - 42

Hainan - 14 Source: Company data, Orient Securities (Hong Kong)

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Mercedes-Benz and Audi bring Zhongsheng to new peak

Speed up building the Mercedes-Benz stores to increase GPM Mercedes-Benz becomes Zhongsheng’s top-selling brand and it accounted for 30.6% of group‘s new car sales in 2017. Recently, Zhongsheng operated 42 Mercedes-Benz stores and the management guided that the gross profit margin (“GPM”) of Mercedes-Benz

sales is around 6%, which is much higher than that of BMW (2.8%) and Audi (1.9%). We believe the speed up of Mercedes-Benz network expansion would help to improve the group’s market shares and overall gross profit margins.

Optimistic on Audi’s rebound The resolving of the dispute with dealerships in 2H2017 may lead Audi’s 2018 sales to

rebound significantly. In addition, Audi enters into a new product cycle and 16 new models including the hot models -Q2L (Domestic), Q8 and A8L will be launched this year, it is likely to fuel Audi’s demand. Given that c.10% of Zhongsheng’s new car sales revenue came from Audi sales in 2017, we are confident that Zhongsheng will benefit the new

product cycle of Audi.

Figure 11: 2017 Zhongsheng’s sales by Figure 12: 2017 GPM by brands Figure 13: Zhongsheng's market share by brands brands in China in 2017

Lexus, 700% 25% Benz, 6 Lexus, 22.0% 600% Benz, 5.3 Others, 20% 31% 500% 31% 400% 15% Benz, Toyota, 10.0% 300% Audi, 2.1 10% Toyota, 1.9 Audi, 200% 6.0% 4.5% Lexus, 5% Toyota, 11% 100% 17% Audi, 0% 10% 0% Benz Lexus Audi Toyota Benz Lexus Audi Toyota

Source: Company data, Orient Securities (Hong Kong) Source: Company data, Orient Securities (Hong Kong) Source: Company data, Orient Securities (Hong Kong)

Lexus is a hidden gem of Zhongsheng 11% of Zhongsheng’s new car sales revenue came from Lexus’s sales in 2017. Lexus, which ranked No. 6 bestselling brands in China, delivered 22% yoy sales growth in 2017. Given the launch of 5 new models (NX, RX, GX, LX and UX) in 2018, Lexus aimed to achieve a year-on-year growth of 23%, to 160,000 units in China this year. Due to a high GPM generating from Lexus new car sales (5.3%) , we can see a growth opportunity of Zhongsheng’s GPM.

New technology of Toyota is likely to support Zhongsheng’s growth 17% of Zhongsheng’s new car sales revenue came from Toyota sales in 2017. GZ Toyota and FAW Toyota set to beat totally 1.215 million units sales goal in 2018, indicating 7.7% target growth. New Camry, which is the first model designed and manufactured with TNGA (Toyota New Global Architecture) in China, was launched by the end of 2017, it earned very positive feedbacks from customers. The other two TNGA models named C-HR and IZOA will be launched in 2018, we believe they may boost Toyota’s sales on the back of superior performance. Since Zhongsheng is Toyota’s largest dealership in China and we see its upside potential here.

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Luxury brands sales growth remains intact Maintain inventory at reasonable level Zhongsheng must pay the deposits to car manufacturers before the vehicles were shipped out, when the vehicles arrive the ports, all the payments must be settled, thus the tight control of inventory level can avoid excess cash outflow. Zhongsheng has a ERP system which allows it and car manufacturers to monitor the inventory by time to time. The management stated that the inventory levels of Mercedes-Benz and Lexus are c.30 days and c.20 days respectively, which are in the reasonable level. Given a high sales contribution from these two brands, the low inventory level can speed up the group’s cash inflow. On the other hand, the inventory days of BMW and Audi are c.40 days. Thanks to the new product cycle of Audi and BMW, we believe their sales will speed up and inventory level will be improved in 2018.

