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Equity Research / Company Analysis Company / Research Equity Co., Ltd. (SHSE:600690) November 27 2015

Qingdao Haier: The Falling Angel Consumer Discretionary | Household Appliances

Initiating Coverage – SELL

Investment Highlights: Market Data (as of 27 Nov, 2015)  : Haier’s Leading Position Challenged Current Price (CNY) 9.92

We believe that Midea and Little Swan will surpass Haier to Target Price (CNY) 9.11 become the top player in the washing machine sector, as they have % Decrease -8.2% developed a full spectrum of models that can better meet market Rating Sell demands (by double-branding strategies and focus on product 52 Week Range (CNY) 8.61~32.20 quality since 2013) Market Cap (CNY m) 60,742  Air Conditioner: Price War is Stealing Haier’s Market Share Shares Outstanding (m) 6,123 Due to mistaken strategy, Haier didn’t participate in the recent price

war in air conditioner sector, leading to a severe market share loss. Market share, as the single most important driver in the sector, is rather hard to take back even if Haier fights a price war in the future  Air Conditioner: Haier’s Weak Position in Central Air Conditioner Drags the Whole Segment Down Price Performance (LTM) We estimate the market size of central air conditioner in China to Qingdao Haier (LHS) SSECI (RHS) grow at a 16.3% CAGR to CNY 150bn by 2019, becoming the 18 6000 major source of growth. Despite overall market growth, Haier is 15 5000 losing this pie, owing to the weak technological position

12 4000 Valuations: 9 3000  We initiate a SELL rating on Qingdao Haier with a target price 6 2000 of CNY 9.11. We use DCF and comparable company approaches to derive our target price, with the belief that Haier’s washing machine and air conditioner will miss market expectations Upside Risks:  Real Estate: Stronger than expected growth in sales volume of Chinese real estate market, on which white goods are highly dependent  Product Upgrade: Demand for product upgrade explodes, bringing forth huge growth for Casarte; Haier’s excessive return from its smart appliance portfolio  Mergers and Acquisitions: the overseas assets owned by Haier Group (parent company of Qingdao Haier) may be injected into Qingdao Haier in the future and thus increase the its EPS

1 Figure 1 Haier’s Business Structure 1. Business Description

1.1. Introduction: the World’s Largest White Good Manufacturer Established by reorganizing the Qingdao Factory in 1989, Qingdao Haier is the world’s largest manufacturer by retail volume. According to China IOL, Haier's and washing machines ranked #1 in global market shares in 2014 (17%/14.4% by volume). In the domestic market, it Source: Company Website has a share of 24%/27% in refrigerator and washing machine by volume, according to CMM. With multi- lines, sales reached CNY 89bn in 2014, Figure 2 Revenue Breakdown by growing at 2.5% YoY, and net income rose to CNY 6.7bn with a 20.4% YoY. Geographies However, besides growth driven by ongoing urbanization, Haier’s washing

100% machine and refrigerator sales growth have lagged behind Midea in recent years. 10% 11% 11% 11% 12% 12% 80% Haier has an excellent operational track record, with revenue and net income 60% growing at 23%/20% CAGRs over the past 15 years, but growth has been 40% 90% 89% 89% 89% 88% 88% slowing down (even negative in LTM). Its 3Q15 results have painted a picture of 20% the trends of the business - sales declined by 11.0%, net income declined by 0% 2010 2011 2012 2013 2014 LTM 17.0%, both the largest declines ever seen. This sets the tone of our report. China Others 1.2. Business Segments: Multiple Product Lines and Source: Company Filings Haier’s business is divided into 6 segments: Refrigerator, Air-conditioner,

Washing Machine, Water Heater, Equipment and Integrated Channel Services. Figure 3 Haier’s Brands It owns a 51.2% stake in Haier Electronics (1169.HK), which contributed 76%/45% of the sales/EBIT in 2014. Haier Electronics’ business includes WM High-end and WH, as well as ICS, which caters to distribution of home appliances for Haier brand and third party brands, logistics for big-item products, and e-commerce.

Mid-end Haier has adopted a multi-brand strategy, with high-end brands of Casarte and Fisher & Paykel (not consolidated), a mid-end brand of Haier and mass-market brand of Leader. “Haier” brand dominates 95% of the company’s home appliance sales in FY2014. As part of its high-end strategy, Haier established a team to run Low-end Casarte in 2H2014, hence boosting brand sales up by 40%/40% in 4Q14/1H15.

1.2.1. Refrigerator Source: Company Website As the largest business sector through which Haier rose to prominence, Figure 4 Sales from Refrigerator refrigerator makes up 28% of revenue in FY2014. Haier led the refrigerator market, which Euromonitor expects to grow at 3% volume CAGR over CNY bn 26.0 25.0 25.2 25.3 24.7 2015-2019, with a volume share of 26% (from CMM) in 2014. 24.0 However, refrigerator sales declined by 5.9% YoY in 1H2015, while market was 24.0 22.8 down by 2.1%. Moreover, sales from refrigerator have barely grown since 2011. 22.0 2010 2011 2012 2013 2014 LTM 1.2.2. Washing Machine

Washing machine makes up 17% of revenue in FY2014. As a leader in the Figure 5 Sales from Washing Machine washing machine market, Haier shares 27% ofvolume in 2014. Faced with heavy CNY bn 15.3 15.6 competitions from Midea and Little Swan, Haier has lost 5.3% of washing 16.0 14.2 13.3 machine market share since 2012, with growth slowing down in 3Q2015. 14.0 12.2 11.5 1.2.3. Air-conditioner 12.0 10.0 Haier is the third-largest air conditioner manufacturer in China, with a market 2010 2011 2012 2013 2014 LTM share of 12% by volume in 2014. While air conditioner makes up 23% of revenue in FY2014, it has a high penetration in the 3rd and 4th tier markets, with 1,200 air conditioner specialty stores and 18,000 county stores. Despite growth during 2 Figure 6 Sales from Air-conditioner FY2010-2014, its air conditioner sales fell by 18.8% YoY in 1H2015.

CNY bn 1.2.4. Integrated Channel Services 22.0 20.0 17.9 17.8 Under Haier Electronics, the fast-growing ICS business (4-year CAGR of 26.1%) 18.0 14.8 12.1 serves as the distribution/logistics network in lower tier cities by offering one-stop 14.0 11.4 supply chain services to Haier brands and third party brands. 10.0 2010 2011 2012 2013 2014 LTM In 2013, Haier Electronics reached alliance with Alibaba to strengthen logistics cooperation with e-commerce platform Tmall. This can be a potential source of Figure 7 Sales from ICS growth, but logistics sales from Tmall are still small, accounting for 1% of total CNY bn 18.0 revenue. Further considering the low margin nature of the logistic business (4.8% 20.0 17.4 17.0 12.6 GPM in 1H2015), we are not optimistic about its effect on Haier’s bottom line. 15.0 11.5 6.9 10.0 2. Management and Governance 5.0 2010 2011 2012 2013 2014 LTM Haier has a dedicated management team that has been continuously driving the Source: Company Filings company’s success. Being with Haier for >30 years, Zhang has turned the small factory with a loss of CNY 1.5m into the world’s leading white good manufacturer. Zhang is one of the most charismatic leaders in China. He received the "Ideas Figure 8 Revenue Breakdown by into Practice" award and was selected into the 2015 Thinkers50 ranking. Known Product Lines as the "Oscars of Management Thinking", the Thinkers50 rankings are admired

100% 11% 16% 16% 21% 20% 20% globally for its objectivity, and have recognized Zhang of his management 13% 80% 11% 9% 7% 5% 3% 5% 5% 6% 5% 7% 8% methods. Obsessed with the belief in high-value products, Zhang insists Haier 60% 18% 17% 17% 17% 17% 19% 18% 40% 17% 19% 21% 23% 21% always adhere to the "only value of war, not price war" principle. While we 20% respect his belief, we deem such strategy as a potential risk, given the 36% 34% 32% 30% 28% 29% 0% increasingly competitive market. In particular, the sector is one in which 2010 2011 2012 2013 2014 LTM RF AC WM WH EQ ICS customers have homogeneous demands, and are price sensitive. Being Source: Company Filings excessively tenacious of " high-end market" can pose threat when it shows sign of losing to low-end markets. Haier delivers best practices in corporate governance. The company was Figure 9 Residential real estate Sales awarded the Best Internal Governance Award by National Business Daily, and msm % Annual Information Disclosure Award by Shanghai Stock Exchange. In addition, 1,500 100 we evaluated Haier’s quality of governance in three main facets: 1,000 50  Committees - Established Audit, Risk, Compensation, Nomination and 500 0 Governance Committees to oversee company operations. 0 -50 2006 2008 2010 2012 2015  Shareholder Rights - Ensures shareholders enjoy equal rights; decisions YTD Residential Gross Floor Area Sold (LHS) regarding equity incentive plan, director appointments, and share YoY repurchase are made based on the results of open voting. Source: National Bureau of Statistics (PRC)  Fairness - Hired lawyers with securities qualification to attend the shareholders' meeting to witness. Figure 10 Number of married couples 3. Industry Overview and Competitive Positioning mn % 20 20 3.1. Key-drivers are trending down, the growth potential is limited

10 0 The residential real estate sector is a key driver for the white goods industry, as people almost always purchase new appliances when they move into a new 0 -20

apartment. Driven by the relaxation of property control, we see a recent pick-up

1993 1996 1999 2002 2005 2008 2011 2014 1990 in the property market, which underperformed in 2014. We believe this is a short Number of marriaged couple (LHS) term factor and the property market is expected to keep slowing down in the Source: National Bureau of Statistics future, driven by the descending growth rate of real estate investment amount.

