abc Global Research 1 November 2016

ZTE Corporation Equities

Challenging outlook but inexpensive valuation, China Neutral Communications Technology

12-month rating Neutral

US sanctions are a key overhang 12m price target HK$12.20 Prior: HK$13.00 ZTE reported a solid recovery in domestic revenue growth in 2014-15 (13.9%/30.9% YoY in 2014/15 from -0.1%/-9.7% in 2012/2013) riding on 4G network expansion and Price HK$10.68 the fibre broadband upgrade cycle in China. With the domestic businesses contributing RIC: 0763.HK BBG: 763 HK over 100% of its net profit, ZTE could have leveraged on its strong China growth to cross-subsidise its overseas expansion in 2016, particularly since the merger between Trading data and key metrics Nokia and Alcatel-Lucent and business slowdown of Ericsson presented a good 52-wk range HK$18.94-9.45 opportunity to gain market share. However, the sanctions imposed by the US Market cap. HK$67.1bn/US$8.65bn Department of Commerce (DoC) in March 2016 changed the situation: overseas Shares o/s 756m (ORD) revenue declined 7.4% YoY in H116 after rising 15.1% YoY in 2015. Moreover, in the Free float 67% domestic market, we expect a downward trend in telco capex. Despite the challenging Avg. daily volume ('000) 4,635 fundamental outlook, we maintain our Neutral rating due to the inexpensive valuation. Avg. daily value (m) HK$52.1 Common s/h equity (12/16E) Rmb41.7bn Wireless capex trending downward, but wireline capex picking up P/BV (12/16E) 0.9x We expect China telco capex to decline 15.5% YoY in 2016, and continue to trend Net debt / EBITDA (12/16E) NM downward at a 3.2% CAGR in 2017-19, until 5G capex kicks in in 2020. Structurally, Chinese telcos are shifting capex spending from wireless to wireline (transmission and EPS (UBS, diluted) (Rmb) access), as 4G rollout has peaked but the fibre broadband upgrade is still an ongoing From To % ch Cons. 0.95 0.86 -9 0.89 trend. As a result, we expect optical product revenue CAGR of 9.8% in 2016-18, 12/16E 12/17E 0.99 0.98 -1 0.95 representing a key growth driver for ZTE over the next three years. We also forecast 12/18E 0.97 1.10 13 0.99 government and corporate revenue to grow at a 25% CAGR over the same period, benefiting from increasing Information Communication Technology (ICT) demand in Jinjin Wang, CFA China. We forecast overall revenue/earnings CAGRs of 4.5%/12.2% in 2016-18, a Analyst S1460514100001 significant slowdown from the 23%/21.8% YoY growth in 2015. [email protected] We expect ZTE's handset business to remain difficult in the next 12 months +86-105-832 8922 ZTE's handset business has performed poorly over the past few years, and ZTE is no Navin Killa longer a tier 1 handset OEM in China. Since China’s handset market is overly Analyst [email protected] competitive and crowded, we expect ZTE's handset business to remain difficult and +852-2971 7594 growth in its consumer business will come from other products. Valuation: trading at historical low PE, maintain Neutral rating ZTE is trading at 9.7x 2017E PE, a historical low versus its range of 15-25x over the past 10 years. ZTE is also trading at a large discount to its peers. We believe downside risk is limited. We lower price target from HK$13.0 to HK$12.20 (DCF, based on a WACC of 8.7% and g of 2%) implies 10.9x 2017E PE.

Highlights (Rmbm) 12/13 12/14 12/15 12/16E 12/17E 12/18E 12/19E 12/20E Revenues 75,234 81,471 100,186 106,559 110,805 114,366 120,623 127,667 EBIT (UBS) 3,247 5,435 5,777 5,818 6,204 6,795 7,530 8,160 Net earnings (UBS) 1,358 2,634 3,208 3,551 4,035 4,527 5,137 5,654 EPS (UBS, diluted) (Rmb) 0.33 0.64 0.78 0.86 0.98 1.10 1.25 1.37 DPS (Rmb) 0.02 0.17 0.19 0.22 0.14 0.27 0.31 0.34 Net (debt) / cash (5,945) (9,096) 5,484 7,099 6,992 9,276 10,937 12,572

Profitability/valuation 12/13 12/14 12/15 12/16E 12/17E 12/18E 12/19E 12/20E EBIT margin % 4.3 6.7 5.8 5.5 5.6 5.9 6.2 6.4 ROIC (EBIT) % 11.8 17.6 16.7 16.1 16.0 16.3 17.2 17.6 EV/EBITDA (core) x 9.6 7.6 11.1 6.5 6.5 6.1 5.6 5.3 P/E (UBS, diluted) x 28.9 17.1 18.3 10.8 9.5 8.5 7.5 6.8 Equity FCF (UBS) yield % (1.0) (0.6) 5.4 4.2 1.2 4.8 4.7 4.9 Net dividend yield % 0.3 1.5 1.4 2.3 1.5 2.9 3.3 3.7 Source: Company accounts, Thomson Reuters, UBS estimates. Metrics marked as (UBS) have had analyst adjustments applied. Valuations: based on an average share price that year, (E): based on a share price of HK$10.68 on 31 Oct 2016 22:41 HKT

www.ubssecurities.com

This report has been prepared by UBS Securities Co. Limited. ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 31. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

ZTE Corporation Neutral (Price target HK$12.20)

UBS-S Research THESIS a guide to our thinking and what's where in this report OUR THESIS IN PICTURES MAP

PIVOTAL QUESTIONS Q: How has the US sanction impacted ZTE's businesses? Negatively. ZTE reported overseas revenue declined 7.4% YoY in H116 after rising 15.1% YoY in 2015, reflecting the negative impact of the sanction. Until removed, we think it will remain an overhang on the share price. more Q: What are the implications of structural capex change in China? We expect the majority of incremental revenue growth to come from its optical products and government and corporate businesses, which together accounted for 31% of total revenue in 2015. We expect the portion to rise to 42% in 2018. more Q: Will ZTE's handset business remain difficult in the next 12 months? Yes, we expect it to. ZTE's handset business has performed poorly in the past two to three years, and it is no longer a tier 1 handset OEM in China. We expect ZTE to drive up revenue growth of its consumer business via other products such as broadband terminals and IPTV set-up boxes. more

UBS-S VIEW We are cautious on the fundamental outlook for ZTE over the next three years: 1) the US sanctions have damaged its brand name; 2) we expect China capex to decline in 2016-19; and 3) ZTE's handset business has performed poorly. However, with the shares trading at a historical low PE and deep discount to peers, largely reflecting the weak fundamentals, we maintain our Neutral rating.

EVIDENCE 1) ZTE's 2015 and H116 financial results. 2) Capex guidance of Chinese telcos. 3) UBS Evidence Lab survey on global smartphone demand. 4) Industry data provided by Gartner, IDC, etc.

WHAT'S PRICED IN? 1) Qualitative feedback: we believe the share price is unlikely to move much until the sanctions are removed. 2) UBS’s “What’s Priced In” residual income model: medium- and long-term growth jointly contribute -10% of the share price, indicating concerns on export sanctions. more

UPSIDE / DOWNSIDE SPECTRUM

Value drivers Sanction penalty Carriers' network Consumer business Gov&Corp business Gross (Rmb bn) business growth growth (5yr CAGR) growth (5yr CAGR) margin (5yr CAGR) HK$14.3 upside 1.0 3.3% 0.6% 22.3% 29.9% HK$12.2 base 2.0 3.0% 0.4% 21.9% 29.7% HK$8.1 downside 6.0 2.8% -1.6% 21.1% 29.8% Source: UBS-S more COMPANY DESCRIPTION ZTE is one of China's top two networking hardware companies, with products ranging from wireless, wireline, data/optical equipment and handsets to services and software. It has one... more 

Jinjin Wang, CFA, Analyst, S1460514100001, [email protected], +86-105-832 8922

ZTE Corporation 1 November 2016 abc 2

ZTE Corporation UBS-S Research

OUR THESIS IN PICTURES return 

Revenue breakdown by business segment, 2014-20E 100% 10.9% 10.5% 12.3% 14.8% 17.9% 20.4% 22.2% 80% 35.2% 32.4% 31.0% 29.3% 28.2% 27.1% 25.9% 60% We expect optical and government and corporate business to be the key growth drivers; the consumer 20.6% 20.1% 22.1% 40% 22.5% 23.8% 24.5% 24.3% business (mainly handset business) should continue to shrink 20% 36.6% 36.6% 31.4% 33.8% 30.0% 28.0% 27.6% 0% 2014 2015 2016E 2017E 2018E 2019E 2020E Wireless Optical Consumer business Gov and Corp business

Overseas revenue declined 7.4% YoY in H116, a substantial slowdown from the 15.1% YoY growth in 2015

We expect revenue growth to slow in 2016-18, and then pick up starting from 2019

ZTE is trading at 11x 2016E PE, below -1x standard deviation

Sources for exhibits above: Company data, UBS Research , Bloomberg

ZTE Corporation 1 November 2016 abc 3

ZTE Corporation UBS-S Research

PIVOTAL QUESTIONS return 

Q: How has the US sanction impacted ZTE's businesses?

UBS-S VIEW Negatively. US sanctions are a key overhang, particularly for its overseas businesses in our view. ZTE reported a solid recovery in domestic revenue growth in 2014-15 (13.9%/30.9% YoY in 2014/15 from -0.1%/-9.7% in 2012/2013) riding on 4G network expansion and the fibre broadband upgrade cycle in China. With the domestic businesses contributing over 100% of its net profit, ZTE could have leveraged on its strong China growth to cross-subsidise its overseas expansion in 2016, particularly since the merger between Nokia and Alcatel-Lucent and business slowdown of Ericsson presented a good opportunity to gain market share. However, the sanctions imposed by the US Department of Commerce (DoC) in March 2016 changed the situation: overseas revenue declined 7.4% YoY in H116 after rising 15.1% YoY in 2015.

EVIDENCE 1) ZTE's Q1&Q216 financial results. 2) Our channel checks suggest there has been increasing concerns from both ZTE's suppliers and clients regarding the on-going sanction.

WHAT'S PRICED IN? Based on our conversations with investors, they are finding it extremely difficult to estimate the timing and potential results of the sanctions, which are a matter of government regulation. The share price has dropped from HK$13.75 to a low of HK$9.55 since the export sanctions were imposed, and then gradually moved back to HK$10.82 as of 28 October. ZTE is trading at 9.7x 2017E PE, a historical low, reflecting the negative sentiment on the stock.

US investigation a significant swing factor

Temporary licence to expire on 28 November 2016

On 7 March 2016, the Bureau of Industry and Security (BIS) of the US Department Uncertainties associated with the of Commerce (DoC) added ZTE, along with three other companies, to an export US investigation remain a key restriction list, based on information that those companies exported products to overhang, in our view five embargoed markets: Iran, Sudan, North Korea, Syria and Cuba. As of 8 March 2016, various suppliers subject to the Export Administration Regulations (EAR) are required to apply for a licence to supply certain items to ZTE, and a licence review policy of presumption of denial will apply. In other words, all US suppliers, such as Qualcomm, Intel, Micron, Microsoft, etc, had to stop providing products to ZTE. On 24 March 2016, the DoC amended the afore-mentioned decision by creating a temporary general licence, with the effect that export restrictions on ZTE would not apply until 30 June 2016. On 28 June 2016, the DoC extended the temporary licence until 30 August 2016, and on 19 August, the DoC further extended the expiration date of temporary license to 28 November 2016.

