Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

Dongfeng Motor (489.HK) Automobile Sector 10 January 2013

Research Idea: Moving Up the Gears Target Price HK$15.00 We rate Dongfeng Motor (DFG) a Buy with 12-month target price of 12m Rating Buy HK$15.00. Its sales have dropped since Q3 2012 amid Sino-Japan tensions, 16% upside but we expect a recovery to pre-protest levels in Q1 2013 and growth to DFG – Price Chart (HK$) persist backed by a strong brand lineup. As one of the nation’s leading 22 Bull, HK$20.90 20

automakers, DFG is a good proxy for a secular sector growth story. 18

16 Base, HK$15.00 Three reasons to Buy: 14 12 . Sino-Japanese tensions have eased. DF ’s sales rebounded to 10 8 pre-protest levels while DF ’s rebounded to 80% of pre-protest 6 Bear, HK$6.40 Jan12 May12 Sep12 Jan13 May13 Sep13 Jan14 levels in December, well above expectations. Consumer concerns about damage to vehicles should be offset by Sino-Japan auto JVs Price (HK$) 12.96

guaranteeing to repair damage caused during the recent unrest. We Mkt cap – HK$m (US$m) 112,354 (14,494) expect DFG’s sales volume growth to rebound from down 0.8% to +11% in FY13. Free float – % (H-share) 100.00 3M avg. t/o– HK$m (US$m) 299.5 (38.6) . Strong brand lineup can facilitate market-share gains. DFG has Major shareholder (%) three JVs and a comprehensive range of well-received models, which should help minimize sales fluctuations. It is launching economy sedans DFMC 66.86 and JV own brands, which can help gain market share from local brands, Sources: Bloomberg and Sun Hung Kai Financial while the new can capture rapid growth in the premium market. . Compelling valuation for a market leader. The shares trade at 9X P/E. We are optimistic about an earnings rebound in FY13 and solid growth over the next few years, in view of the company’s strong lineup of models and as Sino-Japan tensions fade. DFG is one of China’s leading automakers and hence a good proxy for the nation’s compelling long-term growth story. Catalysts: Proposed JV; Japanese auto brands regaining market share in China faster than expected; DFG’s domestic-brand business grow exceeding expectations Valuation: DFG’s shares trade at 9X FY13E P/E, below the sector average 1H12 revenues: RMB68bn of 12X. But since the company is one of China’s leading automakers, we Others believe it should trade at least at par with its peers. We initiate coverage with 1%

a Buy rating and 12-month target price of HK$15.00 based on 10.4X forward RESEARCH INSTITUTIONAL P/E, for 16% upside. Commercial vehi cles We forecast EPS of RMB0.915, RMB1.15 and RMB1.43 for FY12-FY14E for 22% growth of -25% y/y, 25% and 24% y/y.

Risks: Weak PV sales; Slow recovery in CV business; Greater-than-expected losses for domestic-brand business. Passenger vehicles Figure 1: DFG – Earnings Summary 77% Year end 31 Dec. FY10 FY11 FY12E FY13E

Revenue – RMB m 122,395 131,441 124,564 141,366

Gross margin – % 21.5 20.1 17.6 18.5 EBIT margin – % 11.9 10.9 8.9 9.8 Net profit – RMB m 10,981 10,481 7,881 9,881 Eva Yip, CFA Net-profit growth – % 75.7 (4.6) (24.8) 25.4 +852 3929-6159 EPS – RMB fen 127.4 121.6 91.5 114.7 [email protected] EPS growth – % 75.7 (4.6) (24.8) 25.4

P/E – X 8.3 8.7 11.5 9.2 Dividend yield – % 1.7 1.7 1.2 1.4 Reports available at: http://www.shkresearch.com P/B – X 2.4 2.0 1.7 1.5 http://www.thomsonreuters.com Issued shares - millions 8,616 8,616 8,616 8,616 http://www.capitaliq.com Sources: Bloomberg and Sun Hung Kai Financial http://www.themarkets.com Bloomberg Code:

Sun Hung Kai Financial Institutional Research 1 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

Valuation and Recommendation

DFG’s shares trade at 9X FY13E P/E, below the sector average of 12X. But since the company is one of China’s leading automakers, we believe it should trade at least at par with its peers.