3 Figure 11 Market Size of refrigerator Besides, new married couples are a huge source of demand, as they have higher sector (Sales Value) tendency to purchase a new set when they start to live together. According to 85.7 87.6 86.4 100 77.8 80.5 40% Euromonitor, newly registered married couples peaked at 13.5mm in 2013, 69.6 75 65.0 20% and recorded a YoY growth of -3.0% in 2014. This signals the demographic 50 0% change, which will eventually result in a growth friction to white goods. 25 0 -20% 3.2. Business Segment Overview 2009 2010 2011 2012 2013 2014 2015 Oct 3.2.1. Refrigerator Sector RF Amount (CMM, CNY bn) YoY According to CMM, retail sales of refrigeration appliances in China encountered a Source: CMM further decrease of -9.57% (sales volume) in 2014, reaching only 31.3 million Figure 12 Market Shares in refrigerator units. Weaker demand is due to the end of government subsidy policy, sector (Sales Value, 2015 Sep) consumer’s sluggish demand and the slowing down of real estate market. 2.35% 4.33% 1.14% 9.94% 27.02% We believe the refrigerator sector has become mature, as the sales volume only achieves 5 years CAGR of 1.40%. Looking forward, the industry is driven by 8.00% replacement demand from existing owners, with their better living standards and rising disposable incomes. As the penetration of refrigeration is high in both 9.76% 12.01% Haier Midea Meiling urban and rural regions, the Subsidy Policy in 2009-2012 has already exhausted Rongsheng Frestec Homa Source: CMM the future demands. Given the weak performance of real estate market, we Figure 13 Expected growth rate in project a 3% CAGR for the market size of refrigerators over next 5 years. washing machine sector from 2015-2020 Within the competitive landscape, Haier retained its leading position in 5.00% refrigerator sector with a steady market share of 27-30% (sales value), thanks to well-known brand reputation, as well as innovative new launches, while Siemens, 4.40% 4.00% CAGR=3.6% 4.20% Midea and Meiling remain the second-tier in the refrigerator sector, accounting 3.80% 3.00% 3.50% for 12.01%, 9.76% and 8.00% market shares respectively. 3.10% 2.80% 3.2.2. Washing Machine Sector 2.00% 2015E 2016E 2017E 2018E 2019E 2020E In 2014, the volume growth rate of washing machine is 0.8%, while sales growth Source: CMM, EUROMONITOR rate is 3.6%. The moderate growth rate in sales is driven by consumer’s desire for product upgrade, which leads to increasing ASP in washing machine. Figure 14 Market Shares in washing Overall, the washing machine penetration rate has reached 76%. Penetration machine sector (Sales Value, 2015 Sep) rate is 98% in urban area and 53% in rural area. A huge part of demand in rural 5.02%1.47% 6.06% 26.53% area is overdrawn by previous subsidies policy. In future, replacement demand 13.67% driven by product upgrade in urban area and new purchase demand in rural area driven by urbanization rate will be the key driver for washing machines. Real 6.58% 7.78% 20.60% estate sales will be a weak driver, but not as strong as it used to be. Haier Midea & Little Swan In the future, there are mainly two trends in the industry: firstly, more diversified Siemens LG products/SKUs are needed to meet the demand of consumer. Secondly, Whirlpool Samsung online sale is growing rapidly and has become a key driver. Online sales Source: CMM have substitution effect for offline sales, but contributes positive outcome for the Figure 15 Domestic air conditioner whole industry. While low and middle end products are popular in online sales, market size (Sales Value) the low and middle end products are expected to take up more market share. 180 145 139 40% As for the competitive landscape, market concentration is high in washing 150 120 109 120 104 machine sector. Competition in top 10 brands is fierce. High-end foreign brands, 77 83 20% 90 such as Siemens and Samsung, enjoy a high market presence in tier-1/2 cities 60 0% and are well-known for their high quality, but they have huge disadvantages in 30 0 -20% distribution networks. They are taking market shares from domestic brands, 2008 2009 2010 2011 2012 2013 2014 leveraging online sales channel. We will see market shares of Siemens and AC Amount (CMM, CNY bn) YoY Samsung continue to increase, while Sanyo and Panasonic to decrease. Source: CMM 4 Midea and Littleswan has become No.1 in sales volume and have shortened

Figure 16 Competitive landscape in air the difference in sales value. conditioner (Sales Value, 2015 Sep) 3.2.3. Air Conditioner Sector

16.7% 31.0% The residential air conditioner market in China has grown at a CAGR of 13% from 8.0% 2009 to 2014. The sector growth is expected to slow but should remain at no less 3.1% 4.1% than mid-single-digit in the coming 3-5 years as urbanization in China continues.

12.2% 25.0% In 2014, urbanization rate in China was 55%, compared with over 80% in most Gree Midea Haier developed countries. However, the industry is suffering from excess inventory Aux Group Chigo Hisense Kelong Others due to the cold summer in 2015 and weaker channel management, resulting in Source: CMM higher channel inventory. Inventory is expected to be cleared by mid-2016. In terms of penetration, China currently averages >120 air conditioner per 100 Figure 17 Ownership in urban regions urban households, compared with >200 in most developed countries. In rural (per 100 households) areas in China, there are only 25 air conditioners per 100 households. Rural 100 households are likely to purchase air conditioners given the fast-improving living

50 standards. Moreover, Chinese households are used to installing air conditioners in every room, further increasing the penetration rate for air conditioners. 0 Replacement demand, which accounts for 41% of total demand, will also be

Air Conditioner Washing Machine resilient. According to Euromonitor, the replacement cycle for air conditioners is 6 Refrigerator years, comparing to 10 years and 11 years in refrigerators and washing Source: National Bureau of Statistics machines. So, the replacement demand is stronger in the air conditioner sector.

In terms of competitive landscape, the air conditioner sector is rather Figure 18 Ownership in rural regions concentrated, with top 3 players (Gree, Midea and Haier) taking ~70% of the (per 100 households) market. Gree is the dominant brand, with the lion's share of value at 31%. Haier 200 is ranked no.3, with a share of 12%. The competitions in the air conditioner

100 sector, as we believe, will become fiercer, because smaller players are aggressively employing a strategy to catch customers’ needs. Also, in order to 0 meet consumers’ needs for energy conservation and environment protection,

Washing Machine Refrigerator energy-saving products become the focus of new product development. Air Conditioner 3.3. Air conditioner sector becomes the next driving force Source: National Bureau of Statistics Limited space for further penetration in refrigerator and washing machine

sectors, yet air conditioner sector becomes the next driving force. Figure 19 Ownership in different dimension (per 100 households, 2013) In the past 14 years, market penetration rates have been primarily driven by the growth of rural regions, as well as the air conditioner sector in urban regions. We 300 believe that the Rural Subsidy Policy in 2009-2012 has already exhausted the 200 future incremental demands for refrigerators and washing machines in China’s

100 rural regions. In 2013, ownership per household for refrigerator and washing machine in urban areas reached 80% and 91% of Japan’s level, which 0 represents the level for mature markets. Meanwhile, the air conditioner sector lags behind and there remains plenty of space for future penetration. Specifically, the ownerships of refrigerator, washing machine and air conditioner Air Conditioner Refrigerator Washing Machine in first-tier provinces have been on the verge of Japan’s level, so we expect the Source: National Bureau of Statistics majority of future demands will be mainly from low-to-mid-end market. With the downtrend in real estate cycle and transformation of demand structure (from penetration to replacement), the white goods industry is shifting from “golden period” to “mature period”. Going forward, the industry will experience more intense competitive landscape and diminishing sale effect.

5 Figure 20 Market shares according to 4. Investment Summary sales amount 4.1. Washing Machines: Haier’s Leading Position is threaten 40%

30% 4.1.1. Low end markets: challenged by Media & Littleswan

20% In washing machine sector, Haier is losing market share significantly

10% (value:-3.4%; volume: -5.3%) since 2012, while Midea & Littleswan have gained total market shares of 3.37% from 17.23% in 2012 to 20.60% in 2015 (YTD, in 0% 2011 2012 2013 2014 2015(Sep) sales value, 19.73% to 24.65% for sales volume). Haier has two star models in Haier Midea & Little Swan Panasonic SANYO low-end market: M1268/M1269 series ranging from 899 to 1198 and Siemens Z2WH/M2WH series ranging from 999 to 1599, but it seems that these two Source: CMM, THOMSON ONE models are not enough to meet the demand of picky clients. Littleswan covers

898-1098, 898-1298, 998-1498, 1298-1698 with 4 models. Midea covers Figure 21 Market shares according to 749-998,798, 1298-1698 with 3 models. These are all very popular models in sales volume low-end market and provide customers with more options. Haier’s market 40% position is challenged by model sea strategy and double branding strategy of 30% M&L. We believe the passive situation for Haier in low-end market will continue 20% unless Haier puts more models into the market. 10%