ZTE Corporation 1 November 2016 abc 4

Figure 1: The timetable of the US sanctions

Date Events March 7, 2016 The US DoC banned US companies from transferring US technology to ZTE unless a special licence was granted. March 7, 2016 ZTE H and A shares both suspended trading. March 8, 2016 The Foreign Minister of China, Mr Wang Yi, commented that the sanctions were an incorrect approach by negatively affecting both parties. March 8, 2016 The Ministry of Commerce of China voiced strong opposition to the sanctions. March 24, 2016 The US Department of Commerce granted a temporary licence to ZTE, which was due to expire on 30 June 2016. ZTE reported 2015 results; revenue and net profit were Rmb639m and Rmb571m lower than the preliminary results, respectively, due to the effects April 6, 2016 of the sanctions (higher provisioning). April 6, 2016 ZTE's H and A shares resumed trading; the share prices declined 15% and 5%, respectively, in the first five trading days. June 28, 2016 The US Department of Commerce announced an extension of the temporary licence to 30 August 2016. August 19, 2016 The US Department of Commerce further extended the expiration date of the temporary license to 28 November 2016. Source: Bloomberg, company data, UBS-S estimates

Negative impact on overseas business in H116

ZTE reported a 7.4% YoY decline in overseas revenue in H116, a significant slowdown from the 15.1% YoY growth in 2015. In contrast, domestic revenue growth remained strong, at 14.1% YoY in H116. Overseas revenue as a portion of total revenue dropped to a historical low of 42% in H116. This highlights the negative impact the US sanctions have had on ZTE's overseas businesses, particularly handset sales in the US, in our view. Though Chinese telcos have been acting more favourably towards ZTE since the sanctions were announced, such as better cash payment, many overseas operators have been taking a more cautious view on ZTE and have moved ZTE to a lower position on their vendor lists, according to our checks. Plus, we also heard there has been increasing concerns from ZTE's suppliers.

Figure 2: Domestic vs. overseas revenue, YoY revenue Figure 3: Regional revenue growth, YoY growth

50% 42.2% 40% 30.9% 30% 23.2% 22.2% 20% 13.9% 14.1% 22.7% 13.0% 2.7% 10% 13.6% 11.9% 1.6% 0.5% 0% -4.3% 5.3% 2011 2012 2013 2014 2015 H116 -9.7% -10% -0.1% -3.3% 0.4% -13.8% -20% -12.4% -13.6%

-30% -25.0% -26.8%

-40%

PRC Asia (excl. PRC) Africa Europe, America and Oceania

Source: Company data Source: Company data

ZTE Corporation 1 November 2016 abc 5

Fundamental business was on improving trend before H116

The company reported a nice recovery in domestic revenue growth in 2014-15 Without the sanctions, ZTE likely (13.9%/30.9% YoY in 2014/2015 from -0.1%/-9.7% in 2012/2013) riding on 4G could have strengthened its network expansion and the fibre broadband upgrade cycle in China. With the competitiveness in global market domestic businesses contributing over 100% of its net profit, the company can in 2016 leverage on its strong China growth to cross-subsidise its overseas growth. We believe the merger between Nokia and Alcatel-Lucent presented a good opportunity for ZTE to gain market share, and 2016 was supposed to be a year for ZTE to gain market share in overseas markets. However, the sanctions have changed the situation. If the sanctions linger on, we believe they will continue to damage the company's brand and reputation for quality in overseas markets, and impact overseas revenue. Moreover, we expect capex in the domestic market to trend downward. All in all, we believe the outlook for the company is challenging.

As result, we have significantly reduced our revenue and earnings forecasts. We now forecast 4.5%/12.2% revenue/earnings CAGRs in 2016-18 (compared to YoY revenue/earnings growth of 23.0%/21.8% in 2015). We have therefore modelled a significant negative impact from the sanctions over the next couple of years. As we will explain, we do believe that the more likely scenario is that the company receives a fine and the sanctions are lifted. As such, we have also factored in an improvement in operating momentum from 2018. Clearly the timing and indeed the occurrence of the removal are uncertain.

Figure 4: Revenue and net profit growth accelerated in Figure 5: FCF largely improved, and financial leverage 2014-15 strengthened in 2014-15

Source: Company data Source: Company data

ZTE Corporation 1 November 2016 abc 6

Figure 6: ZTE increased R&D spending in 2014-15 to gear Figure 7: Operational costs as a percentage of revenue up business development

14 16% 16% 14.8% 13.1% 14% 14% 13.5% 13.5% 12 12.7% 12.9% 12.8% 12.7% 0.8 12.2% 13.5% 12% 12% 11.1% 11.9% 10 10.5% 10.1% 9.8% 9.8% 0.7 0.9 1.3 10% 10% 8 6.8% 9.5% 1.0 0.5 8% 8% 6 8.0% 11.3 7.1% 6% 6% 8.5 4 8.2 8.3 3.6% 6.8 6.5 4% 4% 3.0% 2.9% 3.0% 3.0% 2.6% 2.5% 2 2% 2%

0 0% 0% 2011 2012 2013 2014 2015 H116 2010 2011 2012 2013 2014 2015 H116

Expensed R&D (Rmb bn) Capitalized R&D (Rmb bn) Capitalized rate R&D Selling and distribution Admin

Source: Company data Source: Company data

Two possible scenarios regarding the sanctions

We lay out two scenarios below: one assumes the US government will remove the sanctions and issue a one-off penalty, with the timing assumed to be in 2017. The second scenario assumes the sanctions will be permanent.

Scenario 1: permit with a one-off penalty

In forming views around this scenario, we spoke to several specialists specializing on US export controls and economic sanctions, and analysed past penalties imposed by the BIS. According to the specialists, based on the past precedents, BIS will remove the sanction if the company under investigation demonstrated completed internal control system to ensure such violation can be avoided in the future. According to the management, ZTE has been actively recruiting industry professions in the US to fulfil the task, demonstrating their willingness to cooperate with BIS.

. The DOC granted a temporary licence to ZTE only 18 days after the sanctions were announced—much sooner than expected. The temporary licence is a general licence not limited to certain types of products/goods. This suggests full cooperation from ZTE with the on-going investigation being conducted by DoC according to the specialists.

. On 5 April, ZTE announced the change of the Chairman and President, which demonstrate the willingness of the company to improve its corporate governance and internal management system.

. According to one of the specialists we talked with, a senior government official of BIS commented that the fundamental purpose of the sanction is to enforce ZTE to revamp its internal compliance system and largely change its compliance culture to comply with the US export regulations in the BIS West-coast Forum in April 2016.

Though largely uncertain, the specialists we talked with expect that a penalty would be somewhere in the vicinity of US$150-500m, based on precedents of US Bureau of Industry and Security (BIS) penalty cases in the past as well as an estimated contract value of businesses involved. This could impact our earnings forecasts from 2017 onwards by 0.2-0.5% because of higher interest expenses,

ZTE Corporation 1 November 2016 abc 7

and could reduce our DCF valuation 2.0-6.0%. In our base case, we assume a one- off penalty of US$300m (around Rmb2bn) in 2017.

. The maximum civil penalty for a violation of the Export Administration Regulations (EAR) violations is US$250,000 per violation or twice the amount of the value of the transaction whichever is greater. ZTE wrote down Rmb639mn (around US$100mn) revenue in 2016 because of the sanction, indicating the contract value involved with the investigation is around Rmb639mn (US$100mn) and twice the amount is Rmb1.3bn (around US$200mn).

. Our review of the BIS webpage listing civil penalties showed that the highest EAR penalties imposed have been in the range of dozens of million dollars, and that only a few such penalties have been imposed. The highest civil penalty case on the history is "Weatherford" (Weatherford International in Houston, Texas, and four of its subsidiaries, collectively) which received a combined total penalty of US$100m from the US government in 2013, for transferring oil and gas equipment for drilling operations to Iran, via Weatherford’s Dubai-based subsidiary, with knowledge that a violation would occur.

Figure 8: Impact of potential penalty on our DCF valuation

Potential penalty Impact on DCF DCF per share (HK$) US$150m ( approx. Rmb1bn) -3% 12.60 US$300m (approx. Rmb2bn) -6% 12.20 US$500m (approx. Rmb3bn) -8% 12.00 Source: UBS-S estimates

Scenario 2: permanent sanctions

The worst case would be if the DoC banned ZTE from purchasing US products from US suppliers, which we estimate could impact 80-90% of ZTE's products. As shown in the figure below, ZTE procures core components such as chipsets, CPU, OS, etc. from US suppliers. ZTE could seek replacements from other suppliers but it could take a long time and the quality of ZTE's products could drop to an uncompetitive level. We expect that such a sanction would quickly become a political issue—and therefore regard the scenario as relatively less likely.

ZTE Corporation 1 November 2016 abc 8

Figure 9: ZTE's supply chain exposure to the US

Contribution to Contribution to Contribution to Contribution to Chipsets Components Software Distributor COGS COGS COGS COGS Qualcomm 2.54% Finisar 0.20% Microsoft 1.56% Avnet 0.35% Intel 1.80% Oclaro 0.19% Oracle 0.23%

Micron 0.93% IDCC 0.11%

Xilinx 0.63% Corning 0.08%

Qorvo 0.33% NeoPhotonics 0.06%

Nvidia 0.27% Lumentum 0.04%

Silicon Laboratories 0.20%

Lattice 0.18%

Microchip 0.18%

Maxim 0.16%

IDT 0.15%

Sensata 0.11%

Skyworks 0.10%

Intersil 0.10%

Inphi 0.03%

Source: Bloomberg, UBS-S estimates

ZTE Corporation 1 November 2016 abc 9

ZTE Corporation UBS-S Research

PIVOTAL QUESTIONS return 

Q: What are the implications of structural capex change in China?

UBS-S VIEW We expect capex in China to shift from wireless to wireline in 2016-18, as 4G network rollout peaked out in 2015, while telcos still need to upgrade their transmission and access networks to accommodate substantial data traffic growth. The fast growing ICT demand from government and corporate clients presents new opportunities for ICT infrastructure spending. We therefore expect the majority of the incremental revenue growth to come from optical products and government and corporate business, which together could offset the decline in revenue from wireless products.

EVIDENCE Accelerated fibre broadband upgrade undertaken by Chinese telcos since 2015. In 2015, ZTE reported Rmb10.5bn of revenue from government and corporate business, representing 18.2% YoY growth, higher than the market had expected.

WHAT'S PRICED IN? Our 2016/2017/2018 revenue forecasts are 0.9%/3.6%/4.4% below consensus estimates, indicating the market has: 1) fully factored growth from optical products into forecasts; or 2) has not fully factored in the decline in the wireless products.

Structural change of capex in China

Looking forward, we believe ‘ubiquitous connections and ultra-broadband’ will become the new trademarks of the telecommunications industry. The sophistication of 4G technology, together with the rapid development of smart mobile terminals, has provided a significant boost to users' demand for information services, which has driven the evolution of telecommunications operations and networks. With the 4G network largely built in China, we expect Chinese telcos' capex to tilt towards the following areas:

. Construction of high quality full-fibre networks to support fibre household broadband and IPTV services;

. Construction of transmission networks to build high speed, efficient business carriages with smart capabilities;

. Construction of big IT, IDC, big data and cloud computing networks/facilities/infrastructure to build strategic competencies in infrastructure.

On the other hand, the penetration and development of ‘Internet+’, the government's emphasis on information security, and the accelerated pace in the construction of smart cities, digitalisation of railways, and the informatisation of the energy sector will present new opportunities for ICT infrastructure spending.

ZTE Corporation 1 November 2016 abc 10

Figure 10: The value chain of optical products

EPI Wafer Chip Optical Optical module Optical component equipment

•IQE •Accelink •Accelink •Accelink •Cisco •LMOC (002281.SZ) (002281.SZ) (002281.SZ) •Huawei •VPEC •Truelight •LuxNet •Innolight •ZTE(0763.HK) •IntelliEpi •LuxNet •Innolight •PCL •Ericsson •Elaser •MACOM SPAR Technogies •Nokia •Innolight •PCL •HGTech •FiberHome Technogies (000988.SZ) (600498.SH) •O-Net •Molix •O-Net (0877.HK) •EoptoLink (300502.SZ)

Finisar, Avago, Sumimoto, JDSU/Lumentum, Oclaro, Oplink, NeoPhotonics, Source Photonics, Fujitsu

Source: UBS-S estimates

Figure 11: The network structure

Backbone Network Transceiver , Amplifier, DWDM, Linecard, Coherent

Metropolitan Area Network Transceiver , Amplifier, DWDM, Linecard, Coherent

Access Transceiver, GPON/EPON Network

Wireless FTTx transmission

DWDM: Dense Wavelength Division Multiplexing

Source: UBS-S estimates

ZTE Corporation 1 November 2016 abc 11

We expect optical communication products to be a growth driver in the next two to three years

As shown in the following table, we expect industry capex to decline 15.5% in 2016, and then trend down slightly at a 3.2% CAGR in 2017-19, before resuming growth in 2020 as 5G capex kicks in.