Historically, the shares have traded at 9X-12X during the middle of the industry cycle and below their long-term mean of 8X during a downcycle. We believe the coming industry rebound justifies a valuation of around 10X.

The company has a comprehensive range of well-received models, which should help ensure solid earnings growth over the next few years. As one of the nation’s leading automakers, DFG is also a good proxy for what we believe is a secular growth story. We believe the stock’s current discount to domestic-only brands is not justified in view of its JV exposure and burgeoning own-brand business.

We rate DFG a Buy with 12-month target price of HK$15.00 based on 10.4X forward P/E, for 16% upside.

Figure 2: Valuation scenario

Target Upside/ FY13E EPS Scenario price (HK$) downside (%) Key assumptions (RMB) 15% PV growth, PV ASP back to FY11 level, with 21% PV GPM Bull 20.90 61 10% CV sales growth 1.33 12.5X FY13E P/E 12% PV growth, 3% PV ASP growth, 19.5% PV GPM Base 15.00 16 1.15 10.4X FY13E P/E 6% PV growth on prolong weak Japanese sales, -3% ASP fall with 17% PV Bear 6.40 (51) GPM and no recovery in CV segment 0.85 6X FY13E P/E Source: Sun Hung Kai Financial

Our estimates vs. consensus

Our FY12 revenue and EPS are below consensus. We believe the market is still too optimistic about ASP and profitability that plunge sharply in 2H12.

Our FY13 revenue is in line with consensus and FY14 numbers slightly above consensus.

Sun Hung Kai Financial Institutional Research 2 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

Investment Thesis

Sino-Japan tensions to fade

Japanese brands contributed 60% of DFG’s PV sales volumes in FY11 and FY12 and have long been popular in China, reflected in their 20% market share. Sino-Japan JVs’ sales have been hit hard since September amid rising tensions, but we believe the worst is over.

Figure 3: Japanese auto brands have long been popular in China (L); DFG’s sales by JV (R) (%) ('000 units) 60 1,600 50 1,400

40 1,200 1,000 30 800 20 600 10 400 0 200 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 0 Chinese brands Japanese brands German brands FY08 FY09 FY10 FY11 FY12E American brands South Korea brands Other brands DF Nissan DF PSA DF Honda

Sources: The Company, WIND and Sun Hung Kai Financial

From our conversations with management, we gather that DF Honda’s sales are already above pre-crisis levels while DF Nissan’s sales rebounded to 80% of pre-protest levels in December, well above management expectations. Inventories had also fallen from peaks of 86 days for DF Nissan and 55 days for DF Honda in September, to 1½ months in December.

Recovery has been helped by Sino-Japan JVs easing their sales targets for auto dealers. As a result dealers have not had to slash prices to clear inventory, which would have tarnished their brand image.

In addition the JVs have offered to repair any of their damaged during the protests until 31 Dec 2014. The company usually makes warranty provisions for these expenses, included in other expenses on the income statement, based on sales volumes and historical levels of returns. We believe the company has enough provisions to cover upcoming repair expenses since actual repair expenses have typically been less than warranty provisions in recent years. Management also does not expect much impact on operating expenses.

Figure 4: DF Nissan’s marketing initiatives to revive consumer confidence

Sources: The Company

Sun Hung Kai Financial Institutional Research 3 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

Steady sales growth to persist

DFG’s key models have consistently sold more than 12k units per month. This is likely attributable to its strong JV partners, with Honda and Nissan in particular introducing cars each year that meet or exceed consumer expectations. As a result, DFG has outperformed the industry during difficult times and has been able to adapt to changing consumer preferences.

Figure 5: DFG’s sales growth vs. the industry

(%) 50 45 40 35 30

25 20 15 10 5 0 2005 2006 2007 2008 2009 2010 2011

DFG Industry

Sources: WIND and Sun Hung Kai Financial

DFG will continue its aggressive launch strategy this year with new-generation models for all its brands (excluding upgrades/facelifts). Its JVs plan to introduce seven new models next year: Concept-S MPV from DF Honda, three from DF PSA, and three from DF Nissan, including the long-anticipated Teana. DF PSA will introduce two compact economy sedan models, which should help it gain market share from domestic brands. In 2014, DFG will produce two Infiniti models in China, which should strengthen its hand in the fast-growing premium PV market.