0% Table 1 Low end models for Haier, Midea & Littleswam 2011 2012 2013 2014 2015(Sep) Brand Haier Haier Midea Midea Midea Littleswan Littleswan Littleswan Littleswan Haier Midea & Little Swan Model M1268/9 Z/M2WH V1010H V3006G Eco11W V1068 8168H V1059/(H) easy60W Panasonic SANYO Capacity (L) 5.5-7 6-8 5.5-7 5.5 6.5-8 5.5-7.3 5.5-7.5 6-8 6.5-8 Price 899 999 749 798 1298 898 898 998 1298 Range 1198 1599 998 798 1698 1098 1298 1498 1698 Source: CMM, THOMSON ONE Source: CMM, EUROMONITOR, THOMSON ONE, company filings

Figure 22 Forbes’ Mass affluent class 4.1.2. Limited high end market for Casarte population Total white goods consumption is CNY 304.5 billion, which is 0.93% of total national consumption CNY 32,831 billion. Based on these numbers, we assume 20.0 20% 16.2% 16.6% 15.3 1% of income will be used on buying white goods. The lowest selling price for 16.0 15.9% 16% 12.0 13.9 Casarte seires is CNY 5,000, indicating only household with annual income 11.2% 10.3 12.0 10.1% 12% 500,000+ will consider buying Casarte. 8.8 8.0 8% According to CHFS (Chinese Household Financial Survey), for the richest 1% 4.0 4% households (4.3 million households), their average annual income is CNY 0.0 0% 494,322, very close to CNY 500,000. Assuming that 100% of them are buying 2011 2012 2013 2014 2015 Casarte, implied annual average sales for Casarte is CNY 21.5 billion. Mass affluent class Growth rate

According to Forbes China, the growth rate of mass affluent class (invesFigure Source: Forbes China funds more than CNY 600,000) has already dropped to 10%, which is still much

higher than GDP growth rate + CPI. Based on the estimation above, we believe Figure 23 Number average selling price that growth rate for Casarte will drop to 10% or even lower in 3 years. for air-conditioner players (2015) 4.2. Air Conditioner: Price War is Stealing Haier’s Market Share Mar Apr May Jun Jul Aug Sep 0% 4.2.1. Major players in white goods sector have started fierce price war -0.50% -0.20% -1.60% Since 2015H1, major players including Gree and Media started a price war, -4% -1.90% lowering their ASP so as to quickly clear their inventories. In the meantime, the -5.20% -5.10% discounts and promotions also helped them boost market shares and expand -8% distribution channels, which are the key success factors for a manufacturer in a saturated market like white goods. -12% -10.40% Total Gree 4.2.2. Market share remains the key to win Midea Haier In such a matured market with volume steadily growing at 3.1% CAGR since Source: CMM 2011, manufacturers’ revenue and net income growths are mainly driven by their

6 Figure 24 Market share has dropped market shares, due to the following three reasons: 2.53% since 2015 Feb Branding effect and consumer behavior - With its market share losing in the 13% 12.93% losing 2.53% market price war and the lack of effective marketing, Haier’s air conditioner business is 12.26% 12.05% 11.81% severely suffering from “brand crises” stirred by losing market share. 12% 11.49% 10.97% Control over distributors - With a larger market share, a manufacturer can 10.74% 11% 10.58% effectively lift inventory turnover rate, which can either attract more distributors or have the power to lower rebates, both help with the company’s overall 10% profitability. Take Gree as an example, thanks to the largest market share, they 9% are capable of returning 5~6 bps without upfront discounts to distributors. Economies of scale - Large-share manufacturer benefit from lower raw material

prices, efficient management model and usage of fixed costs, and broader labor Source: CMM, EUROMONITOR educations, hence enjoying a lower per unit cost of goods sold.

Figure 25 Haier’s lower than expected 4.2.3. Haier’s strategy will push it to the dead end air conditioner revenue in 2015H1 Haier’s management follows a long standing strategy of not participating in price wars of any kind. As its CEO, Zhang Ruimin, once publicly stated, “Haier has 0.00% Haier Industry always insisted on not participating in price wars, but only value wars”. In the air -5.00% -4.68% conditioner sector, Haier lost 1.67% share during the first 8 months of 2015, -10.00% whilst that of Gree surged by 8.96%. This has led to its underperformance in

-15.00% 2015, and greatly damaged its shareholder value, no matter how Zhang applauds their strategy of protecting the margin. -20.00% -18.77% In the air conditioner market, the lost market share is hard to grasp back for Source: Company Filings Haier, due to the following two reasons:

- “Value and services” mindset - Haier insists on not participating in price Figure 26 China air conditioner market war, as they are committed to providing “value and services” to customers. size (CNY bn) - “Zero-inventory” business model - Without any inventory in advance, it is hard for Haier to quickly boost outputs to take part in price wars. Evidence 120 139 145 120 has shown that in the latest quarter, after major price reduction in March and 109 70 104 April, Haier has been gradually recovering its price since June. The little 83 77 71 58 59 64 discount in the peak season in July is resulted from a lack of capability to 20 45 34 34 produce more air conditioners within such short-term. 2009 2010 2011 2012 2013 2014 Based upon our analysis, we believe Haier’s mistaken strategy made itself losing Central AC Residential AC market share in air-conditioner, which is quite hard to gain back. Source: CMM, THOMSON ONE 4.3. Air Conditioner: Weak position in central air conditioner drags the segment down Figure 27 Central air conditioner market 4.3.1. Central air conditioner market is the future focus of growth share The central air conditioner market is a higher growing and more fragmented

Others Gree sector comparing to residential air conditioner, with multiple foreign players such 26% 18% as Dakin and York taking large shares due to the higher entry barrier, having grown at a CAGR of 15.7% from 2009 to 2014. Due to higher complexity and Midea Trane 13% 3% stability requirements, central air conditioner sector also has a higher gross Haier 4% margin (30-40%), compared with residential air conditioner’s 15%-30%. Carrier 4% Dakin McQuay Hisense 13% In 2014, the central air conditioner market size in China was CNY71bn, York 5% 6% 8% compared with the residential air conditioner market of CNY145bn. Central air conditioner will continue to grow quickly in coming years as China is on its way to Source: Euromonitor, THOMSON ONE roll out more infrastructure projects and commercial facilities to maintain its GDP

growth and these will be the main drivers for central air conditioner demand. 7 Figure 28 Domestic central air Applying the average “area of commercial construction completed / central conditioner market share market size” multiple, which historically ranges from 2.0-2.2x, we estimate the market size of central air conditioner in China will grow to CNY150.1bn by 2019, 44% 55% 53% 50% 47% 65% 62% 61% 57% implying a CAGR of 16.3% vs.7.1% for residential air conditioner by Euromonitor. 4% 3% 4% 2% 4% 4.3.2. Despite market growth, Haier is losing this pie, now and forever 3% 3% 13% 5% 5% 14% 14% 17% 17% 14% 15% 16% 11% 12% 13% There is a clear trend of domestic manufacturers taking shares from foreign 16% 11% 10% 9% 9% 7% 9% 14% 16% 17% 18% 5% 6% 7% 10% 11% players, as the quality of domestic products have been improving to reach the international standard. Gree, by surpassing Daikin in central air conditioner

Gree Midea Dakin market in China in 2012, takes the largest share, driven by its strong brand and Hisense Hitachi Haier Others quality products. Midea, on the other hand, surpassed Daikin as well in the Source: Euromonitor, THOMSON ONE 1H2015, becoming the second player. By contrast, as the first to enter the

market, Haier (1996) has been thrown far off by Gree (2003) and Midea (2002). Figure 29 Selected technological The main engines of central air conditioner systems is the technical barrier for advance of competitors most domestic players, thus the “Big 4”, McQuay, Trane, Carrier and York control Selected technological advance 70% of the world’s central air conditioner market. In recent years, investing 2015 Gree’s million-kilowatt centrifugal chiller broke foreign monopoly 2012 Midea and Carrier agreed to form JV in India heavily in technology have made Gree and Midea’s counterattacks against the 2011 Midea introduced full DC inverter air conditioner, with energy efficiency up to 5.7 2011 Gree launched the world’s first super high efficiency centrifugal chiller foreign players very successful. Yet, we do not see Haier making a move. 2010 Midea rolled out the first three-control air conditioner 2009 Midea introduced Carrier’s DC inverter to best-selling model MDV4+ The lost market share will further weaken Haier’s future market position in 2008 Gree developed DC inverter air conditioner, breaking JPN’s tech monopoly 2005 Gree developed world's first ultra-low temperature digital air conditioner air-conditioner sector, and as with the negative impact on the potential revenue 2002 Gree developed GMV digital multi-connected air conditioner Source: Company Filings growth in the air-conditioner market, which is the largest white-good market.

5. Valuation Table 2 FCFF Prediction (CNY FY FY FY million) 2015E 2016E 2017E Target Price: CNY 9.11/Share Recommendation: Sell EBIT 4,980 4,458 4,203 -Tax -866 -776 -731 We value Haier based on discounted cash flow analysis and multiples of + D&A 1,164 1,119 1,128 comparable firms. DCF incorporates our key assumptions, including slow -△WC -737 -90 -38 -Capex -2,527 -2,665 -2,802 growing industry, declining market share, improving gross margin and increasing FCFF 2,014 2,047 1,759 (CNY FY FY FY selling expense. Public company multiples reflect the current market’s opinions of million) 2018E 2019E 2020E future growth of similar companies. EBIT 4,370 4,952 6,025 -Tax -760 -862 - ,048 5.1. DCF Analysis + D&A 1,274 1,428 1,589 -△WC 52 134 233 In DCF analysis, we make detailed income statement and cash flow projections -Capex -2,970 -3,150 -3,319 FCFF 1,967 2,502 3,480 until 2020, and then we apply the perpetual growth to compute its terminal value.

