Financial Reporting Analysis Final Project

CFA Institute Research Challenge Hosted in Beijing Tsinghua University

CFA Institute Research Challenge November 29th, 2013 Huayi Brothers (300027.SZ) Sector: Consumer Cyclical Industry: Media – Diversified Investment Highlights Fundamentals and valuation methodologies indicate BUY. Based on Discounted Cash Flow RECOMMENDATON: BUY valuation methodologies, we arrive at the target price of RMB 46.9, a 48.3% upside from close price as of Nov. 29, 2013. We believe Huayi Brothers will outperform due to the promising ￥ PRICE TARGET: 46.90 prospect of its integration of business line, which successfully mitigates content quality risk from vertical integration and creates synergy across different business line through horizontal integration. Market Data Huayi Brothers (SZSE:300027) Huayi’s vertical integration of film business can effectively reduce its exposure to content Market Capitalization 36,675M quality fluctuation and increase gross margin. The company has established a synergetic Shares Out.（mn) 1,209.60 Main share Holders: business line from vertical integration in its film business, consisting of production and - Zhongjun, Wang 23.90% investment, distribution, film exhibition and talent agency. The distribution business successfully - Zhonglei, Wang 7.32% - Tencent Holdings Ltd. 4.60% smooth content volatility and thus provides stronger downside protection via (1) advanced Free Float (%) 64.18% decision of the best timeslot in releasing films, (2) provision of sufficient screening schedule rate,

Last Share Price 31.6 and (3) effective advertising campaign to attract customers, while the theatre business provides 1 year Range 12.09-79.30 its distribution business strong negotiating power with theatre circuits, maximizing the return from Beta 0.9 the film production. P/E(TTM) 151.6 Huayi has the best horizontal integration in the industry, enabling it to largely diversify EPS(TTM) 0.2 EV/EBITDA (2013E) 52.5x content risk and fully utilizing its content resource, and brings huge positive synergy. The ROE 12.6 integration of mobile gaming with film allows Huayi to fully utilize premium film and drama BV per share (2013E) 17.8 resources, on a recursive basis. Integration of TV drama series and music with film allows sharing of resources, and gives Huayi positive synergy. Integration of travel with film has a huge potential with a downside protection. Current stage of development of the Chinese film industry remains the growth period, providing a good opportunity in investing in industry leader. In recent years, China’s film industry has been growing steadily. The industry continuously grows overall with high profits and low levels of competition. But it is still marginal in the media industry, implying a huge room for future expansion. The immature state of the market provides potentials for investment and a good sign for the industry leader, Huayi, due to its occupation of first-mover advantage. Business Description Huayi is one of the largest private-owned listed media companies in China Founded in 1994 by the Chairman & CEO Mr. Wang Zhongjun and President Mr. Wang Zhonglei, Huayi Brothers (“Huayi”) is one of the largest private entertainment players in China. Huayi got listed on ChiNext in 2009 with a current market capitalization of approximately RMB 33bn, among the largest companies listed on ChiNext. Figure 1: Huayi’s revenue structure Emphasis stressed on integration and aiming at full coverage of media industry 100% 90% The Beijing-based company first started out with film production, and later expanded into talent 80% 70% management and TV drama production. In July 2013, the company announced its acquisition of 60% mobile game developer Yinhan Technology to expand into game content creating, showing an 50% 40% attempt to execute a broad entertainment strategy consisting of 6 components, namely, film 30% 20% production and distribution, TV drama production, talent management, movie theatres, music, 10% 0% gaming and derivatives (i.e., theme parks). (Figure 1) 2007 2008 2009 2010 2011 2012 Film business chain: Huayi itself produces and distributes films. It also has an interest in Film TV drama Assault Films (founded by Wu Yanzu and Feng Delun) and Eastern Legend (a joint venture with Talent agent & music Theater Game Legend Film Company). Huayi has several overseas companies to help distribute their films. Source: Huayi annual reports Additionally, Huayi holds theater subsidiaries to occupy whole produce-distribute- show value chain. 1