Figure 6: DFG’s upcoming new car models

DF Nissan DF Honda DF PSA 2013 Teana Concept-S Citroen sedan Livina Peugeot sedan Peugeot 3008 (extend from Dec 2012) Sources: The Company and Sun Hung Kai Financial

Local brands could drive growth in lower-tier cities

Domestic automakers have operated JVs with foreign automakers for years but still have limited access to technology and not a single Chinese brand is competitive globally. The Chinese government is strongly encouraging JVs to launch local brands so that their foreign partners transfer more advanced technology.

DFG launched its first independent brand, Fengshen, in 2009. Its JVs have also developed local brands, with DF Nissan unveiling the Venucia and DF Honda the CIIMO last year. Local brands should help DFG fill the mid-range gap in its product mix.

While new local brands use the same platforms as the existing JV models, we don’t expect them to cannibalize sales. We believe the new local brands will be targeted at first-time car buyers in lower-tier cities, mainly in inner provinces. Such buyers are more price sensitive and prefer entry-level

Sun Hung Kai Financial Institutional Research 4 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

Chinese brands, which account for 40% market share by sales volume in these markets. The new local brands could help DFG compete more effectively in this growing market.

CV sales recovering along with exports

The worst should also be over for the CV industry as the domestic economy recovers next year from a low base. DFG’s CV products are typically used in transporting cargo in the export industries (80%), and segment sales volumes have plunged 21% in 2012 amid weak exports.

We see little impact on CV sales from the upcoming implementation of National IV standards covering HDT emissions, which will reportedly be implemented on 1 July 2013. The only effect should be truck sales frontloaded in 1H13 as buyers look to snap up older, cheaper models. (National IV-compliant engines will lift production costs by RMB20k-RMB40k per vehicle.)

A recovery in truck sales will be positive for DFG, though the company’s growth is driven more by its PV segment. CVs contributed just 14% to operating profit in FY11.

Maintaining high utilization

DFG has expanded capacity steadily in the past few years. It posted a 15% sales CAGR and 9% capacity CAGR over 2007-2011, with utilization close to 100%. All its JVs plan to have new plants starting up in 2012-2013, which bodes well for utilization to remain high and support margins.

Figure 7: DFG’s utilization has stayed around 100% in the past few years (%) (%) 125 24 120 115 22 110 20 105 18 100 16 95 14 90 85 12 80 10 FY09 FY10 FY11

CV (LHS) PV (LHS) PV margin (RHS) CV margin (RHS)

Sources: The Company and Sun Hung Kai Financial

Sun Hung Kai Financial Institutional Research 5 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

Business model

China’s leading automaker

Dongfeng Motor Group (DFG) manufactures and sells commercial vehicles (CV), passenger vehicles (PV) and auto engines and parts. 77% of sales were from PVs in 1H12, 22% from CVs, and less than 1% from others. Together with parent DFMC it is the second largest automaker in China by sales volume, according to China Association of Automobile Manufacturers (CAAM). It is also a leading manufacturer of heavy and medium trucks in the PRC.

Figure 8: DFG’s 1H12 revenue breakdown (L) and FY08-FY11 unit sales by product type (R)

Others 1% ('000 units) 2,500

Commercial 2,000 vehicles 22% 1,500

1,000

500 Passenger vehicles 77% 0 FY08 FY09 FY10 FY11

Sedan MPV SUV Truck Bus Sources: The Company and Sun Hung Kai Financial

Figure 9: Major Chinese automakers’ market share (%) 25

20

15

10

5

0 SAIC DFMC FAW DFG Changan Beijing GAC Brilliance JAC GWM Auto

2011 2010

Sources: The Company, CAAM and Sun Hung Kai Financial

The company operates its PV business through subsidiary Dongfeng Passenger Vehicles Company and three JVs with foreign partners: Dongfeng Motor Co (partnering with Nissan), Dongfeng Peugeot Citroën Automobiles Company (PSA Peugeot Citroën Group), and Automobile (Honda Motor). Dongfeng’s PV segment focuses on the mid-range to high-end segments.

The company operates its CV business, which sells whole vehicles, engines and parts, through Dongfeng Motor Co.