Table 3 WACC We calculate the implied EV/EBITDA multiple and benchmark with comparable companies to justify our assumptions. FCFF predictions are shown in Table 2. WACC Rf 3.0% Key assumptions and key considerations include (For detailed assumption, Rm 6.5% Beta 1.03 please refer to Appendix 2 DCF Valuation Assumptions): Rd 4.9% Revenue: Estimated by breaking down Haier’s business into different business D/(E+D) 10% Tax Rate 17.0% lines. The change of market share is in line with our prior analysis on WACC 9.2% Haier’s competitive positioning in air conditioner and washing machine

sectors. Casarte’s sales is estimated separately to evaluate its impact. Table 4 Target Price (CNY million) Gross Margin: A slight increase due to Casarte’s growth and KKR’s participation PV of FCF 10,885.48 PV of TV 31,999.66 Operating Margin: Selling expense as a percentage of revenue increases to Enterprise Value 42,885.14 open market for Carsarte. General and administration expense is assumed to be TV as a % of EV 75% - Minority Interest -9,165.27 7% of revenue, in line with historical proportion. - Totel Debt -2,188.57 +Excess Cash 24,257.10 CAPEX and Operating Working Capital: The percentages of revenue are the Equity Value 55,788.40 Outstanding Shares 6,123.15 same as historical average level. Target Price: 9.11 Terminal Value: We incorporate a 2% terminal growth rate, implying an exit 8 Upside/Downside -8% EV/EBITDA of 8.4x. Upside/Downside After adjustment -14% WACC: shown as Table 3. Risk free rate comes from YTM of 10 year government

bond. Beta comes from the historical performance of Qingdao Haier’s stock Table 5 Sensitivity Analysis relative to SHSZ market index. 5.2. Comparable Valuation Using Multiples Although there are many players in the white goods industry, there are a few with similar size and comparable market position as Haier’s. Therefore, we exclude small players with revenues less than CNY 10bn. The multiples for comparable companies are as below:

Table 6 Selected Comparable Multiples Company Mkt cap EV P/E(X) P/SALES (X) Name (CNY mn) (CNY mn) 15E 16E 15E 16E A-Share Listed

Media Group 120,208 145,691 9.7x 8.3x 0.8x 0.8x Gree 111,832 49,775 8.0x 7.2x 0.9x 0.9x Hisense 22,506 21,526 15.5x 13.9x 0.7x 0.7x 9,678 12,294 23.0x 17.8x 0.4x 0.4x Little Swan 12,686 11,142 13.8x 11.3x 1.0x 0.8x Meiling 5,432 6,078 17.2x 15.0x 0.5x 0.5x Mean 15.1x 13.3x 0.7x 0.8x

Haier (Adj.) 64,994 64,247 14.0x 12.0x 0.8x 0.7x Haier 60,742 59,995 13.1x 11.3x 0.7x 0.6x When applying our estimates of Net Income and Sales for FY2015 and FY 2016 to trading multiples, we conclude with a valuation range of CNY 5.8-12.5 /Share. 5.3. Target Price Our target price is 9.11 CNY/Share, which combines comprehensive valuation methods we have discussed above. Valuation ranges given by different assumptions as shown in the sensitivity analysis in Figure 33.

Figure 30 Residential real estate sales 6. Investment Risks and white good sales 100 6.1. Economics Risks 50 0 As we can see from Figure 30, residential real estate sales act as a strong -50 leading driver of white goods sales (approximately leading by 3 months). If there 2007 2009 2011 2013 2015 YTD Residential real estate Sales (YoY%) is a stronger-than-expected growth in sales volume of Chinese real estate YTD China White Goods Sales (YoY%) market, it might induce an increasing incremental demand of white goods and thus provides augmented spaces for Haier to achieve revenue growth. Source: National Bureau of Statistics 6.2. Market Risks

Management of Haier may react to the competition rapidly, by focusing more Figure 31 Scenario Analysis on the low-to-middle-end market, thus the market share of Haier may fall less 9.8 9.66 significantly. The revenue growth of Caserte may be faster than expectation. 0.11 9.3 9.11 0.28 0.31 6.3. Merger and acquisition 8.8 0.26 0.16 8.54 The parent company of Qingdao Haier, Haier Group, has acquired overseas 8.3 white goods assets, boosting the valuation. 7.8 6.4. Scenario Analysis In order to check the robustness of DCF model, we conduct a scenario analysis by setting up three upside scenario and two down side scenarios as Figure 31. By incorporating all these factors, we can achieve the adjusted price range. The estimated price in the bull-case scenario is still lower than the current

9 market (CNY 9.92) and adjusted current market price (CNY 10.61). Therefore, we reaffirm our sell recommendation on Qingdao Haier. Table 7 Financials 7. Financial Analysis History Forecast Financial Analysis 2013A 2014A 2015E 2016E Profitability 7.1.1. Consumption Upgrade Gross Margin 23.6% 25.2% 25.3% 27.5% EBITDA Margin 7.6% 7.8% 4.5% 3.8% Consumption upgrade in China is key driver for increasing gross margin, as a EBIT Margin 6.6% 7.6% 8.6% 5.9% Net Margin 6.4% 7.5% 5.4% 4.6% result of higher per capita disposable income in both urban and rural areas. This Return on Assets 11.8% 11.2% 6.7% 5.9% trend has experienced rapid development during 14-15, which also contributed to Return on Equity 57.8% 44.8% 27.8% 24.5% Liquidity the raise in unit prices. With the accelerated pace of life, home appliances with Current Ratio 1.30 1.43 1.54 1.56 Quick Ratio 0.86 0.87 0.88 0.87 stronger capacity and more functionalities are gaining increasing popularity. Cash Ratio 0.54 0.69 0.79 0.79 Operation 7.1.2. Increasing Market Competition Days Reiceivable Outstdg. 18.2 21.8 19.7 19.7 Days Sales of Inventory 39.0 42.9 41.8 41.8 We will see major players continue to gain markets share from minor players. Total Assets Turnover 0.7 0.8 0.9 0.9 Financial Leverage Home appliance is a traditional manufacturing industry where there is a strong Liability to Equity 2.05 1.58 1.24 1.18 effect of scale of economy. Larger market shares represent lower cost of goods Asset to Equity 3.05 2.58 2.24 2.18 Interest Coverage 62.1 59.3 67.1 82.5 and higher supply chain bargaining power. Based on our analysis, Haier is losing market shares in both air conditioner and washing machine markets, thus we will Table 8 Financials (Cont’d) see a decrease in its EBITDA margin and net profits. This is mainly due to higher

Forecast R&D expense and commission fee to promote high end products. We expected 2017E 2018E 2019E 2020E EBITDA margin drop to 3.1% in 2018E from 4.5% in 2015E and then rebound to Profitability Gross Margin 27.4% 27.5% 27.5% 27.4% 4% in 2020E driven by larger contribution from high profits Casarte products. EBITDA Margin 3.3% 3.1% 3.4% 4.0% EBIT Margin 5.0% 4.5% 4.4% 4.7% 7.1.3. Stable Operation Net Margin 4.2% 4.1% 4.4% 5.0% Return on Assets 5.3% 5.2% 5.6% 6.4% Haier is experiencing organizational transformation towards a flatter Return on Equity 22.8% 23.1% 24.7% 27.7% Liquidity management structure. However, KKR is helping on cost saving projects. In Current Ratio 1.53 1.53 1.53 1.55 Quick Ratio 0.87 0.87 0.87 0.87 general, the operations will maintain stable, and historical data is also supporting Cash Ratio 0.76 0.75 0.74 0.75 this statement. We expect days of receivable outstanding, of sales of inventories, Operation Days Reiceivable Outstdg. 19.7 19.7 19.7 19.7 and total assets turnover to keep at 21.8 days, 42.9 days and 0.87. Days Sales of Inventory 41.8 41.8 41.8 41.8 Total Assets Turnover 0.9 0.9 0.9 0.9 7.1.4. Cash cow Financial Leverage Liability to Equity 1.10 1.07 1.04 1.01 Haier’s business is generating strong cash flow, despite deteriorating profitability. Asset to Equity 2.10 2.07 2.04 2.01 Interest Coverage 77.8 195.4 221.4 269.3 The CFO is enough to cover capital expenditure, increase in net working capital, Shareholder as well as investment activities. And it is also contributing to the cash balance Dividend Payout Ratio 30.6% 30.6% 30.6% 30.6% after about 30% of dividend payout ratio. As a result, we will see the cash

balance increase to CNY 38 billion in 2020E from 29 billion in 2014A under the circumstances where no long-term debt is issued and all short-term is paid back. 7.1.5. DuPont Analysis Based on our analysis on 2015Q3 financial report, we expected ROE drop to 27.8% in 2015E from 44.8% in 2014A and 57.8%, as a result of deleveraging and worse profitability combined. We expect the decline trend in ROE to continue, but in a lower rate, from 27.8% in 2015E to 22.8% in 2017E and then back to 27.7% driven by rebound in profitability. The equity multiplier is 2.05, 1.58 and 1.24 in 13A/14A/15E respectively, which explains about 40% decrease in ROE. The net margin is 6.4%, 7.5% and 5.4% in 13A/14A/15E, which explains 15% decrease.