Figure 14: Business Model of Zhongsheng

1st Stage 2nd Stage Final Stage

After received the deposit, Automobiles OEMs deliver the cars to Zhongsheng

Automobiles OEMs Zhongsheng receives the cars Zhongsheng pays the deposit When the cars arrive the ports, and places them to automobile OEMs before Zhongsheng pays the rest into its warehouse. the cars ship out payments to OEMs

Source: Company data, Orient Securities (Hong Kong)

Accelerating expansion of luxury brands’ network to boost the new car sales Figure 15: Revenue by segments in 2017 New car sales accounted for 86.6% and 28.7% of Zhongsheng’s total revenue and profit

After- contribution, respectively, in 2017. Thanks to an impressive growth in luxury cars sales, sales services the launch of a variety of new models by ABB, coupled with continuous expansion of new 13.4% luxury stores, we expect Zhongsheng’s 2018E/2019E luxury car sales to rise by 21.4%

New car /16% yoy, to RMB59,839 mn / RMB69,389 mn. The mid-high end brands sales is sale revenue expected to record growth of 7.5% and 7.6% yoy in 2018E and 2019E to RMB27,302 mn 86.6% and RMB29,365mn in 2018E and 2019E respectively. We forecast that the proportion of

luxury brands to new car sales will increase from 66.0% in 2017 to 68.7% and 70.3% in Source: Company data, Orient Securities (Hong Kong) 2018E and 2019E respectively. With higher contribution from luxury brands car,

2018E/2019E’s new car sales volume is expected to increase by 11.9%/10.5% yoy to

382,061/422,059 units and new car sales is expected to grow by 16.7%/13.3% yoy to

RMB87,141 mn / RMB98,754 mn in 2018E/2019E.

Figure 16: Increasing contribution from luxury brands to new Figure 17: New car sales car sales in 2018E

Luxury/ultra-luxury brands Mid-high end brands RMB Mn New car sales (LHS) YOY growth (RHS) 150,000 30% 100% 67% 65% 66% 69% 70% 71% 100,000 20% 33% 35% 34% 31% 50% 30% 29% 50,000 10%

0% 0 0% 2015 2016 2017 2018E 2019E 2020E 2016 2017 2018E 2019E 2020E

Source: Company data, Orient Securities (Hong Kong) Source: Company data, Orient Securities (Hong Kong)

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Potential upside for after-services and value-added services sales

Robust performance of after-sales services business The revenue and profit contribution of after sales revenue were 13.4% and 54.2% respectively in 2017. Due to the relative high maintenance fee of luxury brand vehicles, the rapid expansion of luxury cars network is likely to bolster after-sales service revenue

growth. We estimate that the segment’s revenue will grow by 15% and 12% yoy to RMB13,333 mn and RMB14,933 mn in 2018E and 2019E, respectively. To conclude, the total revenue of Zhongsheng is expected to rise by 16.4%/13.2% yoy to RMB100,474 mn / RMB 113,687 mn in 2018E/19E.

Figure 18: Profit contribution by segments in 2017 Figure 19: After-sales revenue

Value-added services RMB mn After-sales revenue (LHS) YoY Growth (RHS) 17% 20,000 30% New car sales 25% 15,000 29% 20% 10,000 15% After-sales 10% 5,000 services 5% 54% 0 0% 2016 2017 2018E 2019E 2020E

Source: Company data, Orient Securities (Hong Kong) Source: Company data, Orient Securities (Hong Kong)

Low penetration rate drives financial services business growth The profit from value–added services including car insurance, car finance and second-hand automobiles business rose by 39.4% yoy, to RMB1,789mn in 2017. Thanks to 1)low penetration rate of auto finance in China; 2) an increasing number of young

drivers; and 3)an aggressive promotion of auto finance by car manufacturers, we believe Zhongsheng’s car finance penetration rate will continue to rise and auto finance business will sustain robust growth in 2018E/2019E.

More room for insurance and second hand business growth The trade volume for used cars rose by 41.2% yoy to 38,484 units in 2017. Given a

growing popularity of using second-hand cars, the demand for second-hand cars is likely to increase going forwards. Zhongsheng give the guidance that the second car sales volume will grow by 50% yoy in 2018-19E on the back of product mix enhancement. For insurance segment, given an expected increasing number of luxury car sales in the future, the growth of insurance commission is expected to be sync with the growth of luxury cars sales. With the above assumptions, we forecast the commission income from value

added services to rise by 23.6% and 18.3% yoy to RMB2,210 mn and RMB2,615 mn in 2018E and 2019E, respectively.