In terms of structural mix, we expect wireless capex as a percentage of total industry capex to decline from 44.0% in 2015 to 35.1% in 2018, while we expect wireline capex (mainly optical products) to rise from 39.0% of total industry capex to 44.8% over the same period.

Figure 12: We expect total industry capex to decline 15.5% in 2016, and then trend slightly downward (-3.2% CAGR in 2017-19)

(Rmb bn) 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E CM Group 168.4 179.9 224.2 245.0 215.6 202.9 195.0 193.0 186.1 207.9 CU Group 76.7 99.8 73.5 84.9 133.9 79.7 76.6 75.4 76.0 76.2 CT Group 84.0 85.0 85.0 78.4 110.6 100.1 93.3 88.2 85.7 91.6 Towerco 32.4 33.7 35.9 35.4 30.1 26.7

Total industry capex 329.1 364.7 382.6 408.3 492.5 416.4 400.8 392.0 377.9 402.5

YoY growth %

CM Group 2.2% 6.8% 24.6% 9.3% -12.0% -5.9% -3.9% -1.0% -3.6% 11.7% CU Group 9.2% 30.2% -26.4% 15.5% 57.8% -40.5% -3.9% -1.5% 0.7% 0.3% CT Group 9.0% 1.2% 0.0% -7.8% 41.1% -9.5% -6.8% -5.4% -2.8% 6.8% Towerco 3.8% 6.8% -1.6% -14.8% -11.3%

Total industry capex 5.5% 10.8% 4.9% 6.7% 20.6% -15.5% -3.7% -2.2% -3.6% 6.5%

Breakdown (%)

CM Group 51% 49% 59% 60% 44% 49% 49% 49% 49% 52% CU Group 23% 27% 19% 21% 27% 19% 19% 19% 20% 19% CT Group 26% 23% 22% 19% 22% 24% 23% 23% 23% 23% Towerco 0% 0% 0% 0% 7% 8% 9% 9% 8% 7% Total industry capex 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% Source: UBS-S estimates

Figure 13: We expect capex spending to structurally shift from wireless to wireline (mainly optical products)

Total industry 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E capex mix Wireless capex 37.6% 36.2% 35.2% 43.4% 44.0% 43.4% 39.3% 35.1% 35.2% 37.8% 2G 22.5% 15.6% 9.6% 5.6% 3.3% 2.1% 1.6% 1.2% 0.6% 0.2% 3G 14.9% 19.3% 13.0% 8.4% 6.3% 1.9% 1.6% 1.3% 0.7% 0.4% 4G 0.2% 1.3% 12.6% 29.4% 34.4% 39.4% 36.1% 32.6% 22.3% 8.0% 5G 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 11.5% 29.3% Wireline capex 38.7% 41.5% 42.7% 37.0% 39.0% 39.6% 42.1% 44.8% 46.3% 44.9% Access 27.8% 25.9% 18.9% 14.3% 18.5% 16.2% 17.5% 18.4% 17.2% 16.7% Transmission 10.8% 15.6% 23.8% 22.7% 20.6% 23.4% 24.7% 26.4% 29.1% 28.2% Others 23.8% 22.3% 22.0% 19.6% 16.9% 16.9% 18.5% 20.1% 18.5% 17.3% VAS 4.7% 4.3% 4.5% 3.9% 3.4% 3.7% 4.1% 4.6% 5.1% 4.8% IT support 4.0% 4.2% 4.2% 3.8% 3.5% 4.1% 4.6% 5.3% 5.7% 5.5% Infrastructure 15.1% 13.9% 13.4% 11.8% 10.0% 9.1% 9.8% 10.2% 7.7% 7.1% Total industry 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Source: UBS-S estimates

ZTE Corporation 1 November 2016 abc 12

We expect ZTE's wireless product revenue to grow 6.4% YoY in 2016, after strong growth of 43.1% YoY in 2015, mainly because we assume 30% of telco capex spending in 2015 has been rolled over to 2016. We expect wireless product revenue to decline 4.0%/8.4% in 2017/2018. In contrast, we forecast wireline product revenue to grow 4.0%/14.3%/11.4% YoY in 2016/2017/2018. As a result, we expect the optical revenue portion of total revenue to rise from 20.6% in 2015 to 23.8% in 2018, with wireless declining from 36.6% of revenue to 30%.

Figure 14: ZTE revenue mix: optical products and govt. & Figure 15: Growth in optical products should offset the corp. to account for higher portion of revenue decline in wireless products, YoY revenue growth

100% 50.0% 43.1% 10.9% 10.5% 12.3% 14.8% 17.9% 20.4% 22.2% 40.0% 80% 30.2% 32.4% 35.2% 31.0% 29.3% 30.0% 28.2% 27.1% 25.9% 60% 20.0% 14.3% 20.6% 20.1% 12.3% 11.4% 22.5% 22.1% 8.3% 5.2% 40% 23.8% 24.5% 10.0% 6.4% 24.3% 5.5% 4.7% 4.0% 2.8% 4.2% 2.5% -0.5% 0.0% 20% 36.6% 36.6% 33.8% 2015 2016E 2017E 2018E 2019E 2020E 31.4% 30.0% 28.0% 27.6% -4.0% -10.0% -1.5% -8.4% 0% 2014 2015 2016E 2017E 2018E 2019E 2020E -20.0%

Wireless Optical Consumer business Gov and Corp business Wireless Optical Total carriers' network

Source: Company data, UBS-S estimates Source: Company data, UBS-S estimates

We expect gross margin to improve due to revenue mix improvement

The company reported a 16.3% gross margin for its consumer business (mainly handsets) in 2015 compared to 34.5% for its carriers' network business and 38.6% for the government and corporate business. As we expect ZTE's future growth to come mainly from optical products and government and corporate business, which have 30-40% gross margins, we expect the company's gross margin to expand gradually from 29.0% in 2015 to 29.2%/29.5%/29.8% in 2016/2017/2018.

Figure 16: Gross margin by business segment

Gross margin 2014 2015 2016E 2017E 2018E 2019E 2020E Carriers' network 34.9% 34.5% 35.0% 34.8% 34.8% 34.6% 34.4% Wireless 36.5% 36.0% 36.0% 36.0% 36.0% 35.8% 35.6% Optical 32.6% 31.9% 33.1% 33.1% 33.3% 33.3% 33.1% Consumer business 17.0% 16.3% 15.0% 14.8% 14.6% 14.4% 14.4% Government and corporate business 39.7% 38.6% 38.6% 38.6% 38.6% 38.4% 38.2% Total 29.1% 29.0% 29.2% 29.5% 29.8% 29.9% 30.1% Source: UBS-S estimates

ZTE Corporation 1 November 2016 abc 13

ZTE Corporation UBS-S Research

PIVOTAL QUESTIONS return 

Q: Will ZTE's handset business remain difficult in the next 12 months?

UBS-S VIEW Yes. ZTE's handset business has performed poorly over the past two to three years, and it is no longer a top-tier manufacturer in China. The Chinese handset market is overly competitive and crowded and ZTE has been focusing more on selling handsets in overseas markets. It has achieved a No. 4 rank by handset sales in the US market. However, the US sanctions have damaged its brand name in the US. We expect ZTE's handset business to remain difficult in the next 12 months and growth driver in the consumer business will be other products such as broadband terminals and IPTV set-up boxes. While we forecast handset revenue to decline 9.8%/14.5%/14.5% in 2016/2017/2018, we expect other consumer product revenue to grow 30%/20%/16% and total consumer business revenue to remain relatively stable in 2016-18. We expect consumer business revenue to decline from 32.4% of total revenue in 2015 to 28.3% in 2018.

EVIDENCE In our recent UBS Evidence Lab survey (UBS Evidence Lab: Survey suggests smart-phone demand fears may be over-done), ZTE scored poorly in terms of key consumer perceptions, with few owners of ZTE devices seeing them as unique (16%), high quality (21%) or trustworthy (28%), and owners having a low commitment to the brand (12%).

WHAT'S PRICED IN? Based on our conversations with investors, investors have been downplaying ZTE's handset business for a long time, and expectations have therefore been low.

Chinese smartphones playing musical chairs

Gartner estimates China's smartphone shipments at 109.1m units in Q216, up Oppo and Vivo surpassed Xiaomi, 11.6% YoY (-0.2% QoQ), and accounting for 31.7% of the worldwide Lenovo and ZTE smartphone market, up from 29.6% in Q215. Overseas shipments increased 10% YoY suggesting Chinese handset OEMs are expanding overseas to avoid domestic competition. The Chinese market is highly saturated, and crowded with both traditional handset OEMs and new competitors like Meizu, LeTV and 360. We believe that in the long term fierce competition will push out smaller vendors in China and create opportunities for leading vendors to gain share as the Chinese smartphone market consolidates.

ZTE Corporation 1 November 2016 abc 14

Figure 17: Chinese handset vendor shipments m units Q115 Q215 Q315 Q415 2015 total Q116 Q216 QoQ % YoY %

Huawei 18.1 25.8 27.3 32.1 103.3 28.9 30.7 6% 19% -domestic shipment % 60% 55% 57% 53% 56% 56% 57% Xiaomi 14.7 16.1 17.2 18.2 66.2 15.0 15.5 3% -3% -domestic shipment % 89% 84% 88% 84% 86% 87% 87% Lenovo (+ Moto) 18.9 16.4 17.4 20.0 72.7 12.7 11.7 -8% -29% -domestic shipment % 46% 39% 30% 22% 34% 16% 17%

ZTE 9.8 11.9 12.0 14.8 48.5 11.1 12.2 10% 3% -domestic shipment % 34% 26% 25% 23% 26% 29% 25%

Coolpad 6.9 6.1 5.4 4.6 23.0 4.1 3.8 -8% -38% -domestic shipment % 97% 96% 94% 88% 94% 90% 88%

OPPO 6.6 8.2 11.9 13.0 39.6 16.1 18.5 15% 126% -domestic shipment % 87% 85% 88% 84% 86% 82% 82%

BBK 6.1 7.4 10.4 11.4 35.3 14.0 14.2 2% 91% -domestic shipment % 99% 95% 95% 90% 94% 89% 88% Meizu 2.6 4.8 6.6 7.6 21.6 5.6 5.6 1% 18% -domestic shipment % 97% 97% 97% 94% 96% 91% 91% TCLC 9.5 9.2 9.6 11.8 40.1 7.5 6.6 -13% -28% -domestic shipment % 18% 18% 5% 3% 10% 7% 1%

China smartphone market 101.5 97.8 103.1 113.3 415.7 109.3 109.1 0% 12% % of global smartphone market 30% 30% 29% 28% 29% 31% 32%

Source: Gartner, UBS-S

In a separate note from our Taiwan Hardware analyst, Arthur Hsieh (What do the Chinese flagship smartphones tell us?), according to several different sources listed below, the performance of Chinese handset vendors varied in Q216. Huawei maintained its strong growth momentum and gained share in the premium smartphone segment, while Xiaomi faced strong competition from local brands and lost its leading position in China. Surprisingly, Oppo and Vivo gained significant market share, surpassing Xiaomi, Lenovo and ZTE, and becoming tier-1 OEMs in China.