CFA Institute Research Challenge November 29th, 2013 Talent management: Huayi’s subsidiary Shidai Agent manages talent agent business; Lanhai Huayi, a joint venture with Jiangsu broadcasting and TV bureau, organizes vocal live shows. Shishang Media engages mainly in super model agent. TV drama production: Huayi’s subsidiary Yule Investment produces and distributes TV drama series. Besides studios incorporated, Huayi also have subsidiaries named Zhengjiang Tianyi and Zhejiang Film Investment. Music: Subsidiary Huayi Music engages in music. Derivatives: Huayi holds an interest in Ourpalm Technology, an A-share listed mobile game company; Huayi announced acquisition of Yinhan Technology, also a mobile game maker; Giant Information conducts the online game business; Shijing Entertainment takes part in theme part and tourism business; Huayi Vision does advertising business. Successful and sustainable production of high-quality movies On the back of first-in-class talent management franchise and near exclusive relationship with highest-grossing directors in China, Huayi is China’s most accomplished and consistent movie producer with a track record of delivering regional blockbusters including, If You Are the One (2010), After Shock (2010), Painted Skin (2012), CZ12 (2012) and Young Detective Dee (2013), all with box office results in the region of multi-hundred million RMB. Industry Overview & Competitive Positioning Industry overview Current stage of development of the Chinese film industry remains the growth period, Figure 2 but still marginal in the media industry, implying a huge room for future expansion Chinese film industry growth In recent years, China’s film industry has been growing steadily. (Figure 2) Despite a gradual 60%

50% decline since 2010, the industry continues to grow overall with high profits and low levels of

40% competition. Compared with the film industry in North America, China’s film industry may not be 30% as stable, due to the lack of capital. However, the immature state of the market provides 20% potentials for investment. Moreover, revenue for the film industry only makes up 3% of the entire 10%

0% cultural industry, implying a huge room for future growth and expansion. (Appendix 1) 2006 2007 2008 2009 2010 2011 2012 2013 Highly competitive and volatile nature of the movie production and distribution industry Source: Enn As in the production side, in 2012, China's top ten movie companies took 37% of market share, with the most remarkable of these companies being Enlight Pictures, Huayi Brothers and China Film Group. Looking at both the number of productions in which they were involved and their box office shares, these companies have shown considerable stability. (Figure 3) Figure 3: Market share in film production industry 2011 2012 Market No. of Market Company share films Company share No. of films 1 China Film Group 4.39% 18 Enlight Pictures 7.23% 10 2 Bona Film 3.81% 10 Huayi Brothers 6.82% 8 3 Huayi Brothers 2.42% 8 Yingyitong 3.14% 1 4 Galloping Horse Film 2.20% 4 Zhengledao Media 3.14% 1 5 Movie Channel Center 1.98% 14 H/B Studio 3.14% 1 6 Shanghai Film Group 1.60% 7 China Film Group 2.70% 17 Hangzhou Culture 7 Zhonglian Jinghua 1.64% 3 Radio Film 2.35% 3 8 Henan Film Group 1.63% 2 H&R Century 2.30% 2 9 Guoli Changsheng 1.58% 2 Huashu Media 2.30% 1 10 Anhui Media Group 1.49% 2 Sichuan Zhonglan 2.30% 1 In distribution side, five companies with the largest market shares in distribution accounted for 82.7% of the nationwide market, which was a noticeable increase over the 77.6% concentration 2

CFA Institute Research Challenge November 29th, 2013 in the market in 2011. (Appendix 2) Notably, private companies are becoming more active and four companies split market share for each season. (Appendix 3) Content exposure remains the theme of risk in film industry The fate of film companies largely depend on the unpredictable quality of content The inherent nature of the film industry is the co-existence of high investment, high risk and high return, with the risk largely owing to the unpredictability of the boxing performance, which in essence is the uncertainty of content quality and creation. Also, the impact of such exposure would be enhanced by the increasing requirement of initial capital of the film production. Cases include MGM’s failure on Wingtalkers, which later induces the resignation of senior management and acquisition by SONY Corp. While Enlight used Lost in Thailand to jump from number 15+ in 2011 to the first place in 2012 among China's movie companies. (Figure 4) Figure 4: Enlight Media stock performance