10 Appendix

1. Detailed Investment Highlights

1.1. Washing Machines: Haier’s Leading Position is threaten 1.1.1. Midea & Littleswan is surpassing Haier, especially in low end market In washing machine sector, Haier is losing market share significantly (value:-3.4%; volume: -5.3%) since 2012, while Midea & Littleswan have gained total market shares of 3.37% from 17.23% in 2012 to 20.60% in 2015 (YTD, in sales value, 19.73% to 24.65% for sales volume). It is claimed that the difference between the growth rates of value and volume is due to Haier’s product upgrades, but more importantly, there’s no doubt that that Haier fails to maintain its market share in low end markets. We believe that Midea and Little Swan (M&L) will surpass Haier to become the top leader in the washing machine sector, as they have developed a full spectrum of models that better meet market demands (by their double-branding strategies and by focusing on product quality since 2013)

Figure 32: Market shares according to sales amount (LHS) and sales volumes (RHS)

35% 35% 30% 30% 25% 25% 20% 20% 15% 15% 10% \ 10% 5% 5% 0% 0% 2011 2012 2013 2014 2015(Sep) 2011 2012 2013 2014 2015(Sep) Haier Midea & Little Swan Haier Midea & Little Swan Panasonic SANYO Panasonic SANYO Siemens Siemens

Source: CMM, EUROMONITOR, THOMSON ONE, company filings

1.1.2. Low end markets: challenged by Media & Littleswan In the low end market, Haier is being challenged by model sea and double brands of Media & Littleswan. Haier has two star models in low end market: M1268/M1269 series ranging from 899 to 1198 and Z2WH/M2WH series ranging from 999 to 1599. But it seems that these two models are not enough to meet the demand of picky clients. We list as below other popular models of Midea & Littleswan from micro data on retail channels. Littleswan covers 898-1098, 898-1298, 998-1498, 1298-1698 with 4 models. Midea covers 749-998,798, 1298-1698 with 3 models. These are all very popular models in low end market and provides customers with more options. Haier’s market position is challenged by model sea strategy and double branding strategy of M&L. We believe that the passive situation for Haier in low end market will continue unless Haier puts more models into the market.

Table 9: Low end models for Haier, Midea & Littleswan

Brand Haier Haier Midea Midea Midea Littleswan Littleswan Littleswan Littleswan Model M1268/9 Z/M2WH V1010H V3006G Eco11W V1068 8168H V1059/(H) easy60W Capacity (L) 5.5-7 6-8 5.5-7 5.5 6.5-8 5.5-7.3 5.5-7.5 6-8 6.5-8 Price 899 999 749 798 1298 898 898 998 1298 Range 1198 1599 998 798 1698 1098 1298 1498 1698

Source: official website

11 1.1.3. Haier is losing in low end market Seeing from micro data from retail channels and online channels, we deduct Haier is losing in low end market. We manually collected data of the weekly top 10 bestseller for washing machine starting from 2014 by AVC, which monitors 5,250 home appliance stores across 1,018 cities and counties. The data show the brands, prices, rankings, market shares and model types of each bestseller. With the data of 82 weeks, representing a total market share of 15.1%, we can get an idea of the competition between the leading players, especially Haier, Midea & Little Swan. In the low end market (below 1500), the difference between Haier and Midea & Littleswan narrowed down significantly in 2014, and the difference basically disappears in 2015. Midea & Littleswan has already dominated the market below 1000 in our top 10 bestseller list. So, faced with cut-throat competitions from Midea and Little Swan, Haier’s shares in the low end washing machine market are shrinking severely.

Figure 33: Market Share in Top 10 Bestsellers Figure 34: Market Share in Top 10 Bestsellers below 1500

10.0% 5.0% 8.0% 4.0% 6.0% 3.0% 4.0% 2.0% 2.0% 1.0% 0.0% 0.0% 2 7 1217222834394450 3 8 1318232934 2 7 1217222834394450 3 8 1318232934 2014 2015 2014 2015 Haier Midea & Little Swan Haier Midea & Little Swan

Source: CMM, EUROMONITOR

We also collected data of recent monthly sales volume of washing machines from tmall official store of Haier, Media, Littleswan and Siemens. We filters out models of sales volume <500/m. The data includes monthly sales, branding, and other detailed information on models. The data indicates that Midea & Littleswan do surpass Haier in low end market, even though Haier ranks 1st in tmall home appliance category at tmall. Considering customers of online channels are more sensitive to the price. We believe that Midea and Littleswan have established an image of low price and high quality. Given the fact that online sales are growing rapidly, we are quite conservative about Haier’s performance on low end market.

Figure 35: Monthly Sales Volume for selected brands Figure 36: Monthly Sales Volume Share for selected brands

120000 100%

80% 90000 60% 60000 40% 30000 20%

0 0%

Haier Midea & Littleswan Siemens Haier Midea & Littleswan Galanz Siemens

Source: Manually collected from tmall.com

12 1.1.4. Mid-high end markets are dominated by foreign brands We also collected data from suning.com. For the sales volume is not available on suning.com, we use number of comments as a proxy for sales volume, which follows the formula: number of comments = sales volume * comment rate. Big number of comments indicates either stronger sales volume or higher participation rate. For the analysis is focused on mid-high end market, we filter out models of price <3500. Brands include Beko, Bosch, Casarte, Daewoo, , Haier, LG, Littleswan, Midea, Panasonic, Samsung, Sanyo, Siemens, Whirlpool and other brands available on suning. As the data indicates, in mid-high end market, Haier and Casarte are not performing as well as it claims to be. Overall, Haier is weaker than LG and Siemens & Bosch in mid-high end market. If we exclude 3500-4500, Haier is even weaker than Samsung. This is consistent with our on-site visits to several home appliance stores in Beijing. Our survey shows that mid-high end customers prefer foreign brands for their high quality and brand premium. We believe that it is difficult for Haier to acquire more market shares in mid-high end market, faced with fierce competitions from LG, Samsung, Siemens & Bosch and other foreign brands. We are conservative about how much Haier could benefit from the so-called product upgrade, especially in the mid-high end market.

Figure 37: Cumulative Volume for products above 3500 Figure 38: Cumulative Percentage for products above 3500

30000 100%

25000 80% 20000 60% 15000 40% 10000

5000 20%

0 0%

Haier Casarte Midea & Littleswan Haier Casarte Midea & Littleswan Others Panasonic Whirlpool Others Panasonic Whirlpool Sanyo Samsung Siemens & Bosch Sanyo Samsung Siemens & Bosch LG LG Source: Manually collected from suning.com

1.1.5. Limited high end market for Casarte Total sales for air conditioner, Refrigerator and washing machine are CNY 157.5 billion, 89.4 billion and 57.6 billion respectively in 2014. Per capita white goods consumption capita is CNY 223, which is 1.11% of Per capita disposable income CNY 20,167 in 2014. Total white goods consumption is CNY 304.5 billion, which is 0.93% of total national consumption CNY 32,831 billion. Based on these numbers, we assume 1% of income will be used on buying white goods. The lowest selling price for Casarte seires is CNY 5,000, indicating only household with annual income 500,000+ will consider buying Casarte. According to CHFS (Chinese Household Financial Survey), for the richest 1% households (4.3 million households), their average annual income is CNY 494,322, very close to CNY 500,000. Assuming that 100% of them are buying Casarte, implied annual average sales for Casarte is CNY 21.5 billion.

13 Figure 39: Forbes’ Mass affluent class population

20.0 20.0% 16.6% 16.2% 15.9% 15.3 16.0 13.9 16.0% 12.0 11.2% 12.0 12.0% Mass affluent class 10.3 10.1% 8.8 8.0 8.0%

4.0 4.0% Growth rate

0.0 0.0% 2011 2012 2013 2014 2015

Source: Forbes China

Given the fact that Haier’s 2015 sales estimate for Casarte is 10 billion, Haier’s target to double sales of Casarte in 5 years, which implies 15% CAGR, seems almost impossible. According to Forbes China, the growth rate of mass affluent class (invesFigure funds more than CNY 600,000) has already dropped to 10%, which is still much higher than GDP growth rate + CPI. It is almost impossible that the growth rate of number of households with annual income more than CNY 500,000 will maintain at 10%, for there are only 4.3 million of them compared to 15 million mass affluent class. Based on the estimation above, we believe that growth rate for Casarte will drop to 10% or even lower in 3 years. 1.2. Air Conditioner: Price War is Stealing Haier’s Market Share 1.2.1. Since 2015H1, major players in white goods sector have started a fierce price war Since 2015H1, major players including Gree and Media started a price war, lowering their ASP so as to quickly clear their inventories. In the meantime, the discounts and promotions also helped them boost market shares and expand distribution channels, which are the key success factors for a manufacturer in a saturated market like white goods. In 2015, except for March, Midea has been lowering their ASP to the largest extent, especially in the last 3 months. At the same time, Haier’s ASP even remained unchanged during high sales season (typically from June to August)

Figure 40: Number Average selling price for air-conditioner players (2015)

Mar Apr May Jun Jul Aug Sep 0.00% -0.50% -0.20% -1.60% -1.90% -4.00% Total Gree -5.20% -5.10% Midea Haier -8.00%