Figure 18: Top five smartphone vendors in China

Gartner IDC Strategy Analytics m units Q216 China market share % Q216 Global market share % Q216 China market share % Huawei 17.6 16.1% 32.1 9.4% 19.1 17.5% OPPO 15.1 13.9% 22.6 6.6% 15.2 13.9% Vivo 12.5 11.4% 16.4 4.8% 13.0 11.9% Xiaomi 15.5 14.2% NA NA 12.8 11.7% Apple 10.0 9.2% 40.4 11.8% 7.3 6.7% Total in China 109.1 100.0% 343.3 100.0% 109.0 100.0%

Source: Gartner, Strategy Analytics, IDC Quarterly Mobile Phone Tracker, UBS-S

ZTE Corporation 1 November 2016 abc 15

Key takeaways from Oppo's success

• Expansion via offline channel: Oppo's expansion in China has been via ZTE does not have a strong offline channels, due to its strong retail presence. Oppo is focusing on distribution channel fostering channel partnerships and penetrating the lower-tier market. According to a report from Mobile China Alliance, the number of retail stores owned by Oppo is just behind Apple in China. Oppo has over 30 tier-1 handset distribution agents and collaborates with more than 200,000 retail stores, not only in major cities but also in rural areas. Compared with the online platform, the offline channel is more likely to turn potential customers into final buyers, especially in lower-tier markets. In contrast, the retail channel has been a weakness for ZTE's handset business as ZTE used to heavily rely on the operators' channels. Since Chinese telcos started to cut handset subsidies, as mandated by the Chinese government since H214, ZTE has been losing market share in the domestic market. Around 75% of ZTE's handset revenue was from overseas markets in 2015.

• Innovation capability: Oppo has differentiated its brand by focusing on a front camera for selfies and the fast-charging feature using its self- developed VOOC technology. Oppo launched its flagship Find 7 with VOOC fast charging technology for the first time in 2014, and it established its brand image by introducing the slogan “with five minutes of charging, you can talk for two hours”. Cumulative shipments of the Oppo Find 7 have reached 15m since its launch. In 2016, it unveiled the R9 and R9 Plus with 16mpx front cameras, which appear to have been well received by camera enthusiasts. Due to its design and innovation capability, Oppo has a high brand premium in China and is targeting the mid-to-high-end smartphone market.

• High exposure in the market: In addition to its retail presence and competitive products, Oppo has a large marketing budget and uses entertainment sponsorships to increase its popularity in the market. It sponsored "Happy Camp", "Running Man", and "Idol is Coming", which are popular TV shows in China. Oppo has hired Chinese and Korean pop stars and celebrities as brand ambassadors. It has also signed an agreement with FC Barcelona to become an official partner of the Spanish football club.

Key findings of UBS Evidence Lab Survey

We have used a proprietary UBS Evidence Lab study of consumers' purchasing decisions to analyse a series of key investment debates and draw several conclusions regarding the smartphone and mobile payment markets. Key findings appear below.

ZTE has the lowest retention ratio. Chinese vendors such as Xiaomi, Oppo, Coolpad and Lenovo have much lower retention rates than their developed market peers. We believe this is partly reflective of the propensity of domestic customers to churn (ie they are more agnostic between vendors) but could also reflect the manner of distribution. ZTE ranked last overall, with only a 9% retention ratio.

ZTE Corporation 1 November 2016 abc 16

Figure 19: ZTE ranked last with 9% retention ratio

90% 81% 80% 73% 70% 66%

60%

50% 45% 40% 39% 39% 40% 37% 34% 31% 29% 28% 30% 26% 24% 21% 19% 20% 17% 12% 12% 9% 10%

0% LG ZTE HTC Asus Sony Oppo Sharp Apple Meizu Fujitsu Alcatel Xiaomi Lenovo Huawei Android Coolpad Samsung Motorola Microsoft BlackBerry Note: UBS Evidence Lab conducted an online survey to a representative panel of consumers based on gender, age, and income distribution across the US, UK, Germany, mainland China (tier 1 and 2 cities) and Japan in March 2016. In total, 6,336 smartphone users were interviewed. Qualification criteria were based on ownership of a smartphone. The margin of error for 6,336 total sample responses is between +/-1.02%. Source: UBS Evidence Lab survey

Handset pricing seems to be the only differentiation. The table (from the same Evidence Lab survey) below highlights some of the key consumer perceptions of brands of mobile devices they own. We have two conclusions from the table: 1) like its Chinese peers, ZTE scores well for value for money despite lagging behind Huawei and Xiaomi (Huawei 62%, Xiaomi 61%, ZTE 52%); 2) in terms of the key consumer perceptions, ZTE scores poorly, with few owners of ZTE devices seeing them as unique (16%), high quality (21%) or a brand they trust (28%), and owners having a low commitment to the brand (12%).

As the only category ZTE scores well in is value for money, we expect ZTE to remain relatively competitive in the low-end smartphone segment, but think it would be difficult for the company to move up the ladder.

ZTE Corporation 1 November 2016 abc 17

Figure 20: Key consumer perceptions

Offers value for money Products are unique Produces high quality products Huawei 62% Apple 36% Samsung 55% Xiaomi 61% Microsoft 34% Apple 54% Alcatel 59% Blackberry 33% Microsoft 53% Nokia 57% Lenovo 33% Sony 50% Motorola 56% OPPO 32% Motorola 48% Meizu 55% Samsung 28% Sony Ericsson 47% LG 53% Meizu 28% LG 42% Microsoft 52% Xiaomi 28% Nokia 41% ZTE 52% ASUS 24% Xiaomi 41% HTC 51% LG 23% Blackberry 40% Samsung 49% Sony 22% HTC 39% ASUS 45% HTC 22% Huawei 39% Lenovo 43% Coolpad 22% OPPO 38% Coolpad 41% Huawei 22% Fujitsu 33% OPPO 40% Fujitsu 22% ASUS 29% Blackberry 39% Motorola 21% Alcatel 29% Sony Ericsson 35% Nokia 20% Sharp 26% Kyocera 32% Sony Ericsson 18% Meizu 26% Sony 29% Kyocera 18% Lenovo 25% Fujitsu 27% Sharp 16% Coolpad 24% Sharp 26% ZTE 16% ZTE 21% Apple 24% Alcatel 14% Kyocera 20%

Is a brand I trust I am familiar with the brand Is a brand I feel committed to Samsung 56% Samsung 63% Samsung 37% Nokia 55% Nokia 62% Microsoft 35% Motorola 54% Motorola 59% Apple 31% Apple 52% Xiaomi 59% Nokia 30% Xiaomi 47% Huawei 58% Sony Ericsson 29% Sony 47% Apple 56% Sony 27% Sony Ericsson 46% Microsoft 55% Motorola 26% Huawei 45% HTC 55% Blackberry 26% LG 45% Meizu 53% Xiaomi 25% HTC 44% LG 53% ASUS 24% Microsoft 43% Sony Ericsson 52% Huawei 24% Blackberry 41% Lenovo 51% Meizu 23% OPPO 38% Sony 50% OPPO 23% Lenovo 36% OPPO 48% HTC 22% Kyocera 36% Blackberry 46% LG 21% Sharp 35% Coolpad 43% Coolpad 19% ASUS 33% ZTE 41% Lenovo 18% Meizu 32% ASUS 39% Fujitsu 16% Coolpad 30% Kyocera 39% ZTE 12% Fujitsu 29% Sharp 39% Alcatel 11% Alcatel 29% Fujitsu 29% Kyocera 11% ZTE 28% Alcatel 27% Sharp 9% Source: UBS Evidence Lab survey (from the same Evidence Lab survey)

ZTE Corporation 1 November 2016 abc 18

We lower our handset shipment and revenue forecasts

Our ZTE handset shipment and revenue forecasts have been conservative. We are cutting our 2016/2017/2018 estimates for handset shipments a further -8.9%/- 16.4%/-23.2% to 44.6m/40.2m/36.1m, which implies YoY growth of -8.0%/- 10.0%/-10.0%. Our lower estimates reflect the weakness of its brand name and customer stickiness mentioned in the UBS Evidence Lab survey.

Growth from other consumer products to offset decline in handset revenue

The company has been shifting its focus from handsets to home media terminals, such as broadband terminals and IPTV set-up boxes. While we estimate handset revenue will decline 9.8%/14.5%/14.5% in 2016/2017/2018, we expect other product revenue to grow 30%/20%/16% and total consumer business revenue to remain relatively stable in 2016-18. We expect consumer business revenue to decline from 32.4% of total revenue in 2015 to 28.3% in 2018.

Figure 21: We expect revenue from other consumer products to surpass handset revenue in 2018

2014 2015 2016E 2017E 2018E 2019E 2020E

Consumer business revenue (Rmb m) 28,644 32,467 33,044 32,498 32,291 32,695 33,096 Growth % 32.0% 13.3% 1.8% -1.7% -0.6% 1.3% 1.2% As % of total rev 35.2% 32.4% 31.0% 29.3% 28.2% 27.1% 25.9% Handset revenue (Rmb m) 23,000 23,000 20,737 17,730 15,159 13,370 11,793 Growth % NA 0.0% -9.8% -14.5% -14.5% -11.8% -11.8% As % of consumer business 80% 71% 63% 55% 47% 41% 36% Handset ASP 535 474 465 442 419 411 403 Growth % NA -11.3% -2.0% -5.0% -5.0% -2.0% -2.0% Handset sales volume (m) 43.0 48.5 44.6 40.2 36.1 32.5 29.3 Growth % NA 12.8% -8.0% -10.0% -10.0% -10.0% -10.0% Other consumer products (Rmb m) 5,644 9,467 12,307 14,768 17,131 19,324 21,303 Growth % NA 67.7% 30.0% 20.0% 16.0% 12.8% 10.2% As % of consumer business 20% 29% 37% 45% 53% 59% 64% Source: Company data, UBS-S estimates

ZTE Corporation 1 November 2016 abc 19

ZTE Corporation UBS-S Research

WHAT'S PRICED IN? return 

Figure 22: UBS estimates versus consensus

2016E 2017E 2018E

UBS Consensus Diff% UBS Consensus Diff% UBS Consensus Diff%

Revenue (Rmb m) 106,559 107,536 -0.9% 110,805 114,914 -3.6% 114,366 119,602 -4.4% Gross profit (Rmb m) 31,133 32,167 -3.2% 32,709 34,230 -4.4% 34,063 35,522 -4.1% Gross margin 29.2% 29.9% -0.7% 29.5% 29.8% -0.3% 29.8% 29.7% 0.1%

Net profit (Rmb m) 3,551 3,705 -4.2% 4,035 4,029 0.1% 4,527 4,107 10.2% Net margin 3.3% 3.4% -0.1% 3.6% 3.5% 0.1% 4.0% 3.4% 0.5% EPS 0.86 0.89 -3.6% 0.98 0.99 -1.6% 1.10 1.00 10.2% Source: Bloomberg, UBS-S estimates

1. Qualitative Feedback: as we talked with investors, many noted that they have put ZTE on restricted lists because of the US sanctions. We therefore believe the share price is unlikely to move significantly unless and until the sanctions are removed. It is extremely difficult to estimate the timing of the removal and the

ZTE Corporation 1 November 2016 abc 20

potential outcome, such as a civil penalty. There is no consensus view based on our conversations with investors.

2. Consensus forecasts: our revenue forecasts for 2016/17/18 are 0.9%/3.6%/4.4% below consensus, probably because: 1) we have factored more negative impact from the sanctions on overseas businesses; and 2) we are more bearish on the capex outlook in 2016-18 in China. Our gross profit estimates are 3.2%/4.4%/4.1% below consensus in 2016/2017/2018, mainly because of lower revenue forecasts. Our 2016 earnings estimate is 3.6% below consensus, our 2017 estimate is largely in line with consensus, and we are 9.2% above consensus for 2018, as we expect operational leverage to play out in 2018 as the company keeps R&D and selling and marketing costs well under control.