Figure 20: Car finance penetration rate of Zhongsheng Figure 21: Commission income from value-added services

RMB Mn % 50 Commission income (LHS) YoY Growth(RHS) 4,000 50% 40 3,000 40% 30 30% 45.0 2,000 20 35.3 39.8 20% 28.6 10 1,000 10% 0 0 0% 2014 2015 2016 2017 2015 2016 2017 2018E 2019E 2020E

Source: Company data, Orient Securities (Hong Kong) Source: Company data, Orient Securities (Hong Kong)

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Improving GPM drives earning growth

Continuous growth of GPM

ABB and Lexus will be Zhongsheng’s key developing brands in upcoming years, with solid

growth of these brands’ sales and the higher GPMs of Mercedes-Benz (6%) and Lexus

(5.3%) vs other luxury brands (~4%), we believe an increase number of these brands’

stores can boost Zhongsheng’s GPM growth, we thus estimate the GPM of new car sales

to increase by 0.3ppt and 0.1ppt to 4.3% and 4.4% in 2018E and 2019E respectively. On

the other hand, the gross profit margin of after-sales services was 48.9% in 2017, given

the growing of luxury brands network, we expect Zhongsheng’s GPM of after-sales

services business to be stable at 48.9% in 2018E-19E.

The overall GPM of Zhongsheng is expected to increase by 0.1ppt and 0.0ppt to 10.2%

and 10.2% in 2018E and 2019E respectively and gross profit is estimated to rise by 18.1%

/13.6%, to RMB10,255 mn / RMB11,652 mn in 2018E/2019E.

Figure 22: Gross profit and gross profit margin Figure 23: Expenses ratio and net margin

Gross profit (LHS) Selling expenses ratio G&A expenses ratio RMB mn New car sales GPM(RHS) Finance cost ratio Gross Profit Margin % 20.0% 14,000 After-sales services GPM (RHS) 60.0 Net Margin 12,000 50.0 10.2% 10.2% 10.3% 10,000 40.0 9.2% 10.1% 8,000 7.9% 30.0 10.0% 6,000 20.0 3.9% 4.0% 4.2% 4.3% 4,000 2.6% 2,000 10.0 0.8% 0 0.0 0.0% 2015 2016 2017 2018E 2019E 2020E 2015 2016 2017 2018E 2019E 2020E

Source: Company data, Orient Securities (Hong Kong) Source: Company data, Orient Securities (Hong Kong)

Stable expenses ratio As the selling expenses ratio maintained at 3.8%-3.9% in 2016-2017, thus we forecast Figure 24: Zhongsheng’s net profit that the ratio will keep unchanged at 3.8% in 2018-19E. In addition, we expect the G&A Attributable to: Equity holders of the expenses ratio to maintain stable at 1.6% in 2018E-19E, which is the same as that in RMB Company (LHS) mn YoY growth (RHS) 2016-2017. Due to the achievement of economies of scale, the financial cost ratio is 6,000 400% estimated to reduce from 1.25% in 2017 to 1.16% and 1.04% in 2018E and 2019E 5,000 300% respectively. 4,000 200% 3,000 2,000 100% 1,000 0% An expected solid growth for net profit 0 -100% Base on the above estimation, we forecast that 2018E/2019E net profit will rise by 19.3%/18.1% yoy to RMB4,000 mn/RMB4,726 mn, EPS is estimated to grow by

Source: Company data, Orient Securities (Hong Kong) 19.3%/18.1% yoy to RMB1.81/RMB2.14. Net profit margin is expected to increase slightly

from 3.9% in 2017 to 4.0%/4.2% in 2018E/2019E.

See an improvement of DPS in 2018E

Zhongsheng was under cash flow pressure due to fast increase of CAPEX, thus it lowered

its payout ratio from 31% in 2016 to 20% in 2017. We estimate that the group’s cash flow

will improve and hence we use the average rate of 2016 and 2017 payout ratio as our

final payout ratio in 2018E-19E, which is equivalent to 25%. Therefore, the group’s DPS is

expected to increase by 53% and 18% yoy to RMB0.453 and RMB0.535 in 2018E and

2019E respectively.

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Hong Kong Equity | Automobile Company in-depth

Significant operating cash inflow in 2018E

Robust operating cash flow

Zhongsheng’s operating cash flow kept rising and reached RMB5,235mn in 2017. Thanks

to the increase of earnings and tight control of inventory level, we expect the group’s

operating cash inflow to increase continuously and reach RMB5,263 mn and RMB6,340

mn in 2018E and 2019E respectively.