-10.40% -12.00%

Source: Forbes China

14 1.2.2. Market share remains the key for winning in the air conditioner market In such a matured market with volume steadily growing at 3.1% CAGR since 2011, manufacturers’ revenue and net income growths are mainly driven by their market shares, due to the following three reasons: Branding effect and consumer behavior - consumers are very scrupulous in choosing the brands for white goods, which are normally low-frequency consumption decisions, and very important without doubt. Market share hence serves as a positive signal to consumers, whose decisions are easily affected by the others’. That being said, with its market share losing in the price war and the lack of effective marketing, Haier’s air conditioner business is severely suffering from “brand crises” stirred by losing market share recently. Market share is what Haier, “the globally largest white good producer”, can’t afford to lose. Control over distributors - distributors’ revenues comprise of two parts: inventory turnover rate and rebate. With a larger market share, a manufacturer can effectively lift inventory turnover rate, which can either attract more distributors or have the power to lower rebates to them, both of which help with the company’s overall profitability. Take Gree as an example. In their offline channel, thanks to the largest market share, they are capable of returning 5~6 bps without upfront discounts to distributors. On the other hand, Haier, being the 3rd largest player in air conditioner, needs to provide 2~3bps upfront discounts and 4~5 bps return points to their distributors. Economies of scale - this is rather plain and easy to understand. Large-share manufacturer benefit from lower raw material prices, efficient management model and usage of fixed costs, and broader labor educations, hence enjoying a lower per unit cost of goods sold. 1.2.3. Haier’s strategy to give its market share up will push it to the dead end Haier’s management follows a long standing strategy of not participating in price wars of any kind. As its CEO, Zhang Ruimin, once publicly stated, “Haier has always insisted on not participating in price wars, but only value wars”. In fact, Haier’s current switch to high-end and so-called “high value” products has made it hard to take part in price wars, because the two concepts are simply contradictory. The firm’s DNA may have mutated to the point where it works against all of those worthy principles, particularly client-centricity. In the air conditioner sector, Haier lost 1.67% share during the first 8 months of 2015, whilst that of Gree surged by 8.96%. This has led to its underperformance in 2015, and greatly damaged its shareholder value, no matter how Zhang applauds their strategy of protecting the margin. The management believes Haier’s products are worth the price, yet the fact that they are beginning to lose ground has mercilessly slapped them on the face.

Figure 41: Market share has dropped 2.53% since 2015 Feb Figure 42: Haier’s lower than expected air conditioner revenue in 2015H1

13% 12.93% losing 2.53% market share 0.00% 12.26% Haier Industry 12.05% 12% 11.81% 11.49% -5.00% -4.68% 10.97% 11% 10.74% 10.58% -10.00%

10% -15.00%

9% 02-15 03-15 04-15 05-15 06-15 07-15 08-15 09-15 -20.00% -18.77%

Source: CMM, EUROMONITOR, THOMSON ONE, company filings

1.2.4. There is limited upside potential for Haier’s participation in price war In the air conditioner market, the lost market share is hard to grasp back for Haier, due to the following two reasons: “Value and services” mindset - Haier insists on not participating in the air conditioner price war, as they are so committed

15 to providing “value and services” to customers. In short, they think their products are “worth the price”. Though this helps Haier keep its margin in washing machine and refrigerator sector, it doesn’t work in the air conditioner sector, because the largest producers, Gree and Midea, are actively leading the price war. “Zero-inventory” business model - Haier lacks the operational flexibility to participate in price wars. air conditioner consumptions are naturally highly sensitive to temperature, which is impossible to predict beforehand. Without any inventory in advance, it is hard for Haier to quickly boost outputs to take part in price wars. Evidence has shown that in the latest quarter, after major price reduction in March and April, Haier has been gradually recovering its price since June. The little discount in the peak season in July is resulted from a lack of capability to produce more air conditioners within such short-term. The air-conditioner sector’s demand is much more volatile than traditional market, thus the inventory model may not suit for this sector naturally. Based upon our analysis, we believe Haier’s mistaken strategy made itself losing market share in air-conditioner, which is quite hard to gain back. 1.3. Air Conditioner: Weak position in central air conditioner drags the segment down 1.3.1. Central air conditioner market is the future focus of growth The central air conditioner market in China is a higher growth and more fragmented sector comparing to residential air conditioner, with multiple foreign players such as Dakin and York taking large shares due to the higher entry barrier, having grown at a CAGR of 15.7% from 2009 to 2014. Due to much higher complexity and stability requirements, central air conditioner sector also has a higher gross margin in the range of 30-40%, compared with residential air conditioner’s 15%-30%.

Figure 43: China air conditioner Market Size (CNY bn) Figure 44: Central air conditioner Market Share

Others Gree 18% 140 26% 145 120 139 100 120 104 109 80 Midea 83 13% 60 77 Trane 64 71 3% 40 58 59 Haier 45 4% 20 34 34 2009 2010 2011 2012 2013 2014 Carrier 4% Dakin McQuay Central AC Residential AC 13% 5% York Hisense 6% Hitachi 8%

Source: CMM, EUROMONITOR, THOMSON ONE, company filings

In 2014, the central air conditioner market size in China was CNY71bn, compared with the residential air conditioner market of CNY145bn. Central air conditioner will continue to grow quickly in coming years as China is on its way to roll out more infrastructure projects and commercial facilities to maintain its GDP growth momentum and these will be the main drivers for central air conditioner demand. In China, the completion cycle for commercial construction is 5 years on average, meaning that the area of commercial construction completed at a year is in line with the area of new commercial construction 5 years ago (see figure 29), implying that the commercial construction completed in 2019 will be ~32,400 m3. Given the fact that central air conditioners are typically sold and installed at the time when a commercial construction is completed, we can forecast the market growth for central air conditioner for the next 5 years. Applying the average “area of commercial construction completed / central market size” multiple, which historically ranges from 2.0-2.2x, we estimate the market size of central air conditioner in China will grow to CNY150.1bn by 2019, implying a CAGR of 16.3%, vs. 7.1% for residential air conditioner forecasted by Euromonitor.

16 Figure 45: Completion cycle for commercial construction is 5 years Figure 46: Commercial construction completed / central market size multiple

mm m3 3 200 2.39x 2.24x 150 2.16x 2.12x 2.16x 2.13x 2.12x Average: 100 2.16x 2 1.95x 50

0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 New commercial construction (5 years ago) 2 Commercial construction completed 2007 2008 2009 2010 2011 2012 2013 2014

Source: CMM, EUROMONITOR, THOMSON ONE, company filings

What’s more, in the global air conditioner market, the size ratio of residential air conditioner to central air conditioner is ~1:1, while that of the domestic market is ~2:1. Assume that the consumption structure of China will converge to that of the global market, we see another reason to believe that the central air conditioner market in China is the future focus of growth.

Figure 47: Global air conditioner breakdown by product Figure 48: China air conditioner breakdown by product

32.7%

51.0% 49.1%

67.3%

Residential AC Central AC Residential AC Central AC

Source: CMM, EUROMONITOR, THOMSON ONE, company filings

Table 10: Global air conditioner breakdown by product

Residential air conditioner Central air conditioner Domestic market size (2014) CNY145bn CNY70.5bn Average selling price CNY3,000-4,000 Varies (generally >CNY1m) Gross margin 15-30% 30-40% Growth Lower Higher Market concentration Concentrated (top 3: 64%) Fragmented (top 3: 44%) User type Residential Commercial, industrial, residential, etc. Entry barrier Low High Specification More standardized More customized

Source: CMM, EUROMONITOR, THOMSON ONE, company filings

1.3.2. Despite market growth, Haier is losing this pie, now and forever There is a clear trend of domestic manufacturers taking shares from foreign players, as the quality of domestic products have been improving to reach the international standard. Gree, by surpassing Daikin in central air conditioner market in China in 2012, takes the largest share, driven by its strong brand and quality products. Midea, on the other hand, surpassed Daikin as well in the 1H2015, becoming the second player. By contrast, as the first domestic manufacturer to enter the central air conditioner market, Haier (1996) has been thrown far off by Gree (2003) and Midea (2002). 17 The main engines of central air conditioner systems is the technical barrier for most domestic players, thus the “Big 4”, McQuay, Trane, Carrier and York control 70% of the world’s central air conditioner market. In recent years, investing heavily in technology have made Gree and Midea’s counterattacks against the foreign players very successful. Yet, we do not see Haier making a move. The lost market share will further weaken Haier’s future market position in air-conditioner sector, and as with the negative impact on the potential revenue growth in the air-conditioner market, which is the largest white-good market.