Sun Hung Kai Financial Institutional Research 6 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

Figure 10: DFG’s company structure

Dongfeng Motor Group (489.HK) Nissan

50% 50% 50% 50% 50%

Dongfeng Dongfeng Honda Dongfeng Dongfeng Peugeot Citroen Automobile Honda Motor Automobile Co., Ltd. Engine Co., Ltd Co., Ltd Company Ltd

60.1% 75%

Dongfeng Dongfeng Automobile Other subsidiaries including Liuzhou Auto Co., Ltd. (600006.CH) Dongfeng Passenger Vehicle Company 51%

Zhengzhou 28.65% Nissan Automobile

Sources: The Company and Sun Hung Kai Financial

Figure 11: DFG’s product portfolio

Business units Foreign JV partners Product range Major models Passenger vehicles Citroën C5, Citroën C-Quatre, Citroën C-Triomphe, PSA Peugeot Citroën Dongfeng Peugeot Citroën Automobiles Company Passenger vehicles Citroën C2, Citroën Xsara Picasso, Citroën Elysee, Group Peugeot , Honda Spirior, Hond CR-V, Honda Dongfeng Co. Honda Motor Passenger vehicles Civic, , CIIMO Nissan GT-R, , , , Nissan Sylphy, , Dongfeng Motor Co. ( Passenger Nissan Motor Passenger vehicles Nissan X-Trail, , Nissa GTS Tiida, Vehicle Company) , Nissan March, , Venucia D50 SUV, MPV, car derived Nissan Paladin, Nissan VN 200, DF Oting, Nissan . Dongfeng Automobile Co. (600006.CH), including Zhenzhou Nissan van (CDV) Patrol, DF Yumsun, DF Succe . MPV Dongfeng Future Dongfeng Passenger Vehicles Company Passenger vehicles Dongfeng Fengshen

Commercial vehicles Dongfeng Motor Co. (Commercial Vehicle Heavy and medium Dongfeng Kingrun, Dongfeng T-Lift, Dongfeng Nissan Motor Company) trucks and bus Kinland, Dongfeng FengShang Dongfeng Duolika, Dongfeng Mengka, Dongfeng Light truck, mini truck, Xiaobawang, Dongfeng Xintianyou, Dongfeng . Dongfeng Automobile Co. (600006.CH), including Zhenzhou Nissan pickup and CV Lianghua, Nissan Pickup, , , DF Rich Pickup Heavy and medium Dongfeng Chenglong, Dongfeng Balong, Dongfeng

. Dongfeng Liuzhou Motor trucks Longka Sources: The Company and Sun Hung Kai Financial

Multiple brands, comprehensive range

DFG has sought cooperation with global auto giants as part of its multi-brand approach. As such it has the widest product portfolio among major Chinese automakers. PVs include small/mid-sized sedans, SUVs and MPVs in the RMB50k-RMB400k price range. CVs include light commercial vehicles (LCVs) and heavy- and medium-duty trucks (MDTs and HDTs).

Working with so many international partners has exposed DFG to a wide range of different technologies. This has helped it roll out a strong lineup of car models every year and appeal to a wide range of consumers. It has also helped limit exposure to any single segment, reflected in outperforming overall sales growth last year and in 1H12 despite significant industry headwinds.

Sun Hung Kai Financial Institutional Research 7 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

Figure 12: DFG’s sales growth outpaced the industry despite headwinds last year and in 1H12 (%) (%) 25 50 20 40 15 30 10 industry: 2.7% 5 20 0 10 -5 0 -10 -10 Jan 2012 Mar 2012 May 2012 Jul 2012 Sep 2012 -15 -20 -20 SAIC DFMC DFG FAW ChanganBeijing GAC CheryBrilliance JAC GWM -30 Auto DFG Industry

Sources: The Company, WIND and Sun Hung Kai Financial

Industry Analysis

Figure 13: China auto sales to accelerate in 2013

(m units) (%) ('000) (%) 25 50 2,000 30 45 1,800 20 1,600 20 40 10 1,400 35 1,200 0 15 30 1,000 (10) 25 800 10 20 (20) 600 (30) 15 400 5 10 200 (40) 5 0 (50) 0 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct 2004 2006 2008 2010 2012E 2014E Total auto (LHS) PV (LHS) CV (LHS) Auto sales volume (LHS) y/y (RHS) auto y/y (RHS) PV y/y (RHS) CV y/y (RHS)

Sources: WIND and Sun Hung Kai Financial

China’s auto-sales growth (CVs and PVs) has slowed since 2009, registering just 2.5% y/y in 2011 and estimated at 3% y/y for 2012. Auto purchases have been hampered by the expiry of tax incentives in 2010, restrictions on registration plates in major cities, a slowdown in FAI, and the weak overall economy. We expect sales to accelerate in FY13 as the domestic economy improves given the high correlation between auto sales and GDP growth. China’s auto growth story still has a long way to run given low penetration and rising disposable income.