CAPEX to be funded by internal cash flow

The capital expenditure of Zhongsheng increased at an accelerate rate in past 3 years,

mainly due to their rapid expansion of networks. The number of stores increased to 286

in 2017, 35 stores increase from the year prior. Zhongsheng guided that 15 self-build

stores will be opened in 2018E and each luxury store costs around RMB600-700million,

the Capex will be funded by internal cash flow, hence we forecast that their total Capex

(self-build + acquisition) will lower to RMB4,690 mn in 2018E and 2019E and their net

gearing ratio will be improved in the next few years.

Figure 25: Cash Flow Figure 26: Capital expenditure

Total Cash Flow from Operation RMB mn RMB mn Total Cash Flow from investment Total Cash Flow from Finance 7000 6000 10,000 5000 4000 5,000 3000

0 2000 1000 (5,000) 0 2014 2015 2016 2017 2018E 2019E 2020E 2014 2015 2016 2017 2018E 2019E 2020E Source: Company data, Orient Securities (Hong Kong) Source: Company data, Orient Securities (Hong Kong)

Improving net gearing position Unlike its peers, Zhongsheng only focuses their business on traditional dealership, up to this moment, they haven’t planned to develop its own auto finance business, since it enjoys to be an auto finance agency which is risk-free and no extra capital need. Recently, most part of its borrowing is using to fund their inventory and Capex, thus we believe Zhongsheng’s borrowing level will remain stable in 2018E-19E. Given an expected strong cash inflow in the coming future, we estimate the net gearing ratio to improve from 91% in 2017 to 78% and 63% in 2018E and 2019E respectively.

Figure 27: Loan and borrowings Figure 28: Net gearing ratio

RMB mn %

25,000 120 101 91 20,000 100 78 15,000 80 63 49 10,000 60 5,000 40 0 20 2015 2016 2017 2018E 2019E 2020E 0 2016 2017 2018E 2019E 2020E Source: Company data, Orient Securities (Hong Kong) Source: Company data, Orient Securities (Hong Kong)

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Hong Kong Equity | Automobile Company in-depth

Valuation: Apply DCF to value the stock

We value Zhongsheng Group based on below assumptions: 1) The new product cycle of Audi and the solid growth of Mercedes-Benz, BMW and Lexus sales would boost Zhongsheng’s new car sales and after-sales services revenue Figure 29: Key DCF assumptions 2) The contribution from luxury cars sales is likely to rise attributable to a rapid growing Discount rate 8.5% of luxury brands stores, hence we estimate the GPM of Zhongsheng to improve going PV of FCF (HK$m) 33,582 forwards. Terminal value (HK$m) 78,656 3) The expenses ratios would be stable. Total PV of FCF (HK$m) 112,238 4) The operating cash flow of Zhongsheng would increase on the back of strong growth Net Cash/Net Debt (HK$m) (18,560) of pre-tax profit. NAV Price/Share (HK$) 42.4 Current NAV Discount (%) -47% Target NAV Discount (%) -40% The fair value of Zhongsheng is HK$25.4 based on DCF methodology Target Price (HK$) 25.4 We value Zhongsheng with a two-stage DCF model, the first stage is from 2018E to 2027E Upside Potential 13% and the second stage is after 2027E.

Source: Company data, Orient Securities (Hong Kong)  According to Bloomberg data, we assume a risk free rate of 3.6%, market risk premium of 8.1% and beta of 0.7 to calculate cost of equity, which is 9.4%;  We then assume tax rate of 30%, debt-to-equity ratio of 110% and after-tax cost of debt of 3.8% to calculate WACC, which is 6.5%. After taking account into the economic risk and financial risk, we apply 8.5% of discount rate to value Zhongsheng.

 We use 3% as terminal growth rate.  The NAV price is expected to be HK$42.4 per share, equivalent to 47% discount to current share price, we would set 40% discount to its NAV after take into consideration of market volatilities and uncertainties, which equivalent to HK$25.4 per share. This implies 11.4x 2018E P/E , 2.4x 2018E P/B and 2.2% 2018E dividend yield.