In 2012, beside the top 3, the remaining 7 companies all rose to top 10 solely because of their participation in one of the hottest movies, with 3 of them in Lost in Thailand and the other 4 in Painted Skin: The Resurrection. The downside potential of content exposure could be mitigated by vertical integration Figure 5: The similarity in marketing An example would be a business model that combines the film production and distribution. As methods between the two industries Film industry FMCG the film industry is quite similar to the cosmetics industry in the demand end, where the High screening consumers’ perception of the quality of goods and movies play an important role. Such nature schedule rate Intensive sales web determines that the loss from a poorly produced film could be partially compensated by the Massive subsequent marketing effect. Thus if a group has substantial interest both in the production and advertising Massive advertising distribution, it could leverage the marketing advantages in distribution to provide a downside campaign campaign protection for the content exposure, and consequently mitigate the risk aroused from the content Optimal timeslot Optimal timeslot in quality. (Figure 5) in film releasing product launching The upside potential of the content quality could be magnified by horizontal integration Under the horizontal integration of film with other forms, one single theme or topic can be transformed into different products, maximizing the business value of the same theme. With horizontal integration, artificially selected premium content would be fully utilized, and the content would be magnified. Sino-US comparison Integration is a trend if benchmarking on the evolution of American movie industry A common practice of media industry study would be benchmarking on the evolution of the American movie industry, due to the maturity of Hollywood and the similar nature of the film industry across border. In the US, firms with premium brands expanded very rapidly, causing smaller firms soon to vanish, or only live in dependency of the big firms. Since the beginning when thousands of film makers competed, the evolution has led to a rather concentrated market. Using the data of 2012 box offices, the United States film industry CR8 has reached 88.4%—indicating that the market is basically divided up by some oligarchs. Case study: Disney Corp 3

CFA Institute Research Challenge November 29th, 2013 Figure 6: The integration of Disney When compared with S&P index, we can conclude 3 high-speed growth periods for Disney: Year Disney’s integration 1967-1973, 1984-1991 and 1994-1997. All of the growth was triggered by Disney’s whole value 1967 Theme park commenced construction 1984 Touchstone Pictures was established chain integrations. (Figure 6)Since November 1994, total return on Disney stock was about 1985 Started to make TV carton 400%, or 150 percentage points above S&P. Currently, Disney is a fully diversified, whole value 1993 Acquisition of Miramax 1996 Acquisition of ABC and Jumbo Pictures chain media empire. (Appendix 4) Competitive landscape of film industry Business coverage of major players The Chinese film industry consists of two types of players: SOEs and private enterprises. The two giant SOEs, China Film and Huaxia, have been dominating Chinese film industry, and are still playing very important role due to their scale, as well as monopoly in film import. The private enterprises diverse in their operation along the film value chain. (Figure 7) Figure 7: Chinese film companies Name Description The biggest and oldest film company in China; have China Film Group biggest annual production Huaxia Film Distribution One of the two companies that can distribute foreign Company films (the other is China Film) SOEs Local SOEs, e.g.: Shanghai Film Group Provincial film makers, e.g.: Shanxi Film Studio A-share listed; full value chain coverage, the most Huayi Brothers famous media group in China Focusing more on distribution; have many self-own Private Bona theaters enterprises The only national film experiment district; has film Hengdian Film Group toursim industry A-share listed; prestigious in TV programs; Lost in Enlight Media Thailand is the No.1 gross box office in China