Figure 14: China auto sales vs. nominal GDP

Auto sales (units) 25,000,000

2 20,000,000 R = 0.9649

15,000,000 2011

10,000,000

5,000,000 2002

0 0 10,000 20,000 30,000 40,000 50,000

GDP (RMB bn) Sources: WIND and Sun Hung Kai Financial

Sun Hung Kai Financial Institutional Research 8 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

PV market to grow steadily

We project an 8%-10% CAGR for new PV sales over 2013-2015 and PV penetration to double to 100 per 1,000 people by 2015, still only 20%-25% the level in developed countries.

Figure 15: China auto story still has a long way to run given low penetration (vehicle density) 160 700 USA 140 600 UK Germany 120 500 100 Japan 400 80 300 60 40 200 20 100 China 0 0 2000 2002 2004 2006 2008 2010 2012 2014 0 10,000 20,000 30,000 40,000 50,000 60,000 GDP per capita (US$) PV population (million units) PV penetration (per 1,000 perople) Sources: WIND, JD Power, IMF and Sun Hung Kai Financial

Rising disposable incomes should also support auto sales. From the chart below, possession of PV is particular high in coastal cities, where disposable incomes per capita are usually above RMB20k. Rising disposable incomes will fuel upgrade demand in tier one and two cities as well as first purchases in lower-tier cities.

Figure 16: PV ownership in China vs. disposable incomes (R)

(10,000 units) (RMB) 800 40,000 700 35,000 600 30,000 500 25,000 400 20,000 300 15,000 200 10,000 100 5,000 0 0 Jilin Jilin Tibet Inner Tibet Inner Anhui Hebei Anhui Fujian Hebei Hubei Fujian Henan Hunan Gansu Tianjin Beijing Shanxi Henan Hunan Gansu Tianjin Jiangxi Beijing Hainan Shanxi Jiangxi Hainan Ningxia Ningxia Qinghai Yunnan Jiangsu Xinjiang Qinghai Yunnan Jiangsu Shaanxi Sichuan Xinjiang Guangxi Guizhou Shaanxi Sichuan Liaoning Guangxi Zhejiang Guizhou Liaoning Zhejiang Shanghai Shandong Shandong Chongqing Heilongjian Chongqing Heilongjian Guangdong Guangdong

Sources: WIND and Sun Hung Kai Financial

CV market to rebound in FY13

The CV market is more cyclical than the PV market as it is more macro driven and affected by environmental regulations, such as fuel-efficiency standards and emissions standards. We expect the CV market to rebound in FY13 amid an improving macro backdrop, with infrastructure investment and freight shipments set to increase plus further monetary easing. Within the CV market, trucks contribute 60%-70% of sales and also rely on ample money supply since truck purchases are typically funded by bank loans.

Figure 17: CV market is highly volatile (L) and correlated to loan growth (R) (%) (%) (%) 200 200 40

150 150 35

30 100 100 25 50 50 20 0 0 15 (50) (50) 10 Jan10 Jul10 Jan11 Jul11 Jan12 Jul12 Jan09 Jul09 Jan10 Jul10 Jan11 Jul11 Jan12 Jul12 CV y/y Bus y/y Trucks y/y CV sales y/y (LHS) Total loans growth y/y (RHS) Sources: WIND and Sun Hung Kai Financial

Sun Hung Kai Financial Institutional Research 9 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

Chinese brands gaining presence overseas

China's auto exports hit a record 849k units in 2011 despite the global financial crisis, helped by improving product quality, lower ASPs than peers, and demand in emerging markets.

Mainland automakers are also setting up more assembly plants overseas, such as in Malaysia and Indonesia and Great Wall in Bulgaria. We see exports as a long-term growth driver.