Figure 30: DCF forecasts RMB $mn 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E 2026E 2027E Pre-tax profit 5,928 7,004 8,070 9,217 10,251 11,541 12,575 13,639 14,659 15,747 Taxes paid (1,778) (2,101) (2,421) (2,765) (3,075) (3,462) (3,772) (4,092) (4,398) (4,724) Depreciation and amortization 1,277 1,449 1,610 1,669 1,757 1,823 1,913 1,906 1,936 1,995 Change in working capital (838) (1,432) (1,256) (1,223) (859) (1,034) (1,122) (931) (872) (964) Others 675 1,420 1,467 1,177 1,100 972 823 680 515 400 Operating cash flow 5,263 6,340 7,470 8,075 9,173 9,840 10,416 11,202 11,840 12,454 CAPEX (4,690) (4,690) (5,390) (4,190) (3,990) (4,690) (4,190) (3,990) (4,690) (4,190) Annual Free Cash Flow (RMBmn) 573 1,650 2,080 3,885 5,183 5,149 6,226 7,212 7,150 8,264 Annual Free Cash Flow (HK$mn) 709 2,042 2,575 4,809 6,416 6,374 7,707 8,928 8,851 10,230 Discounted free cash flow(HK$mn) 653 1,731 2,009 3,455 4,243 3,882 4,320 4,608 4,206 4,475

Source: Company data, Orient Securities (Hong Kong)

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Hong Kong Equity | Automobile Company in-depth

Key risk factors

1) Changes in economic condition: The above assumption are based on the

continuous prosperity in China, while the economic condition changes, the demand

for luxury brands may weaken and the inventory level may go up, which would harm

Zhongsheng’s cash flow and profit.

2) Keen competition to boost G&A expenses: Given intensifying competition,

Zhongsheng may need to increase their advertising costs or hold more marketing

activities to increase their customers’ loyalty, the higher G&A cost may drag down

the profit.

3) Weaker-than-expected luxury cars demand: If the consumers’ preferences change,

the demand for ABB or other luxury brands may fall.

Figure 31: Peer valuation table

Ticker Company Reporting Share Market P/E (x) PEG P/B Div. Yield (%) EV/EBITDA Currency Price Cap. (x) (x) (x)

(HK$mn) 2017 2018E 2019E 2020E 17-19E 2017 2018E 2017 2018E 2017 2018E 2019E

881 HK ZHONGSHENG GROUP CNY 22.55 51,122 12.0 10.1 8.5 7.4 0.6 2.6 2.2 1.6 2.4 8.2 6.8 5.9 3669 HK CHINA YONGDA AUTO CNY 8.55 15,692 7.6 6.3 5.0 4.1 0.3 1.3 1.3 2.8 4.8 7.8 6.1 5.0 1728 HK CHINA ZHENGTONG CNY 5.95 14,825 8.9 7.0 5.4 4.3 0.3 1.1 1.0 2.3 3.6 10.1 7.3 6.0 1293 HK GRAND BAOXIN AUTO CNY 3.32 9,420 8.9 6.7 5.6 5.0 0.3 1.1 1.0 3.7 2.3 9.1 7.5 6.4 3836 HK CHINA HARMONY AUTO CNY 4.35 6,695 5.3 7.3 6.4 4.7 - 0.9 0.8 3.0 1.8 3.4 5.3 4.5 1268 HK CHINA MEIDONG AUTO CNY 3.45 3,971 11.0 9.3 7.2 5.8 0.5 2.9 2.2 4.4 5.4 8.0 5.9 4.6 1828 HK DAH CHONG HONG HKD 4.24 7,831 9.7 8.2 7.3 7.1 0.6 0.8 0.7 4.0 5.0 7.1 6.3 6.0 Sector average 10.1 8.5 7.1 6.1 0.5 1.8 1.6 2.4 3.1 8.1 6.7 5.7

Source: Company data, Orient Securities (Hong Kong) HK$ Figure 32: P/E band Figure 33: Historical P/E

HK$45.0 (x) HK$40.0 22.0x 35.0 HK$35.0 19.0x 30.0 HK$30.0 16.0x 25.0 HK$25.0 +1 Std 13.0x 20.0 HK$20.0 HK$15.0 10.0x 15.0 Mean HK$10.0 7.0x 10.0 HK$5.0 5.0 -1 Std HK$0.0 0.0

Source: Bloomberg, Orient Securities (Hong Kong) Source: Bloomberg , Orient Securities (Hong Kong)

Figure 34: P/B band Figure 35: Historical P/B

(x) HK$35.0 4.0 3.5 HK$30.0 3.5x 3.0 HK$25.0 2.9x 2.5 +1 Std HK$20.0 2.3x 2.0 Mean HK$15.0 1.7x 1.5 1.0 HK$10.0 1.1x 0.5 HK$5.0 -1 Std 0.5x 0.0 HK$0.0