By comparing the business models of the competitors, we may conclude that Huayi is the most integrated film company with broadest coverage involving film, TV drama, talent agent, and derivatives etc. within the industry. (Figure 8) Figure 8: Chinese film companies business models Huayi China Film Huaxia Enlight Company Bona Wanda Brothers Group Film Media Film making √ √ √ √ √ × Film distributing √ √ √ √ √ × Film showing √ √ √ × √ √ Import films × √ √ × × × TV drama making √ × × √ × × and distributing Talent agent √ × × × √ × Music √ × × × × × Figure 9 Game √ × × × × × Box office, 2012 Market share of Huayi 400 25 Huayi is the leading player in production and distribution, with sizable share in TV and music 300 20 15 market. In 2012, average box office result of Huayi’s film was much better than its peers, 200 10 indicating a strong content and distribution ability. (Figure 9) Huayi ranked 2nd and 3rd in 100 5 0 0 production and distribution market, respectively, in 2012. (Appendix 5 & 6) China Film Huayi Enlight Media Group Borthers Investment Summary Average box office per film shown in theater (MM RMB) Average box office per film invested (MM RMB) Vertical integration of film business can effectively reduce its exposure to Film made (right axis) Film shown in Mainland China (right axis) content quality fluctuation and increase gross margin By the construction of the vertically integrated business model, the content volatility in the film can be reasonably mitigated. At the same time the integrated business line also create synergy 4

CFA Institute Research Challenge November 29th, 2013 form cost internalization and revenue cross-boosting that we believe has not been fully reflected in its price currently. The company has established a synergetic business line from vertical integration Figure 10: Huayi’s full value chain Huayi’s expertise and relatively complete construction and participation throughout film industry creates synergy value chain create massive synergy surrounding its core film production business (Figure 10). Production and investment: Through its experience in the movie industry, the company seeks movie projects that can generate best returns. It can secure distribution rights in high potential movies through investing or participating in film production. Distribution: The company uses its distribution experience to decide the best time schedule to produce films, ensuring quality films are released in every peak season. Additionally, distribution experience also enables the company to discern Chinese audiences’ taste and selectively invest in film production, thus reducing investment risk. Also the distribution business would reduce the exposure to the content risk from the production business (elaborated later). Film exhibition: The film exhibition business strengthens the distribution business by giving it significant bargaining power with theatre circuits. Theatre circuits form an important part of the film value chain between film distribution and film exhibition. Talent agency: Talent agency business helps it secure key talent for its in-house production movies. Additionally, it helps in obtaining desirable films for distribution, additional insights into film projects and other source / contacts for promising film opportunities. The company represented over 100 artists at the end of 3Q13 and grows at a 10% growth rate per year. The company is the largest talent agency in the mainland China. Figure 11: Synergetic business line

The distribution business successfully smooths content volatility and thus provides stronger downside protection Huayi’s strong film distribution business may serve as a marketing department for self-produced films and thus smooth the content volatility. Huayi Brothers has emerged as the largest private film distributor in China. The company’s market share in the distribution business is only behind China Film Group and Huaxia, both are government-owned players. As documented in the industry analysis, there is similarity across film industry and the fast-moving consumer goods industry, where the perceived quality of the products plays an essential role, given the prerequisite that the combination of film distribution is strong to create marketing power. Huayi’s distribution business is actually providing a guarantee for the films which it has participated in the production. Noteworthy, almost all the films Huayi distributed are those they 5

CFA Institute Research Challenge November 29th, 2013 have been participating in production. According to Huayi’s CFO, this trend won’t change in the near future, which is quite different from its competitors, whose decision to acquire the distribution rights was supported by the analysis on a variety of factors that typically include a film’s expected critical reception, marketability, and potential for box office success. Thus, there would be clear evidence that such business model would provide a guarantee for the films which it has participated in the production. The theatre business provides its distribution business strong negotiating power with theatre circuits, maximizing the return from the film production The theatre business assists companies in securing preferred scheduling rights. The film exhibition business strengthens the distribution business of Huayi by giving it significant bargaining power with theatre circuits. Theatre circuits form an important part of the film value chain between film distribution and film exhibition. (Figure 12) The increasing investments in movie theatres assist in securing the preferred scheduling rights, including timeslot and screening schedule rate of films. The scheduling rights are key drivers to increase selected films’ market share as well as their box office. In 2013, the movie Tiny Times broke the records of the whole Chinese film history by gaining a 45.01% first day screening schedule rate in over 20 major cities. Although the viewers’ opinions mixed, the extremely high screening schedule rate still drives the box office broking RMB 2bn in the first three days of the film releasing. We believe by enhancing control power in scheduling tights, the company will have a stronger capability to provide a premium movie-going experience for the Chinese audience and increase the desire for Chinese-oriented content. (Appendix 7) Figure 12: Presence across film value chain