3. “What's Priced In?” for long-term growth: at the beginning of 2016, the shares traded at HK$16.94. Based on our “What's priced in" residual income model medium- and long-term growth jointly contributed 24% of the valuation at that time, indicating investor's relatively optimistic outlook on ZTE's future growth. However, after the US DoC imposed export sanctions on ZTE on 7 March 2016, the share price slipped and reached a low of HK$9.55 on 24 May 2016. At the share price of HK$9.55, our analysis shows medium- and long-term growth jointly contributed -35% of the valuation, indicating investors’ views were highly pessimistic. The shares are now trading at HK$10.96, implying medium- and long- term growth are jointly contributing -14% of the valuation, indicating investors' concerns on export sanctions.

4. Valuation: ZTE is trading at 9.7x 2017E PE, a historical low point compared to the 15-25x PE band over the past 10 years. Compared with its telecom equipment peers, ZTE trades at a 37-45% discount to its international peers Nokia (15.5x 2017E PE) and Ericsson (17.5x 2017E PE), and a much larger 62-79% discount to its domestic peers Fiberhome (25.4x 2017E PE, a 62% discount), Accelink (36.7x 2017E PE, a 74% discount), and Datang Telecom (46.9x 2017E PE, a 79% discount). Compared with its government and corporate business peers, ZTE trades at a 29-57% discount to its peers Hikvision (13.6x 2017E PE), Dahua (16.8x 2017E PE), SMIC (17.3x 2017E PE) and THTF (22.8x 2017E PE). As we expect ZTE's handset business to remain difficult, the valuation comparison on handset peers might not be that meaningful. As a reference, ZTE is trading at par with Lenovo (9.7x 2017E PE) and a 60% discount to Coolpad (24.0x 2017E PE). All in all, ZTE's valuation is the lowest compared with its peers.

ZTE Corporation 1 November 2016 abc 21

Figure 23: Regional valuation comparison

Share Price Mkt Cap PER (x) EV/EBITDA (x) Div Yield (%)

Country Curr Rating Price Target (US$bn) 2016E 2017E 2018E 2016E 2017E 2018E 2016E 2017E 2018E

Company Line-up ZTE-H China HK$ Neutral 10.82 12.20 8.7 11.0 9.7 8.6 6.6 6.5 6.1 2.3 1.5 2.9 Telecom Equipment vendors

Nokia Finland Euro€ Buy 4.11 6.50 25.3 23.3 15.5 11.4 7.1 6.8 5.7 3.9 3.9 4.4

Ericsson Sweden SKr Neutral 43.55 45.00 16.0 17.6 17.5 15.7 6.8 7.4 6.7 0.0 4.0 4.4

Fiberhome China Rmb Not Rated 27.88 N/A 4.3 32.2 25.4 19.7 24.0 19.6 14.6 1.3 1.8 2.3

Datang Telecom China Rmb Not Rated 19.33 N/A 1.3 86.5 46.9 28.3 18.2 14.6 10.2 0.0 1.0 1.0

Accelink China Rmb Not Rated 76.20 N/A 2.4 50.4 36.7 27.8 37.9 28.4 22.1 1.0 1.4 1.8

Handset vendors

Coolpad China HK$ Not Rated 1.38 N/A 0.4 -7.5 24.0 19.5 mn 25.3 26.4 0.0 0.0 0.0

Lenovo China HK$ Neutral 5.02 5.50 7.2 10.2 9.7 9.2 5.9 5.1 5.1 4.1 4.1 4.1

Govt and corp business providers

Hikvision China Rmb Buy 24.91 31.00 22.4 17.8 13.6 10.9 17.7 13.0 9.7 2.0 2.6 3.2

Dahua Inc China Rmb Not Rated 14.77 N/A 0.6 22.6 16.8 12.5 2.2 1.6 1.2 0.8 1.0 1.5

SMIC China HK$ Neutral 0.94 0.80 5.1 15.2 17.3 22.3 4.9 4.9 5.0 0.0 0.0 0.0

THTF China Rmb Not Rated 14.24 N/A 4.2 6.4 22.8 21.3 2.8 6.9 6.5 0.0 0.0 0.0

Average 8.2 23.2 20.9 17.2 11.8 11.3 9.8 1.3 1.8 2.1

Above data as of 28 October 2016. Source: Wind, UBS-S estimates

ZTE Corporation 1 November 2016 abc 22

ZTE Corporation UBS-S Research

UPSIDE / DOWNSIDE SPECTRUM return 

ZTE is trading at HK$10.82 (as of 28 October)

Value drivers Sanction penalty Carriers' network Consumer business Gov&Corp business Gross (Rmb bn) business growth growth (5yr CAGR) growth (5yr CAGR) margin (5yr CAGR) HK$14.3 upside 1.0 3.3% 0.6% 22.3% 29.9% HK$12.2 base 2.0 3.0% 0.4% 21.9% 29.7% HK$8.1 downside 6.0 2.8% -1.6% 21.1% 29.8% Source: UBS-S

Risk to the current share price is balanced (1.3:1)

ZTE is trading at HK$10.82 (as of 28 October).

Upside (HK$14.30): In this scenario, we assume better- than-expected revenue growth. We would expect revenue CAGR of 5.3% for the next five years (5.0% in our base case). We assume revenue CAGRs of 3.3%/0.6%/22.3% for the operator/consumer/government and corporate businesses over the next five years (versus 3.0%/0.4%/21.9% in our base case). We assume the sanctions penalty is Rmb1.0bn (Rmb2.0bn in our base case). In this case, we would expect the average gross margin over the next five years to be 29.9% (29.7% in our base case) and average net margin improve to 3.8% (3.6% in our base case). Our upside valuation of HK$15.00 implies 12.3x 2017E PE.

Base (HK$12.20): We derive our HK$12.20 price target using a 10-year DCF valuation with a WACC of 8.7% and 2% terminal growth. We raise our revenue estimates for the carrier's network business to Rmb60.4bn/Rmb61.9bn in 2016/2017 (0.4%/4.9%), implying 5.5%/2.5% YoY growth, to reflect better growth in optical business. We lower our revenue estimates for the consumer business to Rmb33.0bn/Rmb32.5bn in 2016/2017 (6.5%/12.4%), implying 1.8%/-1.7% YoY growth, as we expect the handset business to remain difficult. We leave our gross margin estimate unchanged at 29.2% in 2016 and raise it to 29.5% in 2017 (previously 28.8%), as the company is expanding its high-margin businesses (carrier and government and corporate business) and shrinking its low- margin business (consumer business). In our base case, we assume a one-off penalty of US$300m [(Rmb2bn)], which reduces our DCF valuation 4% from HK$13.60 (up from the previous HK$13.00 as WACC declines from 9.0% to 8.7% due to a lower risk-free rate of 4.06%, down from 4.47%) to HK$13.00. Our DCF- based price target therefore remains at HK$13.00, implying 10.9x 2017E PE.

Downside (HK$8.10): We assume slower-than-expected revenue growth in our upside scenario. We assume a revenue CAGR of 4.2% for the next five years (5.0% in our base case). We assume revenue CAGRs of 2.8%/-1.6%/21.1% for

ZTE Corporation 1 November 2016 abc 23

the operator/consumer/government and corporate businesses for the next five years (3.0%/0.4%/21.9% in our base case). We assume the sanction penalty is Rmb6.0bn (Rmb2.0bn in our base case). In this case, we expect the average gross margin in the next five years to be 29.8% (29.7% in our base case) and average net margin to decline to 3.4% (3.9% in our base case). Our downside valuation of HK$9.00 implies 7.9x 2017E PE.

ZTE Corporation 1 November 2016 abc 24

Figure 24: Revisions to financial estimates

2016E 2017E 2018E 2019E 2020E 2021E Revenue (Rmb bn)

Old forecast 108.6 112.2 114.3 119.0 124.8 138.9 New forecast 106.6 110.8 114.4 120.6 127.7 141.6 Growth (%) 6.4% 4.0% 3.2% 5.5% 5.8% 10.9% Revision (%) -1.9% -1.2% 0.0% 1.3% 2.3% 1.9% Revenue: carrier's network business (Rmb bn) Old forecast 60.2 59.0 56.3 56.6 58.8 69.3 New forecast 60.4 61.9 61.6 63.3 66.3 77.0 Growth (%) 5.5% 2.5% -0.5% 2.8% 4.7% 16.1% Revision (%) 0.4% 4.9% 9.4% 11.9% 12.7% 11.1% Revenue: consumer business (Rmb bn) Old forecast 35.3 37.1 38.8 40.4 41.7 42.9 New forecast 33.0 32.5 32.3 32.7 33.1 33.5 Growth (%) 1.8% -1.7% -0.6% 1.3% 1.2% 1.1% Revision (%) -6.5% -12.4% -16.8% -19.0% -20.7% -22.0% Revenue: Govt. & corp. business (Rmb bn) Old forecast 13.1 16.0 19.2 22.1 24.3 26.7 New forecast 13.1 16.4 20.5 24.6 28.3 31.1 Growth (%) 25.0% 25.0% 25.0% 20.0% 15.0% 10.0% Revision (%) 0.0% 2.5% 6.7% 11.4% 16.4% 16.4% Gross margin (%)

Old forecast 29.3% 28.8% 28.4% 28.2% 28.2% 28.6% New forecast 29.2% 29.5% 29.8% 29.9% 30.1% 30.4% Revision (%) -0.1% 0.8% 1.4% 1.7% 1.9% 1.8% Gross profit (Rmb bn)

Old forecast 31.8 32.3 32.5 33.6 35.2 39.7 New forecast 31.1 32.7 34.1 36.1 38.4 43.0 Growth (%) 7.0% 5.1% 4.1% 5.9% 6.4% 12.1% Revision (%) -2.1% 1.4% 4.9% 7.4% 9.2% 8.4% Operating profit margin (%)

Old forecast 5.8% 5.6% 5.4% 5.3% 5.0% 5.4% New forecast 5.5% 5.6% 5.9% 6.2% 6.4% 6.7% Revision (%) -0.4% 0.0% 0.5% 1.0% 1.4% 1.3% Operating profit (Rmb bn)

Old forecast 6.3 6.3 6.2 6.3 6.3 7.5 New forecast 5.8 6.2 6.8 7.5 8.2 9.5 Growth (%) 0.7% 6.6% 9.5% 10.8% 8.4% 16.1% Revision (%) -7.8% -1.8% 9.2% 19.8% 30.2% 26.4% Net margin (%)

Old forecast 3.6% 3.6% 3.5% 3.4% 3.2% 3.6% New forecast 3.3% 3.6% 4.0% 4.3% 4.4% 4.8% Revision (%) -0.3% 0.0% 0.5% 0.9% 1.2% 1.2% Net profit (Rmb bn)

Old forecast 3.92 4.08 3.99 4.03 4.00 5.00 New forecast 3.55 4.03 4.53 5.14 5.65 6.74 Growth (%) 10.7% 13.6% 12.2% 13.5% 10.1% 19.2% Revision (%) -9.4% -1.1% 13.5% 27.4% 41.4% 34.7%

Source: UBS-S estimates

ZTE Corporation 1 November 2016 abc 25

Figure 25: ZTE DCF

Source: UBS-S estimates

ZTE Corporation 1 November 2016 abc 26

ZTE Corporation UBS-S Research

COMPANY DESCRIPTION return 

Market Cap HK$68.1bn Revenue by region, 2015 (%)

Shares Outstanding 4,154m (COM) Govt. and corporate Industry Telecom, Cautious business Region China 10.5% Website www.zte.com.cn

ZTE is one of China's top two networking hardware Consumer companies, with products ranging from wireless, wireline, business Carriers’ 32.4% networks data/optical equipment and handsets to services and 57.1% software. It has one of the top market shares among Chinese vendors in China, and sells its GSM/CDMA 2G/2.5G products in South Asia and Africa. ZTE competes for China's 3G and 4G network contracts, particularly for the country's self-developed TD-SCDMA technology. Source: Company data