Source: Bloomberg , Orient Securities (Hong Kong) Source: Bloomberg , Orient Securities (Hong Kong)

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Hong Kong Equity | Automobile Company in-depth

Financial Statements & Forecast

Income statement (consolidated) Balance sheet (consolidated) FY-end Dec (RMB mn) FY-end Dec (RMB mn) 2016 2017 2018E 2019E 2020E 2016 2017 2018E 2019E 2020E Revenue 71,599 86,290 100,474 113,687 126,673 Current assets 21,488 24,045 25,452 29,388 31,995 New car sale revenue 62,459 74,696 87,141 98,754 110,246 Inventories 6,530 7,510 8,571 9,591 10,572 After-sales revenue 9,140 11,594 13,333 14,933 16,426 Trade and other receivables 9,212 9,727 10,751 12,164 13,427 Cost of goods sold (65,047) (77,606) (90,219) (102,035) (113,675) Pledged bank deposit 1,242 1,406 1,406 1,406 1,406 Gross profit 6,552 8,684 10,255 11,652 12,998 Time deposit 320 356 356 356 356 Selling and distribution Cash and cash equivalents 4,157 5,027 4,369 5,871 6,234 expenses (2,807) (3,294) (3,836) (4,340) (4,836) Others 27 20 - - - G&A expenses (1,179) (1,347) (1,568) (1,775) (1,977) Non-current assets 18,157 23,535 26,584 28,805 31,094 Other income 1,294 1,816 2,210 2,615 3,040 Net Intangible asset 3,306 5,737 6,852 7,689 8,459 Operating Profit 3,861 5,859 7,061 8,151 9,224 Goodwill 2,733 3,940 3,829 3,720 3,614 Finance income 31 26 28 38 40 Property, plant and Finance costs (1,018) (1,077) (1,162) (1,185) (1,194) equipment 8,810 10,056 11,327 12,370 13,531 Share of profits of JV 4 5 0 0 0 Others 3,309 3,802 4,576 5,025 5,490 Profit before tax 2,878 4,813 5,928 7,004 8,070 Total assets 39,645 47,581 52,036 58,193 63,088 Income tax expenses (837) (1,338) (1,778) (2,101) (2,421) Current liabilities 23,584 26,737 27,949 30,240 30,912 Non-controlling interests (182) (125) (150) (177) (204) Trade, bills and other payables 6,069 6,406 7,653 8,655 9,642 Net profit to Shareholders 1,860 3,350 4,000 4,726 5,445 Loans and borrowing 16,135 18,712 18,828 19,828 19,328 EBITDA 4,858 6,900 8,338 9,600 10,834 Income tax payable 1,134 1,373 1,468 1,757 1,941 EBIT 3,861 5,859 7,061 8,151 9,224 Dividend payable 0 0 - - - EPS (RMB) 0.867 1.517 1.811 2.140 2.465 Other liabilities 246 246 - - - DPS (RMB) 0.267 0.295 0.453 0.535 0.616 Non-current liabilities 2,962 4,174 3,974 3,974 3,774