Figure 13: Scale and growth of Chinese film industry

The theatre business also assists companies in securing more favorable revenue split, and prompt and accurate payments by theater circuits. In 2012, revenue generated by the Chinese film industry totaled $3.3 billion, an increase of 18%. Of this total, box office accounted for $2.7 billion. (Figure 13) Due to the policy bonus in China, the box office split is highly leveraged to theatres (Figure 14) by allocating around 50%. At the same time, theatre business also profit from other sources of income, such as the sales of goods, rental of on-site advertising space, and the preshow ads before films are shown. These sources of added income contribute to the daily operational proceeds for each movie theater. Without considering the acquisition of other theaters, assuming that starting in 2012, Huayi Brothers maintain the speed of opening 10 theaters a year, for each movie theater, its main operating revenue includes ticket sales and 6

CFA Institute Research Challenge November 29th, 2013 other revenue (sale revenue, advertising revenue, etc.), the main operating costs include (box office spilt to producers and distributors (39.4%), rent, business tax and surcharges (3%), movie special fund (3.5%) and others. We expect the theater business can achieve operating income of 458 million in 2013. Figure 14: Box office split on an average

Huayi has the best horizontal integration in the industry, enabling it to largely diversify content risk and fully utilizing its content resource, and brings huge positive synergy

Figure 15: The current horizontal integration of Huayi is well positioned Huayi has already stretched to talent agent, TV drama series, films, music, and other derivative businesses. (Figure 15) In the United States, post-window distribution (such as online TV, cables, DVDs etc.) and derivatives has become the majority of the revenue in the film industry, whereas the ticket box revenue accounts for only 20%. (Appendix 8) Film productions have to be run in connection with other media platforms to produce synergy, thus value of the films could be fully utilized. Several recent acquisitions, such as Times Warner’s acquisition of Turner Broadcasting, Viacom’s acquisition of Paramount and DreamWorks, and Disney’s acquisition of ABC, have all proved this idea. Integration of mobile gaming with film allows Huayi to fully utilize premium film and drama resources, on a recursive basis. In 2013, Huayi announced its acquisition plan for Yinhan Technology, a mobile game producer, at a total consideration of 0.67 billion comprised of cash and stock. Mobile game industry is growing fast with a promising future. Mobile game theme has been a hot topic in China’s capital market due to its high growth potential. Chinese online game market size reached 66.2 billion RMB in 2012, an increase of 24% from 2011, according to iResearch. Mobile game accounted for 7.8 billion, or 11.9% of revenue of online game industry, and will Figure 16: witness very fast growth in the following years. It is forecasted that the mobile game market will Computation of Yinhan synergy Stock price of Huayi 6/4 14.275 reach 25 billion in 2016, indicating a CAGR of 35%. Return from 6/4 to 8/14, Huayi 42.91% The acquisition of Yinhan reflects no obvious synergy in stock price. Huayi paused its Return from 6/4 to 8/14, Culture industry index 28.36% trading on Shenzhen Stock Exchange on June 4, 2013, until July 24, when it released its Huayi abnormal return 14.55% acquisition plan and continued its trade. We try to observe the return in the window from June 4 Total outstanding shares of Huayi (MM) 1,210 Increase in Huayi market value (MM) 2,512 to August 14, the day before Huayi announced its Q2 earnings. During this period, the market capitalization of Huayi increased by 2.51 billion (net of the industry effect, as measured by Yinhan comparable companies P/E on 8/14 Shunwang Technology, 300113 67.5 culture and broadcast composite). We compare this additional market capitalization with the Bestv New Media, 600637 58.1 anticipated fair value of the 50.88% investment in Yinhan, which we have estimated through a Peoplecn, 603000 40.3 Ourpalm Technology, 300315 89.3 comparable P/E multiple analyses to be at 3.57 billion. Since there is about 1 billion short in the Average Yinhan comparable companies increase of market capitalization, our analysis suggests that no obvious positive synergy was P/E on 8/14 63.8 Yinhan 2013E profit (MM) 110 recognized in the acquisition by the market. (Figure 16) Huayi's holding interest 50.88% However, the mutual and recursive promotion between gaming and film should provide Implied Yinhan market value (MM) 3,570 significant positive synergy to Huayi. It’s very common in industry practices to make sequels Figure 17: Harry Potter’s film and game for both popular films and games. When a film and a game share one common theme, the interaction mutual and recursive promote between them can be expected: for example, good topic depicted in the film raises demand for the theme game, and the theme game leverages the theme of the topic to fill fans’ imagination, pushing the topic even hotter. Case: Harry Potter series are famous for the recomposing of film to the game. In the Harry Potter game, the players could control the character and explore the magic world, which serves as a perfect complement for the film. The Harry Potter series have been the most successful films series in the history, totaling over 7