Financial Analysis

Revenue DFG’s growth in the past three years has been driven by a 25% CAGR in PV sales over 2008-2011, with these vehicles contributing 72%-77% of sales in FY09-1H12. Auto markets slowed significantly in 2011-2012 after government purchase incentives expired, but DFG posted 12% y/y and 10% y/y sales-volume growth in FY11 and 1H12 respectively thanks to its strong product portfolio.

Figure 18: Sales breakdown and growth trends (L) and sales volume trend (R) (%) (RMBbn) ('000 units) 140 60 2,500 40% 120 50 35% 100 2,000 40 30% 80 25% 30 1,500 60 20% 20 40 1,000 15% 20 10 10% 500 0 0 5% FY09 FY10 FY11 0 0% FY08 FY09 FY10 FY11 PV (LHS) CV (LHS) Revenue y/y (RHS) PV y/y (RHS) CV y/y (RHS) Sedan MPV SUV Truck Bus sales volume y/y (RHS)

Sources: The Company and Sun Hung Kai Financial

Figure 19: PV ASP trend (L) and PV mix (R)

(RMB) (%) 115,000 100

110,000 80

60 105,000 40 100,000 20

95,000 0 FY09 FY10 FY11 1H12 FY08 FY09 FY10 FY11

PV CV DF Nissan DF PSA DF Honda Others

Sources: The Company and Sun Hung Kai Financial

ASP and margin PV ASP has declined and margins have fluctuated widely in the past three years. ASP has fallen as a result of greater contributions from cheaper DF PSA models and fewer from DF Honda. PV gross margin was 20.6% in FY09 and rose to 24.4% in FY10, owing to greater sales of more profitable models and lower unit costs from higher utilization and more efficient production. Gross margin dipped 2.4 ppts to 22% in FY11 amid component shortages caused by the Japan earthquake

Sun Hung Kai Financial Institutional Research 10 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

and construction and education taxes levied on foreign enterprises since December 2010. Gross margin fell 1 ppt y/y to 20.9% in 1H12 on greater contributions from lower-margin models and as the company cut ASPs amid keen competition. CV gross margin was stable at around 14% over FY09-1H12. The overall gross margin ranged from 19%-21.5%, mainly due to changes in PV profitability.

Figure 20: Margin trend (%) 26 24

22 20 18

16 14 12

10 FY09 FY10 FY11 1H12

PV CV Blended

Sources: The Company and Sun Hung Kai Financial

Opex

Operating expenses (opex) to revenue were at a narrow range of 11.3%-11.6% over FY09-FY11 and operating margins were stable.

Figure 21: DFG’s opex/revenue trend (%) 14 12 10 8

6 4 2

0 FY09 FY10 FY11 Selling and distribution costs Adminstrative costs Other operating expenses Total opex

Sources: The Company and Sun Hung Kai Financial

Figure 22: DFG’s margin trend (%) 23.0 21.0 19.0 17.0 15.0 13.0 11.0 9.0

7.0 5.0 FY09 FY10 FY11 1H12

Gross profit margin Operating margin Net margin

Sources: The Company and Sun Hung Kai Financial

Sun Hung Kai Financial Institutional Research 11 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

The company has generally stayed net cash, likely because it needs to fund auto-financing services for dealers, mainly operated through JVs and associate.

The company has consistently generated positive operating cash flows due to its negative cash-conversion cycle. It generally maintains 40-45 days of inventory and grants 1-2 months of credit to dealers, but gets almost four months of credit from suppliers.

Figure 23: DFG’s cash-conversion cycle (days) 140 120 100

80

60

40 20 0

FY10 FY11

A/R T/O Inventory T/O A/P T/O

Sources: The Company and Sun Hung Kai Financial

1H results recap

For 1H12, revenue rose 7% y/y to RMB68bn but EPS fell 8% y/y to RMB62 fen. Overall gross margin held steady at 19.6%, despite CV margin dropping to 13.6% from 14.5% in 1H11 and the company cutting PV and CV ASPs by 3% y/y and 7% y/y respectively amid keen competition.

Operating margin fell 1.6 ppts y/y to 10.2% as the company gave more incentives to dealers in view of the weak economy and increased advertising costs.

Rising inventories at dealership level resulted in a longer A/R period and A/R increasing 37% h/h or 26% y/y. Receivables period rose from 52 days for FY11 to 72 days for 1H12.

The company has also announced Q3 results based on PRC GAAP, but a comparison would not be meaningful since these numbers treat contributions from the three Sino-foreign JVs differently.