Cash flow (consolidated) Loan and borrowings 1,893 2,495 2,295 2,295 2,095 Deferred tax liabilities 1,069 1,680 1,680 1,680 1,680 FY-end Dec (RMB mn) 2016 2017 2018E 2019E 2020E Total liabilities 26,546 30,912 31,923 34,214 34,686 Pre-tax profit 2,878 4,813 5,928 7,004 8,070 Share capital 0 0 0 0 0 Taxes paid (837) (1,338) (1,778) (2,101) (2,421) Reserves 12,218 15,913 19,232 22,959 27,222 Depreciation and amortization 997 1,041 1,277 1,449 1,610 Shareholder's Equity 12,218 15,913 19,232 22,959 27,222 Change in working capital 329 (1,358) (838) (1,432) (1,256) Non-controlling interests 881 756 880 1,020 1,180 Others 1,145 2,076 675 1,420 1,467 Total equity 13,099 16,669 20,113 23,979 28,402 Operating cash flow 4,513 5,235 5,263 6,340 7,470 Total liabilities & equity 39,645 47,581 52,036 58,193 63,088 CAPEX (3,846) (5,949) (4,690) (4,690) (5,390) Net cash/(debt) (12,309) (14,418) (14,993) (14,490) (13,428) Disposals 3,139 1,062 1,429 1,774 2,100 Change in Working capital 329 (1,358) (838) (1,432) (1,256) Investments (463) (453) (709) (700) (698) Total capital employed 16,061 20,843 24,087 27,953 32,176 Others (1,610) 502 0 0 0 Net gearing (%) 101 91 78 63 49 Investing cash flow (2,780) (4,838) (3,970) (3,616) (3,987) BVPS (RMB ) 5.123 6.910 8.708 10.395 12.326 Change in bank borrowings (1,484) 3,196 (84) 1,000 (700) Dividends paid (94) (618) (706) (1,037) (1,226) Key ratios Interest paid (1,018) (1,077) (1,162) (1,185) (1,194) Net proceeds from issuance of FY-end Dec 2016 2017 2018E 2019E 2020E ordinary shares 0 1,176 0 0 0 Growth (%) Others 548 (2,186) 0 0 0 Revenue 21 21 16 13 11 Financing cash flow (2,048) 491 (1,951) (1,222) (3,120) Gross profit 40 33 18 14 12 Free cash flow 667 (715) 573 1,650 2,080 EBITDA 74 42 21 15 13 Net cash flow (315) 888 (658) 1,502 363 EBIT 99 52 21 15 13 Effect on exchange difference 8 (18) 0 0 0 Net profit 304 80 19 18 15 Year-end cash 4,157 5,027 4,369 5,871 6,234 EPS 304 75 19 18 15 DPS 535 11 53 18 15 Semi-annual breakdown Margins (%) FY-end Dec (RMB mn) 2H15 1H16 2H16 1H17 2H17 Gross 9.2 10.1 10.2 10.2 10.3 Revenue 32,256 31,742 39,857 38,322 47,968 EBITDA 6.8 8.0 8.3 8.4 8.6 Gross profit 2,394 2,825 3,728 3,817 4,867 EBIT 5.4 6.8 7.0 7.2 7.3 Operating profit 904 1,430 2,431 2,526 3,333 Net Profit 2.6 3.9 4.0 4.2 4.3 Pre-tax profit 259 961 1,917 2,009 2,804 Others (%) Tax (99) (282) (555) (562) (775) Effective tax rate 33 29 28 30 30 Net profit 151 613 1,247 1,356 1,994 Dividend payout ratio 31 20 25 25 25 Gross margin (%) 7.4 8.9 9.4 10.0 10.1 RoCE 12 16 17 17 17 Operating margin (%) 2.8 4.5 6.1 6.6 6.9 Average RoE 15 21 21 21 20 Effective tax rate (%) 38.1 29.3 28.9 28.0 27.6 Average RoA 5 7 8 8 9 Net margin (%) 0.5 1.9 3.1 3.5 4.2 Interest cover (x) 4 5 6 7 8 EPS (RMB ) 0.070 0.286 0.581 0.631 0.903 DPS (RMB ) 0.042 - 0.267 - 0.308 Key assumptions

Growth (%) 2016 2017 2018E 2019E 2020E New car sale revenue 20 20 17 13 12 After-sales revenue 25 27 15 12 10 Source: Company data, Orient Securities (Hong Kong)

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Hong Kong Equity | China Consumer Goods Company in-depth

Analyst Certification I, Alison Ho(Ho Tsz Ying), being the person primarily responsible for the content of this research report, in whole or in part, hereby certify that: (1) all of the views expressed in this report accurately reflect my personal view about the subject company(ies) and its (or their) securities; (2) no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report, or our Investment Banking Department; (3) I am not, directly or indirectly, supervised by or reporting to our Investment Banking Department; (4) the subject company(ies) do(es) not fall into the restriction of the quiet period as defined in paragraph 16.5(g) of SFC Code of Conduct; (5) I and my associates do not deal in or trade in the stock(s) covered in this report within 30 calendar days prior to the date of issue of the report; (6) I and my associates do not serve as an officer(s) of the listed company(ies) covered in this report; and (7) I and my associates have no financial interests in relation to the listed company (ies) covered in this report.

Meanings of Orient Securities Ratings Buy – Describes stocks that we expect to provide a total return of >10% within a 12-month period. Accumulate – Describes stocks that we expect to provide a total return of >0% within a 12-month period. Hold – Describes stocks that we expect to provide a total return of between -20% and +20% within a 12-month period. Sell – Describes stocks that we expect to provide a total return of <0% within a 12-month period.

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