CFA Institute Research Challenge November 29th, 2013 billion box office earnings. (Figure 17) Integration of TV drama series and music with film allows sharing of resources, and gives Huayi positive synergy. Under the horizontal integration of film with other forms of art, one single theme can be transformed into different chains of Huayi, maximizing the business value of the same theme. Case: Aftershock (Tang Shan Da Di Zhen) was initially a Feng Xiaogang film that was shown in 2010. As the poll reflected positive ticket revenue, Huayi recomposed the film to a TV drama series to be shown in major TV stations in 2013. Integration of travel with film has a huge potential with a downside protection Huayi has already launched its travel program in cities of Shanghai, Suzhou etc., and we believe this act provides both upside potential and downside protection, thus worth a high valuation. Traveling and film business can motivate each other, Huayi especially benefiting from strong contents. Disneyland and its animations being the best example, the tour site that is based on films can in turn promote value for the film themes, and at the same time make considerable profit through tickets and commercial estates. As one of the best content provider in China, Huayi is most possible to translate the contents into attractions in the tour sites, and consequently economical earnings. Huayi’s investment in tour sites has a solid downside protection from licensing of the contents, and no upside limit. Taking the Suzhou Film City as an example, Huayi has only acted as coinvestor in the project, and has an option to increase its share in the future. Plus, before the film city commenced its construction, Huayi could charge a license fee for using the copyrights of its content. Valuation Discount Cash Flow Method Enterprise Value The base priceImplied from thisEquity model Value is and RMB4 Share6.9 Price per share. With 1 year forward EBITDA of RMB Cumulative Present Value of FCF $3,483.5 1,087mm, which implies 52.4x EV/EBITDA FY1, in line with comparable companies. See Terminal Value appendix 9 for FCF calculation. Exit EBITDA $2,035.8 Exit Multiple (1Y Forward) 39.8x Five Year Projected Cash Flow Assumptions Terminal Value $80,941.3 Discount Factor 0.66 We start our projection at Sep. 30, 2013 to Dec. 2017. Five year EPS CAGR is estimated to be Present Value of Terminal Value $53,484.6 39.57% as a result of strong synergy realized from vertical and horizontal integration, safe % of Enterprise Value 93.9% Enterprise Value $56,968.1 margin and continued monetization on well-established competitive positioning. Revenue Projection Implied Equity Value and Share Price We identified 7 segmentsImplied Perpetuity for the purposeGrowth Rate of revenue projection, Film Production, Film Enterprise Value $56,968.1 Less: Total Debt (1,598.7) Distribution, TV Drama Production, Talent Management, Movie Theatres, Gaming and Less: Preferred Securities - Derivatives. Less: Noncontrolling Interest (3.7) Plus: Cash and Cash Equivalents 1,402.1 In projecting revenue from film production, we assumed a reasonable average film production