Industry outlook

We expect Chinese telcos’ capex to enter a downward Gross profit by product segment cycle in 2016-19 and think the capex structure will shift from wireless to wireline (especially optical networks). We Rmb bn 2014 2015 2016E 2017E 2018E expect the smartphone market to be crowded and Carriers’ networks 15.3 19.8 21.1 21.6 21.4 saturated and believe lower-tier OEMs will be forced to exit Consumer business 4.9 5.3 5.0 4.8 4.7 the market in the future. Govt. and corp. business 3.5 4.0 5.1 6.3 7.9

Total gross profit 23.7 29.1 31.1 32.7 34.1 Source: Company data, UBS-S estimates

ZTE Corporation 1 November 2016 abc 27

ZTE Corporation (0763.HK)

Income statement (Rmbm) 12/13 12/14 12/15 12/16E % ch 12/17E % ch 12/18E 12/19E 12/20E Revenues 75,234 81,471 100,186 106,559 6.4 110,805 4.0 114,366 120,623 127,667 Gross profit 20,459 23,712 29,093 31,133 7.0 32,709 5.1 34,063 36,078 38,385 EBITDA (UBS) 4,425 7,261 7,890 8,389 6.3 8,685 3.5 9,099 9,856 10,521 Depreciation & amortisation (1,178) (1,826) (2,114) (2,572) 21.7 (2,481) -3.5 (2,305) (2,326) (2,362) EBIT (UBS) 3,247 5,435 5,777 5,818 0.7 6,204 6.6 6,795 7,530 8,160 Associates & investment income 1,096 255 63 63 0.0 63 0.0 63 63 63 Other non-operating income (865) (590) (267) (107) 60.1 (111) -4.0 (114) (121) (128) Net interest (1,650) (1,562) (1,686) (1,542) 8.5 (1,358) 11.9 (1,369) (1,383) (1,401) Exceptionals (incl goodwill) 0 0 0 0 - (2,000) - 0 0 0 Profit before tax 1,828 3,538 3,887 4,232 8.9 2,798 -33.9 5,375 6,090 6,695 Tax (394) (810) (563) (558) 1.0 (386) 30.8 (695) (781) (853) Profit after tax 1,434 2,728 3,324 3,674 10.5 2,413 -34.3 4,680 5,309 5,841 Preference dividends and Minorities (76) (94) (116) (123) -6.0 (85) 30.8 (153) (172) (188) Extraordinary items 0 0 0 0 - 0 - 0 0 0 Net earnings (local GAAP) 1,358 2,634 3,208 3,551 10.7 2,328 -34.5 4,527 5,137 5,654 Net earnings (UBS) 1,358 2,634 3,208 3,551 10.7 4,035 13.6 4,527 5,137 5,654 Tax rate (%) 21.6 22.9 14.5 13.2 -9.0 13.8 4.6 12.9 12.8 12.7

Per share (Rmb) 12/13 12/14 12/15 12/16E % ch 12/17E % ch 12/18E 12/19E 12/20E EPS (UBS, diluted) 0.33 0.64 0.78 0.86 10.7 0.98 13.6 1.10 1.25 1.37 EPS (local GAAP, diluted) 0.33 0.64 0.78 0.86 10.7 0.56 -34.5 1.10 1.25 1.37 EPS (UBS, basic) 0.33 0.64 0.78 0.86 10.7 0.98 13.6 1.10 1.25 1.37 Net DPS (Rmb) 0.02 0.17 0.19 0.22 10.7 0.14 -34.5 0.27 0.31 0.34 Book value per share 5.46 6.03 9.45 10.12 7.1 10.47 3.5 11.42 12.39 13.45 Average shares (diluted) 4,128.09 4,128.09 4,125.05 4,125.05 0.0 4,125.05 0.0 4,125.05 4,125.05 4,125.05

Balance sheet (Rmbm) 12/13 12/14 12/15 12/16E % ch 12/17E % ch 12/18E 12/19E 12/20E Cash and equivalents 20,903 18,116 28,025 29,641 5.8 29,534 -0.4 31,818 33,478 35,113 Other current assets 57,919 68,175 70,989 75,947 7.0 79,939 5.3 83,513 89,190 95,556 Total current assets 78,822 86,290 99,014 105,587 6.6 109,472 3.7 115,331 122,668 130,669 Net tangible fixed assets 7,698 7,664 8,369 8,432 0.8 8,572 1.7 8,863 9,169 9,493 Net intangible fixed assets 3,081 3,742 3,772 3,269 -13.4 2,864 -12.4 2,556 2,336 2,204 Investments / other assets 12,871 12,558 13,433 16,199 20.6 16,387 1.2 16,545 16,822 17,134 Total assets 102,473 110,255 124,588 133,487 7.1 137,295 2.9 143,294 150,995 159,500 Trade payables & other ST liabilities 48,021 52,793 54,807 58,681 7.1 60,816 3.6 62,596 65,899 69,596 Short term debt 15,343 17,172 16,525 16,525 0.00 16,525 0.00 16,525 16,525 16,525 Total current liabilities 63,364 69,965 71,332 75,206 5.4 77,341 2.8 79,121 82,424 86,121 Long term debt 11,505 10,040 6,016 6,016 0.0 6,016 0.0 6,016 6,016 6,016 Other long term liabilities 3,978 3,957 3,891 6,055 55.6 6,208 2.5 6,337 6,562 6,817 Preferred shares 0 0 0 0 - 0 - 0 0 0 Total liabilities (incl pref shares) 78,847 83,962 81,239 87,277 7.4 89,566 2.6 91,474 95,002 98,954 Common s/h equity 22,533 24,879 38,981 41,731 7.1 43,171 3.5 47,115 51,121 55,490 Minority interests 1,093 1,414 4,367 4,479 2.6 4,559 1.8 4,705 4,871 5,055 Total liabilities & equity 102,473 110,255 124,588 133,487 7.1 137,295 2.9 143,294 150,995 159,500

Cash flow (Rmbm) 12/13 12/14 12/15 12/16E % ch 12/17E % ch 12/18E 12/19E 12/20E Net income (before pref divs) 1,358 2,634 3,208 3,551 10.7 2,328 -34.5 4,527 5,137 5,654 Depreciation & amortisation 1,178 1,826 2,114 2,572 21.7 2,481 -3.5 2,305 2,326 2,362 Net change in working capital (3,070) (4,354) (1,788) (1,597) 10.7 (1,892) -18.5 (1,824) (2,425) (2,726) Other operating 981 598 2,271 49 -97.9 16 -66.4 83 103 120 Operating cash flow 447 703 5,804 4,575 -21.2 2,934 -35.9 5,090 5,141 5,409 Tangible capital expenditure (904) (1,007) (1,604) (2,131) -32.9 (2,216) -4.0 (2,287) (2,412) (2,553) Intangible capital expenditure 0 0 0 0 - 0 - 0 0 0 Net (acquisitions) / disposals 6 72 0 0 - 0 - 0 0 0 Other investing (273) (1,087) (265) (26) - 63 - 63 63 63 Investing cash flow (1,171) (2,022) (1,869) (2,157) -15.4 (2,153) 0.2 (2,224) (2,349) (2,490) Equity dividends paid 0 (103) (688) (802) -16.6 (888) -10.7 (582) (1,132) (1,284) Share issues / (buybacks) 19 254 2,834 0 - 0 - 0 0 0 Other financing 18 (860) 0 0 - 0 - 0 0 0 Change in debt & pref shares (1,082) (1,310) 2,805 0 - 0 - 0 0 0 Financing cash flow (1,045) (2,019) 4,952 (802) - (888) -10.7 (582) (1,132) (1,284) Cash flow inc/(dec) in cash (1,769) (3,338) 8,888 1,616 -81.8 (107) - 2,284 1,661 1,635 FX / non cash items (1,454) 551 1,021 0 - 0 - 0 0 0 Balance sheet inc/(dec) in cash (3,223) (2,787) 9,909 1,616 -83.7 (107) - 2,284 1,661 1,635 Source: Company accounts, UBS estimates. (UBS) metrics use reported figures which have been adjusted by UBS analysts.

ZTE Corporation 1 November 2016 abc 28

ZTE Corporation (0763.HK)

Valuation (x) 12/13 12/14 12/15 12/16E 12/17E 12/18E 12/19E 12/20E P/E (local GAAP, diluted) 28.9 17.1 18.3 10.8 16.5 8.5 7.5 6.8 P/E (UBS, diluted) 28.9 17.1 18.3 10.8 9.5 8.5 7.5 6.8 P/CEPS 15.5 10.1 11.0 6.3 5.9 5.6 5.2 4.8 Equity FCF (UBS) yield % (1.0) (0.6) 5.4 4.2 1.2 4.8 4.7 4.9 Net dividend yield (%) 0.3 1.5 1.4 2.3 1.5 2.9 3.3 3.7 P/BV x 1.7 1.8 1.5 0.9 0.9 0.8 0.8 0.7 EV/revenues (core) 0.6 0.7 0.9 0.5 0.5 0.5 0.5 0.4 EV/EBITDA (core) 9.6 7.6 11.1 6.5 6.5 6.1 5.6 5.3 EV/EBIT (core) 13.0 10.2 15.1 9.4 9.1 8.1 7.4 6.8 EV/OpFCF (core) 9.6 7.6 11.1 6.5 6.5 6.1 5.6 5.3 EV/op. invested capital 1.5 1.8 2.5 1.5 1.5 1.3 1.3 1.2

Enterprise value (Rmbm) 12/13 12/14 12/15 12/16E 12/17E 12/18E 12/19E 12/20E Market cap. 44,623 47,927 77,898 58,666 58,666 58,666 58,666 58,666 Net debt (cash) (1,814) 7,521 7,521 (6,291) (7,046) (8,134) (8,134) (8,134) Buy out of minorities 1,093 1,414 4,367 4,479 4,559 4,705 4,871 5,055 Pension provisions/other 96 115 144 55 55 55 55 55 Total enterprise value 43,998 56,977 89,930 56,908 56,234 55,291 55,458 55,642 Non core assets (1,697) (1,807) (2,459) (2,459) (77) (77) (87) (122) Core enterprise value 42,300 55,169 87,471 54,449 56,156 55,214 55,371 55,520

Growth (%) 12/13 12/14 12/15 12/16E 12/17E 12/18E 12/19E 12/20E Revenue -10.6 8.3 23.0 6.4 4.0 3.2 5.5 5.8 EBITDA (UBS) NM 64.1 8.7 6.3 3.5 4.8 8.3 6.8 EBIT (UBS) - 67.4 6.3 0.7 6.6 9.5 10.8 8.4 EPS (UBS, diluted) - 94.0 21.9 10.7 13.6 12.2 13.5 10.1 Net DPS - NM 16.6 10.7 -34.5 94.5 13.5 10.1

Margins & Profitability (%) 12/13 12/14 12/15 12/16E 12/17E 12/18E 12/19E 12/20E Gross profit margin 27.2 29.1 29.0 29.2 29.5 29.8 29.9 30.1 EBITDA margin 5.9 8.9 7.9 7.9 7.8 8.0 8.2 8.2 EBIT margin 4.3 6.7 5.8 5.5 5.6 5.9 6.2 6.4 Net earnings (UBS) margin 1.8 3.2 3.2 3.3 3.6 4.0 4.3 4.4 ROIC (EBIT) 11.8 17.6 16.7 16.1 16.0 16.3 17.2 17.6 ROIC post tax 5.5 13.3 14.2 13.9 13.7 14.2 15.0 15.3 ROE (UBS) 6.2 11.1 10.0 8.8 9.5 10.0 10.5 10.6

Capital structure & Coverage (x) 12/13 12/14 12/15 12/16E 12/17E 12/18E 12/19E 12/20E Net debt / EBITDA 1.3 1.3 (0.7) (0.8) (0.8) (1.0) (1.1) (1.2) Net debt / total equity % 25.2 34.6 (12.6) (15.4) (14.6) (17.9) (19.5) (20.8) Net debt / (net debt + total equity) % 20.1 25.7 (14.5) (18.2) (17.2) (21.8) (24.3) (26.2) Net debt/EV % 14.1 16.5 (6.3) (13.0) (12.5) (16.8) (19.8) (22.6) Capex / depreciation % 76.7 55.2 75.9 82.9 89.3 99.2 103.7 108.1 Capex / revenue % 1.2 1.2 1.6 2.0 2.0 2.0 2.0 2.0 EBIT / net interest 2.0 3.5 3.4 3.8 4.6 5.0 5.4 5.8 Dividend cover (UBS) 13.2 3.8 4.0 4.0 6.9 4.0 4.0 4.0 Div. payout ratio (UBS) % 7.6 26.1 25.0 25.0 14.4 25.0 25.0 25.0

Revenues by division (Rmbm) 12/13 12/14 12/15 12/16E 12/17E 12/18E 12/19E 12/20E Carriers network 40,696 43,944 57,223 60,395 61,906 61,574 63,327 66,280 Consumer business 21,702 28,644 32,467 33,044 32,498 32,291 32,695 33,096 Government and corporate 12,836 8,884 10,497 13,121 16,401 20,501 24,602 28,292 Others 0 0 0 0 0 0 0 0 Total 75,234 81,471 100,186 106,559 110,805 114,366 120,623 127,667

EBIT (UBS) by division (Rmbm) 12/13 12/14 12/15 12/16E 12/17E 12/18E 12/19E 12/20E Consolidated 3,247 5,435 5,777 5,818 6,204 6,795 7,530 8,160 Others 0 0 0 0 0 0 0 0 Total 3,247 5,435 5,777 5,818 6,204 6,795 7,530 8,160 Source: Company accounts, UBS estimates. (UBS) metrics use reported figures which have been adjusted by UBS analysts.