Figure 49: Domestic central air conditioner market share Figure 50: Selected technological advance of competitors

Selected technological advance 2015 Gree’s million-kilowatt centrifugal chiller broke foreign monopoly 50% 47% 44% 57% 55% 53% 65% 62% 61% 2012 Midea and Carrier agreed to form JV in India 4% 2011 Midea introduced full DC inverter air conditioner, with energy efficiency up to 5.7 3% 4% 4% 7% 8% 3% 4%2% 5% 6% 2011 Gree launched the world’s first super high efficiency centrifugal chiller 5% 3% 4% 13% 5% 3% 4% 14% 14% 3% 17% 17% 14% 2010 Midea rolled out the first three-control air conditioner 15% 16% 11% 12% 13% 16% 11% 10% 2009 Midea introduced Carrier’s DC inverter to best-selling model MDV4+ 9% 9% 7% 9% 14% 16% 17% 18% 6% 7% 10% 11% 2008 Gree developed DC inverter air conditioner, breaking JPN’s tech monopoly 5% 2005 Gree developed world's first ultra-low temperature digital air conditioner Gree Midea 2002 Gree developed GMV digital multi-connected air conditioner

Source: CMM, EUROMONITOR, THOMSON ONE, company filings

18 2. DCF Valuation Assumptions

2.1. Revenue

Table 11: Revenue Prediction by Segments

(CNY million) FY 2014A FY 2015E FY 2016E FY 2017E FY 2018E FY 2019E FY2020E 5 year CAGR Total Revenue 88,775 84,219 88,825 93,403 98,985 105,008 110,629 6% YoY % 2.51% -5.13% 5.47% 5.15% 5.98% 6.08% 5.35% Refrigerator 24,668 25,149 26,917 28,751 30,567 32,154 33,394 6%

YoY % -2.61% 1.95% 7.03% 6.81% 6.31% 5.19% 3.86%

Casarte 3,700 4,810 6,013 7,215 8,298 9,128 9,584 15%

YoY % 30.00% 25.00% 20.00% 15.00% 10.00% 5.00%

Other brand 20,968 20,339 20,905 21,536 22,269 23,026 23,810 3%

YoY % -3.00% 2.78% 3.02% 3.40% 3.40% 3.40%

Market Share 26% 27% 28% 30% 30% 31% 31% Air Conditioner 24,668 15,040 15,733 15,585 16,364 17,182 17,955 4%

YoY % 11.64% -24.85% 4.61% -0.94% 5.00% 5.00% 4.50%

Market Share 12% 10% 9% 8% 8% 8% 8% Washing Machine 15,273 15,441 15,562 16,168 16,632 17,506 18,159 3%

YoY % 7.72% 1.10% 0.79% 3.89% 2.87% 5.25% 3.73%

Casarte 2,291 2,978 3,723 4,467 5,137 5,651 5,934 15%

YoY % 30.00% 25.00% 20.00% 15.00% 10.00% 5.00%

Other brand 12,982 12,462 11,839 11,701 11,495 11,855 12,226 0%

YoY % -4.00% -5.00% -1.17% -1.76% 3.13% 3.13%

Market Share 26% 25% 25% 25% 24% 25% 25% Other Segment 28822 28590 30613 32899 35422 38166 41121 8%

YoY % -0.80% -0.81% 7.08% 7.47% 7.67% 7.75% 7.74%

Source: Student Analysis

Revenues are estimated by breaking down Haier’s business into several segments, including: Refrigerator, Washing Machine, Water Heater, Air-conditioner, Equipment and Integrated Channel Services.

19 In refrigerator, washing machine and air conditioner, Haier’s three main segments, the revenue estimations come from the equation: total market size * expected market share %. As Casarte, the high-end brand under Qingdao Haier, is regarded as an important driver of the company’s growth, we estimate Casarte’s sales separately. Key considerations include: - The overall industry growth is aligned with our analysis in the industry overview section. - Casarte’s growth is based on management’s guidance and historical growth. Note that as a conservative approach, we have given an aggressive growth rate to Casarte. - The change of market share is in line with our prior analysis on Haier’s competitive positioning in air conditioner and washing machine sectors. For refrigerator, as Haier has been a very mature market leader in this segment, we assume a constant market share. - Other segments include:  Integrated services with a 5Y-CAGR of 7%  Special Facilities with a 5Y-CAGR of -25%. The decline is due to the company’s asset spin-off strategy and historical trend  Water heaters and kitchen appliance with a 5Y-CAGR of 7%, which is aligned with the overall growth rate of the industry.

2.2. Gross margin

Table 12: Gross margin prediction by segment

(%) FY 2015E FY 2016E FY 2017E FY 2018E FY 2019E FY2020E Refrigerator 32.08% 32.63% 33.17% 33.50% 33.73% 33.74% Air Conditioner 30.36% 30.46% 30.51% 30.51% 30.51% 30.51% Washing Machine 33.08% 33.63% 34.19% 34.53% 34.77% 34.79% Other Segments 18.64% 17.93% 17.69% 17.44% 17.16% 16.84% Source: Student Analysis The slight increase in gross margin in Refrigerator, Air Conditioner and Wash Machine accounts for following factors: - After KKR became one of the largest shareholders of Haier, the group has been promoting a series of cost efficiency strategies by updating the manufacturing facilities. However, during the first three quarters in 2015 after the cost efficiency plan rolled out, there has been no improvement in gross margin yet. - The premium Casarte brand has a gross margin 1.2% higher than other brands Haier is operating. We take Casarte’s impact on gross margin into consideration, as followed:

Table 13: Casarte’s impacts on Gross Margin

FY2014A FY2015E FY2016E FY2017E FY2018E FY2019E FY2020E Refrigerator 32.1% 32.6% 33.2% 33.5% 33.7% 33.7% 33.7% Casarte share% 15.0% 19.1% 22.3% 25.1% 27.1% 28.4% 28.7% GP of Other Brands 31.9% 32.4% 32.9% 33.2% 33.4% 33.4% 33.4% GP of Casarte 33.1% 33.6% 34.1% 34.4% 34.6% 34.6% 34.6% GP% 32.1% 32.6% 33.2% 33.5% 33.7% 33.7% 33.7%

20 Washing Machine Casarte share% 15.0% 19.3% 23.9% 27.6% 30.9% 32.3% 32.7% GP of Other Brand 32.9% 33.4% 33.9% 34.2% 34.4% 34.4% 34.4% Gp of Casarte 34.1% 34.6% 35.1% 35.4% 35.6% 35.6% 35.6% GP% 33.1% 33.6% 34.2% 34.5% 34.8% 34.8% 34.8% Air Conditioner 30.4% 30.5% 30.5% 30.5% 30.5% 30.5% 30.5%

Source: Student Analysis

- We assume no change in the gross profit margin for Air Conditioner, believing that the overcapacity of air conditioner market is driving ASP down. Even though Haier doesn’t participate in the price war, the price war itself will steal its market share, resulting in a difficulty for Haier to achieve economy of scale and manufacturing efficiency. - The fall in gross margin for other business segments is due to the fact that the Integrated Channel Services segment has an increasing contribution but relatively low gross margin, namely 7%, compared to special equipment (25% gross margin) and water heaters and kitchen appliance (42% gross margin).

2.3. Operating Margin - In 2015-2018, we assume the selling expense as a percentage of revenue increased from 14% to 16%, since the firm has spent a lot to an open new market for Casarte. As Casarte is positioned as a premium brand, the group needs to spend more on building the distribution channels, as well as marketing and advertisements. For example, from 2012 to 2014, since Haier started promoting its Casarte brand, the selling expenses increased from 12% to 14%. - General and administration expense is assumed to be 7% of revenue, in line with historical proportion. 2.4. CAPEX - 3% of annual revenue, same as historical average level. 2.5. Operating Working Capital

- Account payable turnover, inventory turnover and account receivable turnover are assumed to be at historical average level.

- Other accruals are assumed to keep constant for the nature of the accounts.

2.6. Terminal Value - We incorporate a 2% terminal growth rate, implying an exit EV/EBITDA of 8.4x. Comparable companies’ data has a median EV/EBITDA multiple of 10.6x. Given that Haier will grow at a relatively low rate after the terminal year, the assumption is believed to be reasonable. - Terminal value accounts for 75% of total enterprise value.

21 3. Scenario Analysis

In order to check the robustness of our DCF model, we also conduct a scenario analysis by setting up three upside scenario and two down side scenarios. Detailed descriptions of different scenarios that we cover are as below: Upside Scenarios - Stronger than expected growth of Casarte: provides stronger support for Haier’s position in the refrigerator sector - Management reacts to the threats in WM sector rapidly: market share of Haier falls less significantly - Higher than expected demand for product upgrade: Boost up the gross margin of refrigerator and washing machine Downside Scenarios - Huge failure to maintain the market shares in WM sector: continue to lose market share, unable to turn around - Fiercer price wars in AC sector and further weakening position in central AC segment: erodes Haier’s market share in AC sector

Figure 51: Scenario Analysis

9.8 0.28 9.66 0.11 0.16 9.3 0.26 9.11 0.31 8.8 8.54 8.3

7.8 Bear Case Even weaker Fail to Base Case High demand Reacts to Strong Bull Case AC maintain WM for product threats in Casarte share upgrade WM growth

Source: Student Analysis

By incorporating all these factors, we can achieve the following adjusted price range regarding different scenarios. The estimated price in the bull-case scenario is still lower than the current market (CNY 9.92) and adjusted current market price (CNY 10.61). Therefore, we reaffirm our sell recommendation on Qingdao Haier.