Sun Hung Kai Financial Institutional Research 12 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

Earnings Forecasts

PV sales volumes rose just 5.7% y/y in FY12 owing to the negative impact from Sino-Japan tensions, while CV sales volume fell 21%. We see sales volumes picking up with 12% y/y PV growth and 5% y/y CV growth in 2013.

We expect margins and ASP to come under pressure in FY12 due to a less favorable sales mix, with fewer Japanese brands, and lower prices in the first half. Bear in mind that 65% and 22% of after-tax profits are from DF Nissan and DF Honda. We expect blended margin to dip to 18.5% in FY12 from 20.1% in FY11, and recover to 19.5% in FY13 on more contributions from Japanese JVs, which are more profitable. Japanese JVs accounted for 60% of sales volumes in 2012, down from 65% in 2010 and 2011.

Overall, we forecast EPS of RMB0.915, RMB1.15 and RMB1.42 for FY12-14E for growth of -25% y/y, 25% and 24% y/y.

Figure 24: Earnings assumption

FY09 FY10 FY11 1H12 FY12E FY13E FY14E Sales volume – y/y % PV 46 34 16 22 6* 12 13

CV 13 42 0 -19 -21* 5 8

ASP -RMB/unit PV 111,128 107,270 101,288 97,947 98,000 100,940 102,959 PV y/y - % 1 -3 -6 -3 -3 3 2 CV 105,589.48 110,175.90 113,274.80 103,576 105,000.00 107,100.00 109,242.00 CV y/y - % -3 4 3 -7 -7 2 2

Gross margin - % 19.05 21.54 20.08 19.60 17.62 18.46 19.33 PV 20.60 24.40 22.00 20.90 18.50 19.50 20.50 CV 14.10 14.10 14.30 14.30 14.30 14.30 14.50 * Sales volume figures have already been released; the other FY12 numbers are estimates Sources: The Company and Sun Hung Kai Financial

Catalysts

. Proposed Renault JV. Mainland media report that DFG has applied to the NDRC to set up a PV JV with total investment of RMB6.5bn.

. The possibility of exporting the Teana model to Japan, which would be positive for earnings.

. Japanese auto brands regaining market share in China faster than expected.

. DFG’s domestic-brand business growing faster than expected

Sun Hung Kai Financial Institutional Research 13 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

DFG’s shares have rebound strongly from their trough, but despite the rally are still at 9X forward P/E vs. the sector’s 12X (excluding BYD). We believe such a valuation is undemanding and that a discount is unwarranted in view of its 5%-100% premium over Chinese-brand automakers during 1H11-1H12.

Figure 25: Peer comparison

20D FY12E FY13E FY14E FY0 Stock Mkt. avg EPS EPS EPS FY1 FY2 Div. Stock price cap T/O 6M chg growth growth growth P/E P/E yield Company code (HK$) (HK$m) (US$m) (%) (%) (%) (%) (X) (X) (%) Dongfeng Motor 489.HK 12.96 112,354 37.4 19.2 (24.8) 25.4 24.1 9.2 7.4 1.7

Brilliance China 1114.HK 10.72 53,776 16.4 62.1 31.5 30.4 20.7 18.0 13.8 0.0 Geely Automobile 175.HK 4.11 34,031 32.6 49.8 11.5 21.2 17.9 14.3 11.8 0.7 Great Wall Motor 2333.HK 26.40 86,434 18.1 77.5 37.0 13.2 10.9 12.7 11.2 1.4 BYD 1211.HK 25.35 62,585 11.8 78.6 (80.8) 253.0 36.7 177.3 50.2 0.0 GAC 2238.HK 7.83 50,762 6.3 27.4 (42.6) 42.6 19.9 15.8 11.1 4.2 Sector Average 59.1 (8.7) 72.1 21.2 47.6 19.6 1.3 Sources: Bloomberg and Sun Hung Kai Financial

Company Background

DFG can trace its history back to the predecessor of its parent company, Second Automotive Works, which was established in 1969 by the Chinese government. DFG was incorporated by its parent company through a debt restructuring arrangement in 2000. DFG listed on the in 2005.