ZTE Corporation 1 November 2016 abc 29

Forecast returns

Forecast price appreciation +14.2%

Forecast dividend yield 2.3%

Forecast stock return +16.5%

Market return assumption 9.1%

Forecast excess return +7.4%

Valuation Method and Risk Statement We derive ZTE's price target based on a 10-year DCF valuation.

We believe the export sanctions imposed by the US government are the key downside risk in the near term. A slowdown in industry capex in China and underperformance of the handset business could present downside risks for the company in the medium to longer term.

ZTE Corporation 1 November 2016 abc 30

Required Disclosures This report has been prepared by UBS Securities Co. Limited, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS. For information on the ways in which UBS manages conflicts and maintains independence of its research product; historical performance information; and certain additional disclosures concerning UBS research recommendations, please visit www.ubs.com/disclosures. The figures contained in performance charts refer to the past; past performance is not a reliable indicator of future results. Additional information will be made available upon request. UBS Securities Co. Limited is licensed to conduct securities investment consultancy businesses by the China Securities Regulatory Commission. UBS acts or may act as principal in the debt securities (or in related derivatives) that may be the subject of this report. This recommendation was finalized on: 31 October 2016 05:48 PM GMT. Analyst Certification: Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers and were prepared in an independent manner, including with respect to UBS, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report. UBS Investment Research: Global Equity Rating Definitions

12-Month Rating Definition Coverage1 IB Services2 Buy FSR is > 6% above the MRA. 45% 28% Neutral FSR is between -6% and 6% of the MRA. 39% 25% Sell FSR is > 6% below the MRA. 15% 17%

Short-Term Rating Definition Coverage3 IB Services4 Stock price expected to rise within three months from the time Buy <1% <1% the rating was assigned because of a specific catalyst or event. Stock price expected to fall within three months from the time Sell <1% <1% the rating was assigned because of a specific catalyst or event.

Source: UBS. Rating allocations are as of 30 September 2016. 1:Percentage of companies under coverage globally within the 12-month rating category. 2:Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided within the past 12 months. 3:Percentage of companies under coverage globally within the Short-Term rating category. 4:Percentage of companies within the Short-Term rating category for which investment banking (IB) services were provided within the past 12 months. KEY DEFINITIONS: Forecast Stock Return (FSR) is defined as expected percentage price appreciation plus gross dividend yield over the next 12 months. Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and not a forecast of, the equity risk premium). Under Review (UR) Stocks may be flagged as UR by the analyst, indicating that the stock's price target and/or rating are subject to possible change in the near term, usually in response to an event that may affect the investment case or valuation. Short-Term Ratings reflect the expected near- term (up to three months) performance of the stock and do not reflect any change in the fundamental view or investment case. Equity Price Targets have an investment horizon of 12 months. EXCEPTIONS AND SPECIAL CASES: UK and European Investment Fund ratings and definitions are: Buy: Positive on factors such as structure, management, performance record, discount; Neutral: Neutral on factors such as structure, management, performance record, discount; Sell: Negative on factors such as structure, management, performance record, discount. Core Banding Exceptions (CBE): Exceptions to the standard +/-6% bands may be granted by the Investment Review Committee (IRC). Factors considered by the IRC include the stock's volatility and the credit spread of the respective company's debt. As a result, stocks deemed to be very high or low risk may be subject to higher or lower bands as they relate to the rating. When such exceptions apply, they will be identified in the Company Disclosures table in the relevant research piece.

ZTE Corporation 1 November 2016 abc 31

Research analysts contributing to this report who are employed by any non-US affiliate of UBS Securities LLC are not registered/qualified as research analysts with FINRA. Such analysts may not be associated persons of UBS Securities LLC and therefore are not subject to the FINRA restrictions on communications with a subject company, public appearances, and trading securities held by a research analyst account. The name of each affiliate and analyst employed by that affiliate contributing to this report, if any, follows. UBS Securities Co. Limited: Jinjin Wang, CFA. UBS AG Hong Kong Branch: Navin Killa. Company Disclosures Company Name Reuters 12-month rating Short-term rating Price Price date

ZTE Corporation16 0763.HK Neutral N/A HK$10.68 31 Oct 2016

Source: UBS. All prices as of local market close. Ratings in this table are the most current published ratings prior to this report. They may be more recent than the stock pricing date 16. UBS Securities (Hong Kong) Limited is a market maker in the HK-listed securities of this company. Unless otherwise indicated, please refer to the Valuation and Risk sections within the body of this report. For a complete set of disclosure statements associated with the companies discussed in this report, including information on valuation and risk, please contact UBS Securities LLC, 1285 Avenue of Americas, New York, NY 10019, USA, Attention: Investment Research. ZTE Corporation (HK$) Price Target (HK$) Stock Price (HK$) 30.0

20.0

10.0

0 .0 6 6 6 6 5 5 5 5 4 4 4 4 3 3 3 3 2 2 2 2 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 ------t l r t l r t l r t l r t l r t n n n n n c c c c c c u p u p u p u p u p a a a a a J J J J J J J J J J O - O - O - O - O - O A - A - A - A - A ------1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Buy Neutral No Rating

Source: UBS; as of 31 Oct 2016

ZTE Corporation 1 November 2016 abc 32

Global Disclaimer This document has been prepared by UBS Securities Co. Limited, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS. Global Research is provided to our clients through UBS Neo and, in certain instances, UBS.com (each a "System"). It may also be made available through third party vendors and distributed by UBS and/or third parties via e-mail or alternative electronic means. The level and types of services provided by Global Research to a client may vary depending upon various factors such as a client's individual preferences as to the frequency and manner of receiving communications, a client's risk profile and investment focus and perspective (e.g., market wide, sector specific, long-term, short-term, etc.), the size and scope of the overall client relationship with UBS and legal and regulatory constraints. All Global Research is available on UBS Neo. Please contact your UBS sales representative if you wish to discuss your access to UBS Neo. When you receive Global Research through a System, your access and/or use of such Global Research is subject to this Global Research Disclaimer and to the terms of use governing the applicable System. When you receive Global Research via a third party vendor, e-mail or other electronic means, your use shall be subject to this Global Research Disclaimer and to UBS's Terms of Use/Disclaimer (http://www.ubs.com/global/en/legalinfo2/disclaimer.html). By accessing and/or using Global Research in this manner, you are indicating that you have read and agree to be bound by our Terms of Use/Disclaimer. In addition, you consent to UBS processing your personal data and using cookies in accordance with our Privacy Statement (http://www.ubs.com/global/en/legalinfo2/privacy.html) and cookie notice (http://www.ubs.com/global/en/homepage/cookies/cookie- management.html). If you receive Global Research, whether through a System or by any other means, you agree that you shall not copy, revise, amend, create a derivative work, transfer to any third party, or in any way commercially exploit any UBS research provided via Global Research or otherwise, and that you shall not extract data from any research or estimates provided to you via Global Research or otherwise, without the prior written consent of UBS. This document is for distribution only as may be permitted by law. It is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or would subject UBS to any registration or licensing requirement within such jurisdiction. It is published solely for information purposes; it is not an advertisement nor is it a solicitation or an offer to buy or sell any financial instruments or to participate in any particular trading strategy. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained in this document ("the Information"), except with respect to Information concerning UBS. The Information is not intended to be a complete statement or summary of the securities, markets or developments referred to in the document. UBS does not undertake to update or keep current the Information. Any opinions expressed in this document may change without notice and may differ or be contrary to opinions expressed by other business areas or groups of UBS. Any statements contained in this report attributed to a third party represent UBS's interpretation of the data, information and/or opinions provided by that third party either publicly or through a subscription service, and such use and interpretation have not been reviewed by the third party. Nothing in this document constitutes a representation that any investment strategy or recommendation is suitable or appropriate to an investor’s individual circumstances or otherwise constitutes a personal recommendation. Investments involve risks, and investors should exercise prudence and their own judgement in making their investment decisions. The financial instruments described in the document may not be eligible for sale in all jurisdictions or to certain categories of investors. Options, derivative products and futures are not suitable for all investors, and trading in these instruments is considered risky. Mortgage and asset-backed securities may involve a high degree of risk and may be highly volatile in response to fluctuations in interest rates or other market conditions. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related instrument referred to in the document. For investment advice, trade execution or other enquiries, clients should contact their local sales representative. The value of any investment or income may go down as well as up, and investors may not get back the full (or any) amount invested. Past performance is not necessarily a guide to future performance. Neither UBS nor any of its directors, employees or agents accepts any liability for any loss (including investment loss) or damage arising out of the use of all or any of the Information. Any prices stated in this document are for information purposes only and do not represent valuations for individual securities or other financial instruments. There is no representation that any transaction can or could have been effected at those prices, and any prices do not necessarily reflect UBS's internal books and records or theoretical model-based valuations and may be based on certain assumptions. Different assumptions by UBS or any other source may yield substantially different results. This document and the Information are produced by UBS as part of its research function and are provided to you solely for general background information. UBS has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. In no circumstances may this document or any of the Information be used for any of the following purposes: (i) valuation or accounting purposes; (ii) to determine the amounts due or payable, the price or the value of any financial instrument or financial contract; or (iii) to measure the performance of any financial instrument. By receiving this document and the Information you will be deemed to represent and warrant to UBS that you will not use this document or any of the Information for any of the above purposes or otherwise rely upon this document or any of the Information. UBS has policies and procedures, which include, without limitation, independence policies and permanent information barriers, that are intended, and upon which UBS relies, to manage potential conflicts of interest and control the flow of information within divisions of UBS and among its subsidiaries, branches and affiliates. For further information on the ways in which UBS manages conflicts and maintains independence of its research products, historical performance information and certain additional disclosures concerning UBS research recommendations, please visit www.ubs.com/disclosures. Research will initiate, update and cease coverage solely at the discretion of UBS Investment Bank Research Management, which will also have sole discretion on the timing and frequency of any published research product. The analysis contained in this document is based on numerous assumptions. All material information in relation to published research reports, such as valuation methodology, risk statements, underlying assumptions (including sensitivity analysis of those assumptions), ratings history etc. as required by the Market Abuse Regulation, can be found on NEO. Different assumptions could result in materially different results. The analyst(s) responsible for the preparation of this document may interact with trading desk personnel, sales personnel and other parties for the purpose of gathering, applying and interpreting market information. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS into other areas, units, groups or affiliates of UBS. The compensation of the analyst who prepared this document is determined exclusively by research management and senior management (not including investment banking). Analyst compensation is not based on investment banking revenues; however, compensation may relate to the revenues of UBS Investment Bank as a whole, of which investment banking, sales and trading are a part, and UBS's subsidiaries, branches and affiliates as a whole. For financial instruments admitted to trading on an EU regulated market: UBS AG, its affiliates or subsidiaries (excluding UBS Securities LLC) acts as a market maker or liquidity provider (in accordance with the interpretation of these terms in the UK) in the financial instruments of the issuer save that where the activity of liquidity provider is carried out in accordance with the definition given to it by the laws and regulations of any other EU jurisdictions, such information is separately disclosed in this document. For financial instruments admitted to trading on a non-EU regulated market: UBS may act as a market maker save that where this activity is carried out in the US in accordance with the definition given to it by the relevant laws and regulations, such activity will be specifically disclosed in this document. UBS may have issued a warrant the value of which is based on one or more of the financial instruments referred to in the document. UBS and its affiliates and employees may have long or short positions, trade as principal and buy and sell in instruments or derivatives identified herein; such transactions or positions may be inconsistent with the opinions expressed in this document. United Kingdom and the rest of Europe: Except as otherwise specified herein, this material is distributed by UBS Limited to persons who are eligible counterparties or professional clients. UBS Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. France: Prepared by UBS Limited and distributed by UBS Limited and UBS Securities France S.A. UBS Securities France S.A. is regulated by the ACPR (Autorité de Contrôle Prudentiel et de Résolution) and the Autorité des Marchés Financiers (AMF). Where an analyst of UBS Securities France S.A. has contributed to this document, the document is also deemed to have been prepared by UBS Securities France S.A. Germany: Prepared by UBS Limited and distributed by UBS Limited and UBS Deutschland AG. UBS Deutschland AG is regulated by the Bundesanstalt fur Finanzdienstleistungsaufsicht (BaFin). Spain: Prepared by UBS Limited and distributed by UBS Limited and UBS Securities España SV, SA. UBS Securities España SV, SA is regulated by the Comisión Nacional del Mercado de Valores (CNMV). Turkey:

ZTE Corporation 1 November 2016 abc 33

Distributed by UBS Limited. No information in this document is provided for the purpose of offering, marketing and sale by any means of any capital market instruments and services in the Republic of Turkey. Therefore, this document may not be considered as an offer made or to be made to residents of the Republic of Turkey. UBS AG is not licensed by the Turkish Capital Market Board under the provisions of the Capital Market Law (Law No. 6362). Accordingly, neither this document nor any other offering material related to the instruments/services may be utilized in connection with providing any capital market services to persons within the Republic of Turkey without the prior approval of the Capital Market Board. However, according to article 15 (d) (ii) of the Decree No. 32, there is no restriction on the purchase or sale of the securities abroad by residents of the Republic of Turkey. Poland: Distributed by UBS Limited (spolka z ograniczona odpowiedzialnoscia) Oddzial w Polsce regulated by the Polish Financial Supervision Authority. Where an analyst of UBS Limited (spolka z ograniczona odpowiedzialnoscia) Oddzial w Polsce has contributed to this document, the document is also deemed to have been prepared by UBS Limited (spolka z ograniczona odpowiedzialnoscia) Oddzial w Polsce. Russia: Prepared and distributed by UBS Bank (OOO). Switzerland: Distributed by UBS AG to persons who are institutional investors only. UBS AG is regulated by the Swiss Financial Market Supervisory Authority (FINMA). Italy: Prepared by UBS Limited and distributed by UBS Limited and UBS Limited, Italy Branch. Where an analyst of UBS Limited, Italy Branch has contributed to this document, the document is also deemed to have been prepared by UBS Limited, Italy Branch. South Africa: Distributed by UBS South Africa (Pty) Limited (Registration No. 1995/011140/07), an authorised user of the JSE and an authorised Financial Services Provider (FSP 7328). Israel: This material is distributed by UBS Limited. UBS Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. UBS Securities Israel Ltd is a licensed Investment Marketer that is supervised by the Israel Securities Authority (ISA). UBS Limited and its affiliates incorporated outside Israel are not licensed under the Israeli Advisory Law. UBS Limited is not covered by insurance as required from a licensee under the Israeli Advisory Law. UBS may engage among others in issuance of Financial Assets or in distribution of Financial Assets of other issuers for fees or other benefits. UBS Limited and its affiliates may prefer various Financial Assets to which they have or may have Affiliation (as such term is defined under the Israeli Advisory Law). Nothing in this Material should be considered as investment advice under the Israeli Advisory Law. This Material is being issued only to and/or is directed only at persons who are Eligible Clients within the meaning of the Israeli Advisory Law, and this material must not be relied on or acted upon by any other persons. Saudi Arabia: This document has been issued by UBS AG (and/or any of its subsidiaries, branches or affiliates), a public company limited by shares, incorporated in Switzerland with its registered offices at Aeschenvorstadt 1, CH-4051 Basel and Bahnhofstrasse 45, CH-8001 Zurich. This publication has been approved by UBS Saudi Arabia (a subsidiary of UBS AG), a Saudi closed joint stock company incorporated in the Kingdom of Saudi Arabia under commercial register number 1010257812 having its registered office at Tatweer Towers, P.O. Box 75724, Riyadh 11588, Kingdom of Saudi Arabia. UBS Saudi Arabia is authorized and regulated by the Capital Market Authority to conduct securities business under license number 08113-37. Dubai: The information distributed by UBS AG Dubai Branch is intended for Professional Clients only and is not for further distribution within the United Arab Emirates. United States: Distributed to US persons by either UBS Securities LLC or by UBS Financial Services Inc., subsidiaries of UBS AG; or by a group, subsidiary or affiliate of UBS AG that is not registered as a US broker-dealer (a ‘non-US affiliate’ ) to major US institutional investors only. UBS Securities LLC or UBS Financial Services Inc. accepts responsibility for the content of a document prepared by another non-US affiliate when distributed to US persons by UBS Securities LLC or UBS Financial Services Inc. All transactions by a US person in the securities mentioned in this document must be effected through UBS Securities LLC or UBS Financial Services Inc., and not through a non-US affiliate. UBS Securities LLC is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the "Municipal Advisor Rule"), and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule. Canada: Distributed by UBS Securities Canada Inc., a registered investment dealer in Canada and a Member-Canadian Investor Protection Fund, or by another affiliate of UBS AG that is registered to conduct business in Canada or is otherwise exempt from registration. Mexico: This report has been distributed and prepared by UBS Casa de Bolsa, S.A. de C.V., UBS Grupo Financiero, an entity that is part of UBS Grupo Financiero, S.A. de C.V. and is an affiliate of UBS AG. This document is intended for distribution to institutional or sophisticated investors only. Research reports only reflect the views of the analysts responsible for the reports. Analysts do not receive any compensation from persons or entities different from UBS Casa de Bolsa, S.A. de C.V., UBS Grupo Financiero, or different from entities belonging to the same financial group or business group of such. For Spanish translations of applicable disclosures, please see www.ubs.com/disclosures. Brazil: Except as otherwise specified herein, this material is prepared by UBS Brasil CCTVM S.A. to persons who are eligible investors residing in Brazil, which are considered to be: (i) financial institutions, (ii) insurance firms and investment capital companies, (iii) supplementary pension entities, (iv) entities that hold financial investments higher than R$300,000.00 and that confirm the status of qualified investors in written, (v) investment funds, (vi) securities portfolio managers and securities consultants duly authorized by Comissão de Valores Mobiliários (CVM), regarding their own investments, and (vii) social security systems created by the Federal Government, States, and Municipalities. Hong Kong: Distributed by UBS Securities Asia Limited and/or UBS AG, Hong Kong Branch. Singapore: Distributed by UBS Securities Pte. Ltd. [MCI (P) 007/09/2016 and Co. Reg. No.: 198500648C] or UBS AG, Singapore Branch. Please contact UBS Securities Pte. Ltd., an exempt financial adviser under the Singapore Financial Advisers Act (Cap. 110); or UBS AG, Singapore Branch, an exempt financial adviser under the Singapore Financial Advisers Act (Cap. 110) and a wholesale bank licensed under the Singapore Banking Act (Cap. 19) regulated by the Monetary Authority of Singapore, in respect of any matters arising from, or in connection with, the analysis or document. The recipients of this document represent and warrant that they are accredited and institutional investors as defined in the Securities and Futures Act (Cap. 289). Japan: Distributed by UBS Securities Japan Co., Ltd. to professional investors (except as otherwise permitted). Where this document has been prepared by UBS Securities Japan Co., Ltd., UBS Securities Japan Co., Ltd. is the author, publisher and distributor of the document. Distributed by UBS AG, Tokyo Branch to Professional Investors (except as otherwise permitted) in relation to foreign exchange and other banking businesses when relevant. Australia: Clients of UBS AG: Distributed by UBS AG (Holder of Australian Financial Services License No. 231087). Clients of UBS Securities Australia Ltd: Distributed by UBS Securities Australia Ltd (Holder of Australian Financial Services License No. 231098). This Document contains general information and/or general advice only and does not constitute personal financial product advice. As such, the Information in this document has been prepared without taking into account any investor’s objectives, financial situation or needs, and investors should, before acting on the Information, consider the appropriateness of the Information, having regard to their objectives, financial situation and needs. If the Information contained in this document relates to the acquisition, or potential acquisition of a particular financial product by a ‘Retail’ client as defined by section 761G of the Corporations Act 2001 where a Product Disclosure Statement would be required, the retail client should obtain and consider the Product Disclosure Statement relating to the product before making any decision about whether to acquire the product. The UBS Securities Australia Limited Financial Services Guide is available at: www.ubs.com/ecs-research-fsg. New Zealand: Distributed by UBS New Zealand Ltd. UBS New Zealand Ltd is not a registered bank in New Zealand. The information and recommendations in this publication are provided for general information purposes only. To the extent that any such information or recommendations constitute financial advice, they do not take into account any person’s particular financial situation or goals. We recommend that recipients seek advice specific to their circumstances from their financial advisor. Korea: Distributed in Korea by UBS Securities Pte. Ltd., Seoul Branch. This document may have been edited or contributed to from time to time by affiliates of UBS Securities Pte. Ltd., Seoul Branch. Malaysia: This material is authorized to be distributed in Malaysia by UBS Securities Malaysia Sdn. Bhd (Capital Markets Services License No.: CMSL/A0063/2007). This material is intended for professional/institutional clients only and not for distribution to any retail clients. India: Distributed by UBS Securities India Private Ltd. (Corporate Identity Number U67120MH1996PTC097299) 2/F, 2 North Avenue, Maker Maxity, Bandra Kurla Complex, Bandra (East), Mumbai (India) 400051. Phone: +912261556000. It provides brokerage services bearing SEBI Registration Numbers: NSE (Capital Market Segment): INB230951431, NSE (F&O Segment) INF230951431, NSE (Currency Derivatives Segment) INE230951431, BSE (Capital Market Segment) INB010951437; merchant banking services bearing SEBI Registration Number: INM000010809 and Research Analyst services bearing SEBI Registration Number: INH000001204. UBS AG, its affiliates or subsidiaries may have debt holdings or positions in the subject Indian company/companies. Within the past 12 months, UBS AG, its affiliates or subsidiaries may have received compensation for non-investment banking securities- related services and/or non-securities services from the subject Indian company/companies. The subject company/companies may have been a client/clients of UBS AG, its affiliates or subsidiaries during the 12 months preceding the date of distribution of the research report with respect to investment banking and/or non-investment banking securities-related services and/or non-securities services. With regard to information on associates, please refer to the Annual Report at: http://www.ubs.com/global/en/about_ubs/investor_relations/annualreporting.html The disclosures contained in research documents produced by UBS Limited shall be governed by and construed in accordance with English law. UBS specifically prohibits the redistribution of this document in whole or in part without the written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect. Images may depict objects or elements that are protected by third party copyright, trademarks and other intellectual property rights. © UBS 2016. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

abc

ZTE Corporation 1 November 2016 abc 34