22 4. Financial Prediction

(in CNY million) Forecast Fiscal year ends in December 2014A 2015E 2016E 2017E 2018E 2019E 2020E Income statement Total Net Revenue ¥ 88,775.44 ¥ 84,219.49 ¥ 88,825.37 ¥ 93,403.06 ¥ 98,985.11 ¥ 105,007.95 ¥110,629.20 Growth % 2.5% -5.1% 5.5% 5.2% 6.0% 6.1% 5.4%

Cost of Services (64,345.2) (61,113.7) (64,360.8) (67,695.6) (71,822.7) (76,399.7) (80,787.0) Gross Profit 24,430.2 23,105.8 24,464.6 25,707.5 27,162.4 28,608.2 29,842.2 Margin % 27.5% 27.4% 27.5% 27.5% 27.4% 27.2% 27.0%

Selling Expenses (11,578.0) (11,826.0) (13,361.0) (14,516.6) (15,384.2) (15,795.2) (15,534.4) Administrative Expenses (5,994.7) (6,108.1) (6,442.2) (6,774.2) (7,179.0) (7,615.9) (8,023.6)

Operating tax and surcharge (399.7) (379.2) (399.9) (420.5) (445.7) (472.8) (498.1) Operating (Expenses)/Income 6,457.8 4,792.4 4,261.4 3,996.2 4,153.5 4,724.4 5,786.1 Non-operating Income 1,177.5 187.3 196.7 206.6 216.9 227.7 239.1 EBIT 7,635.3 4,979.8 4,458.1 4,202.7 4,370.4 4,952.1 6,025.2

Interest Income 540.0 540.0 539.9 562.9 560.1 579.3 604.8 Interest Costs (128.7) (74.2) (54.0) (54.0) (22.4) (22.4) (22.4) EBT 8,046.6 5,445.6 4,944.0 4,711.6 4,908.1 5,509.0 6,607.6

Income Tax Expenses (1,354.4) (925.7) (840.5) (801.0) (834.4) (936.5) (1,123.3)

Net Income 6,692.2 4,519.8 4,103.5 3,910.6 4,073.7 4,572.5 5,484.3 Growth % 16.9% -31.3% -3.5% 0.9% 10.0% 17.3% 23.8%

23 History Forecast (in CNY million) 2014A 2015E 2016E 2017E 2018E 2019E 2020E Balance sheet Assets Current Asssts Cash and cash equivalents 28,644.0 28,639.0 29,859.8 29,709.2 30,730.4 32,081.3 34,069.2 Account Receivables 5,295.8 4,552.5 4,801.5 5,049.0 5,350.7 5,676.3 5,980.1 Note Receivables 16,434.9 14,158.4 14,932.7 15,702.3 16,640.7 17,653.2 18,598.2 Inventories 7,557.9 6,991.5 7,363.0 7,744.5 8,216.7 8,740.3 9,242.2 Prepaid Expense 850.0 1,107.6 1,221.9 1,313.1 1,391.6 1,444.5 1,454.9 Other recievables and current assets 794.8 530.1 559.1 587.9 623.0 660.9 696.3 Total Current Assets 59,577.4 55,979.2 58,738.1 60,106.0 62,953.1 66,256.5 70,041.0

Non-current Assets PPE 8,056.6 9,539.5 11,018.4 12,490.5 13,978.0 15,485.4 16,995.7 Long-term Equity Investments 3,356.6 3,692.3 4,061.5 4,467.6 4,914.4 5,405.9 5,946.4 Avaible-for-sale financial assets 1,631.3 1,631.3 1,631.3 1,631.3 1,631.3 1,631.3 1,631.3 Deferred income tax assets 894.7 894.7 894.7 894.7 894.7 894.7 894.7 Goodwill 74.5 74.5 74.5 74.5 74.5 74.5 74.5 Intangible 1,040.7 920.5 987.3 1,189.4 1,397.4 1,611.9 1,831.0 Other non-current assets 374.6 374.6 374.6 374.6 374.6 374.6 374.6 Total Non Current Assets 15,429.0 17,127.4 19,042.3 21,122.7 23,265.0 25,478.3 27,748.2 Total Assets 75,006.4 73,106.6 77,780.4 81,228.7 86,218.1 91,734.8 97,789.2

Equity and liabilities Current Liabilities Account Payables 14,126.6 11,120.8 11,729.0 12,333.5 13,070.6 13,865.8 14,608.1 Note Payables 13,487.5 13,410.7 14,144.1 14,873.1 15,761.9 16,721.0 17,616.1 Bank borrowings 1,008.7 ------Advances from customers 4,218.0 3,354.2 3,537.6 3,720.0 3,942.3 4,182.1 4,406.0 Income tax payable 1,216.5 833.2 756.4 720.9 750.9 842.9 1,011.0 Current Portion of Non-Current Liabilities- Other payables 7,570.7 7,570.7 7,570.7 7,570.7 7,570.7 7,570.7 7,570.7 Total Current Liabilities 41,628.1 36,289.6 37,737.9 39,218.1 41,096.4 43,182.6 45,211.9

Non-current Liabilities Bank borrowings 1,800.7 1,800.7 1,800.7 745.7 745.7 745.7 745.7 Bond ------Deferred revenue 135.7 135.7 135.7 135.7 135.7 135.7 135.7 Deferred Income Tax Liabilities 117.6 117.6 117.6 117.6 117.6 117.6 117.6 Accrued Liabilities 2,157.3 2,105.7 2,220.8 2,335.3 2,474.8 2,625.4 2,766.0 Other non-current liabilities 47.2 47.2 47.2 47.2 47.2 47.2 47.2 Total Noncurrent Liabilities 4,258.4 4,206.9 4,322.0 3,381.4 3,521.0 3,671.6 3,812.1 Total Liabilities 45,886.5 40,496.5 42,060.0 42,599.5 44,617.4 46,854.2 49,024.0

Equity Share capital 6,581.7 6,581.7 6,581.7 6,581.7 6,581.7 6,581.7 6,581.7 Reserve 14,879.6 17,210.3 19,458.5 21,726.4 24,221.4 27,147.1 30,768.3 Non-controlling interest 7,279.9 8,439.5 9,301.6 9,942.5 10,419.0 10,773.2 11,036.6 Other compreensive income and foreign currency 378.7 translation 378.7 difference 378.7 378.7 378.7 378.7 378.7 Total Equity 29,120.0 32,610.2 35,720.5 38,629.2 41,600.7 44,880.7 48,765.3

Total equity and liabilities 75,006.5 73,106.7 77,780.4 81,228.8 86,218.1 91,734.9 97,789.3 24 (in CNY million) Forecast Fiscal year ends in December 2014A 2015E 2016E 2017E 2018E 2019E 2020E Cash flow statement

Cash flow from operating activities EBIT 4,979.8 4,458.1 4,202.7 4,370.4 4,952.1 6,025.2

Depreciation of PPE 791.1 919.6 1,049.9 1,185.3 1,328.0 1,476.8 Amortization of intangible assets 372.7 199.5 77.9 88.8 100.3 112.7 Change in NWC (Increase) / decrease in account receivable 743.2 (249.0) (247.5) (301.7) (325.6) (303.9) (Increase) / decrease in note receivable 2,276.5 (774.3) (769.6) (938.4) (1,012.5) (945.0) (Increase) / decrease in inventories 566.4 (371.5) (381.5) (472.2) (523.6) (501.9) (Increase) / decrease in prepaid expense (257.6) (114.3) (91.2) (78.5) (52.9) (10.4) (Increase) / decrease in other receivables and current assets 264.7 (29.0) (28.8) (35.1) (37.9) (35.4) Increase / (decrease) in account payables (3,005.8) 608.2 604.5 737.1 795.3 742.3 Increase / (decrease) in note payables (76.8) 733.4 728.9 888.9 959.0 895.1 Increase / (decrease) in advances from customers (863.8) 183.4 182.3 222.3 239.9 223.9 Increase / (decrease) in income tax payable (383.3) (76.7) (35.6) 30.1 91.9 168.1 Increase / (decrease) in other payable & accruals ------Other operating cash flow Less change in Equity Investment (335.7) (369.2) (406.1) (446.8) (491.4) (540.6) Plus accruel liablities (51.6) 115.2 114.5 139.6 150.6 140.5 Plus change in other non current liablities ------

Net cash from operations 5,019.8 5,233.4 5,000.5 5,389.6 6,173.2 7,447.4 Interest income 540.0 539.9 562.9 560.1 579.3 604.8 Interest paid (74.2) (54.0) (54.0) (22.4) (22.4) (22.4) Tax paid (925.7) (840.5) (801.0) (834.4) (936.5) (1,123.3) Net cash from operating activities 4,559.9 4,878.8 4,708.4 5,092.9 5,793.6 6,906.5

Cash flow from investing activities Purchase of PPE (2,274.1) (2,398.4) (2,522.0) (2,672.8) (2,835.4) (2,987.2) Payment for intangible assets (252.5) (266.3) (280.0) (296.8) (314.8) (331.7) Net cash from investing activities (2,526.6) (2,664.8) (2,802.1) (2,969.6) (3,150.2) (3,318.9)

Cash flow from financing activities Dividends paid (1,029.6) (993.2) (1,001.9) (1,102.2) (1,292.5) (1,599.7) Net decrease in bank borrowings (1,008.7) - (1,055.0) - - - Net cash from financing activities (2,038.3) (993.2) (2,056.9) (1,102.2) (1,292.5) (1,599.7)

Cash and cash equivalents at the beginning of the year 28,644.0 28,639.0 29,859.8 29,709.2 30,730.4 32,081.3 Cash and cash equivalents at the end of the year 28,644.0 28,639.0 29,859.8 29,709.2 30,730.4 32,081.3 34,069.2

25 Disclosures:

Ownership and material conflicts of interest: The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company. The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the content or publication of this report. Receipt of compensation: Compensation of the author(s) of this report is not based on investment banking revenue. Position as a officer or director: The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company. Market making: The author(s) does not act as a market maker in the subject company’s securities. Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with Peking University, CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.

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