cycle of 2 years and built a film premier schedule (Appendix 10) to project number of films put Implied Equity Value $56,767.8 into marketplace per year. Subsequent segment revenue was the product of this number and Shares Outstanding 1,210 Implied Share Price $46.9 average box office result, estimated from prior Huayi movies growing at a conservative rate of 20% per annum (gradually moving down to 10% per annum). Implied EV/EBITDA Our film distribution revenue was taken as a percentage of film production revenue, basing on Enterprise Value $56,968.1 2014E EBITDA 1,086.8 our understanding that Huayi primarily distributes its own productions. The share of distribution Implied EV/EBITDA 52.4x revenue against production revenue reflects synergy realization achieved by production and distribution integration. Our TV drama production projection was based on a bottom-up approach, stemming from a conservative estimation of number of studios and equally conservative production rate estimation (as low as 1 production per studio per year). Average price per production projection was based on historical numbers and a reasonable 15% annual increase due to increasing competition among online video services and TV channels for broadcasting rights, bringing 8

CFA Institute Research Challenge November 29th, 2013 ever-high return for TV drama producers. Revenue from movie theatres was projected basing on a conservative estimation of new theatre addition rate and revenue realization schedule. Gaming revenue projection was based on consensus annual growth rate of 30% and an conservative additional 10% due to synergy realization from game development and Huayi’s ample content reserve that would not have been achieved if Yinhan remained a standalone entity. Since derivative revenue cannot be reasonably estimated, we safely assumed same annual growth as 2012. WACC We use the Chinese 10-year government bond risk-free rate of 4.5%, the expected market return of 11% and the adjusted beta of 0.9 to reflect the Cost of Equity of 10.4%. While the Cost of Debt is 4.8% from the company short term borrowing filings. Also we assume a constant capital structure of Huayi in the following years with a Debt to Total Company Value of 2%. Then we come to the Weighted Average Cost of Capital of 10.24% in the coming years for valuation purposes. Terminal Value Component Assumptions Implied Perpetuity Growth Rate Terminal Year Free Cash Flow $1,315.0 Since Huayi is in an ultra-high growth sector, its valuation enjoys stellar multiple (the EV/FY1 WACC 10.2% EBITDA we used in our model was 39.8x, the median EV/FY1 EBITDA from Huayi’s 10 closest Terminal Value $80,941.3 comparables) which resulted in terminal value taking ~90% of total enterprise value. We believe Implied Perpetuity Growth Rate 8.5% this is well justified as the implied perpetuity growth rate was a mere 8.5%. Financial Analysis Earnings Stable rise in revenue created by the vertical value chain: Movie production revenue is always the largest composition of the company’s revenue, 557.2 million RMB in 2012 and contributing 40.19% of total revenue. Surrounded by the movie production business growth rate of 20.3%, the movie distribution enjoys an increase rate of 79.8% to 55.7 million RMB in 2012, while revenue contributed by the movie theatres increased at 73.08% to 128.5 million in 2012. Gaming business enjoys the highest gross profit margin as a new growth engine: The gaming business has reached a gross profit margin of 92.31% and 94.62% respectively in the past two years, the highest one in all business segments. We believe the gaming industry would continue its rapid growth in the coming five years. Moderate ROE and ROA: Huayi Brothers return on asset reached 4.9% in December 2012, due to large assets generated by abundant cash. Balance Sheet Increasing capacity in short term liquidity: The stable decline trend in three short-term liquidity ratios indicate that Huayi is becoming increasingly capable of paying back its short-term liabilities with its short-term assets (Appendix 14). Aggressive CAPEX to fight in new business fields: The expansion into both vertical and horizontal film business chain cost Huayi Brothers high investment, implying high CAPEX. The capital expenditure was CNY￥156.8, 141.2 million in 2011 to 2012, respectively. We forecast the CAPEX would still maintain a stable growth rate in the coming five years. In the movie theatres investments, since 2010, the number of the newly constructed theatres increased by about five per year. CAPEX to develop them will be CNY￥40-50 million per theatre in 2012-15. Although we forecast aggressive CAPEX, CAPEX to sales ratio tend to be stable due to the rapid growth of sales correspondently. Risks Upside risk National policy reemphasis on accelerating development of the film industry The Third Plenary Session of the 18th Central Committee ended in late November this year reemphasis on accelerating development of the culture sector. In the past three years, the

CFA Institute Research Challenge November 29th, 2013 central government has released over ten policies to support and help the film industry to maintain the high growth rate. On the December 1st last year, three new policies are published. The government will subsidize domestically produced and distributed 3D, IMAX and high-tech films, based on box office revenue, refund policy for newly developed theaters and subsidize the installation of digital projection system - Theaters with a 45% or more box office gross revenue within the last year may also enjoy special subsidized refunds. We believe in the near future, national policy will become more and more leveraged to the support film industry. Huayi diversify this risk by making ongoing investments to keep paces with national trend. More common cross-board M&A stronger competitiveness in the international market As China’s economy becomes stronger, mergers and acquisitions are becoming the most effective way for Chinese companies to enter into and compete in the international market. Data show a total of $11.7 billion USD in foreign investment in 2012, which was a 4.5% decrease over the previous year. Huayi diversify this risk by relying on the fast growing China market to exploit the opportunity of international coinvestment and co-production, becoming the bridge to connect Chinese films with Hollywood as well as comprising pioneers in the international distribution of films produced in China. It has leveraged this advantage in international distribution to cultivate strategic alliances with distributors for foreign markets. Moviegoer numbers reach 470 million as audience tastes mature The total number of moviegoers reached 470 million in 2012, an increase in 27% over the previous year. Between 2007 and 2012, admissions peaked in 2009 and 2010, and were followed by a slowing in growth, which indicates market saturation. In 2012, the domestic slapstick comedy Lost in Thailand was the highest grossing film in China, with total admissions of over 35 million, well surpassing Hollywood blockbusters like “Avatar” and “Titanic 3D”. This is evidence that Chinese viewers are eager for high-quality domestically produced films. Films from a wide range of genres are now able to meet the needs of Chinese audiences and increase box office revenue. Huayi respond to this trend by building up a film library to obtain sustainable revenue. Downside risk Increasing reliance on in-house production adds to business volatility The company has increased its presence in film investment and production, which adds inherent risks to the business. However, Huayi Brothers has a “portfolio” approach to film production, diversifying film investment across genres and reducing economic interest through “film participation”. The company diversifies its capitalat-risk in film investment by syndicating film investment to other investors while trying to keep its stake not more than 50% of the total investment amount. Revenue concentration—Top 5 films comprised over 70% of revenue in 2009 Top 5 films accounted for more than 70% of revenue from the 16 films distributed by the company in 2009. However, as the company continues to seek an overall higher-quality movie portfolio, we expect revenue concentration to be lowered. Potential change in the supportive regulatory landscape Apart from the consensus optimistic view on the national policy in culture industry, overall the government is supportive of the film industry development in China. However, if the government reduces tax breaks or becomes more vigilant on film content, the profitability of the company could be affected. Departure of key management likely to affect distribution and production Film distribution and production business are highly human-centric. The top management of the company significantly uses its influence and reputation to source distribution rights as well as source quality artists for the films it produces. The departure of key management may also affect the execution capabilities of the company, in our view. 10

CFA Institute Research Challenge November 29th, 2013 Appendices

Appendix 1

China’s cultural consumption Film revenue accounts for less than 3% in cultural industry Chinese culural expenditure, 2012

Publishing and printing Tourism Gaming Film

2% 1%

36%

61%