DFG manufactures and sells commercial vehicles (CV), passenger vehicles (PV) and auto engines and parts. 77% of sales were from PVs in 1H12, 22% from CVs, and less than 1% from others. Together with parent DFMC it is the second largest automaker in China by sales volume, according to China Association of Automobile Manufacturers (CAAM). It is also a leading manufacturer of heavy and medium trucks in the PRC.

Risks

. Weak PV sales, which could be affected by a prolonged weakness in domestic consumer sentiment, further Sino-Japan tensions and unsuccessful new models.

. Slow recovery in CV business due to weak demand for truck transport.

. China’s improving railway network reducing demand for truck transport.

. Keen competition forcing the company to cut prices significantly.

. Domestic-brand business diluting DFG’s brand.

. Continued boom in sales of luxury autos. DFG has little exposure to this segment.

. Greater-than-expected losses for domestic-brand business. Breakeven point was originally set at 110k unit sales p.a., with 60k in FY12.

Sun Hung Kai Financial Institutional Research 14 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

Corporate Governance

Equity fundraising. None since the IPO in 2005.

Dividend history. The company has paid dividends every year since FY06. It doubled DPS in FY10 and maintained this level in FY11.

Business structure. The company’s mainly operates through JCEs and non-wholly-owned subsidiaries. Such an opaque business model is difficult to analyze, though the company does disclose selected data for these entities.

Financial reporting standards and auditors. JCE investments are accounted for by proportionate consolidation. Ernst & Young and Ernst & Young Hua Ming are the international and domestic auditors. Ernst & Young has issued a standard and unqualified audit.

Board composition. The chairman and president roles are separate. Combination the roles is sub-optimal corporate governance.

Ownership concentration. 66% is held by the parent (i.e. SOE). Companies with concentrated ownerships may act in their own interests rather than those of all shareholders.

Related-party transactions. There are frequent related-party transactions with the JVs and non-wholly-owned subsidiaries. There is also a mutual supply agreement with its parent, including procuring/supplying raw materials and providing vehicle financing.

Changes in management team. There have been no management changes in the past year.

Sun Hung Kai Financial Institutional Research 15 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

Ownership Structure

State-owned Assets Supervision and Administration Commission

of the State Council

100%

Dongfeng Motor H-share holders Corporation

66.86% 33.1%

Dongfeng Motor Group (489.HK)

Sources: The Company and Sun Hung Kai Financial

SWOT Analysis

Strengths Weaknesses . Alliances with leading auto companies allow access to . Limited flexibility in model design. Most models are advanced technology. designed by foreign partners and are not customized . Extensive dealer network for PVs and CVs. for the China market. . Net cash. . Reliance on Japanese cars, which contribute 80% of after-tax profit. . Strong lineup of new models could drive sales growth.

. Comprehensive product range with mass-market focus.

Opportunities Threats . Still-low auto penetration in China. . Luxury automakers making inroads at the high-end of . Recovery of CV market as domestic economy picks up the mass-market segment by launching entry-level amid monetary easing. versions of their current models. . Rising disposable incomes stimulating car . More companies opting to send shipments via China’s upgrades/purchases. growing railway network rather than by road, which could reduce demand for trucks. . Further delays in the implementation of National IV standards. . Increasing focus on domestic brands diluting DFG’s overall brand image. . Restrictions on car registrations extending to more cities. . Growing second-hand car business in China could threaten sales of new autos. Source: Sun Hung Kai Financial

Sun Hung Kai Financial Institutional Research 16 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

Appendix: Financial statements

Year end Dec. As at end Dec. P/L - RMBm FY10 FY11 FY12E FY13E B/S - RMBm FY10 FY11 FY12E FY13E Revenue 122,395 131,441 124,564 141,366 PPE 18,551 21,578 28,464 33,430 COGS (96,033) (105,051) (102,621) (115,276) Others LT assets 9,734 11,939 12,905 12,516 GP 26,362 26,390 21,943 26,090 Total non-current assets 28,285 33,517 41,369 45,946 Other income 2,322 2,853 2,853 2,853 Inventories 13,935 12,511 14,058 15,791 EBIT 14,516 14,384 11,094 13,888 A/R 17,897 19,600 20,476 20,527 Finance costs (229) (402) (374) (384) Cash & Equivalents 41,404 42,899 41,942 45,846 Profit before tax 14,583 14,361 11,137 13,963 Total current assets 82,337 84,016 85,855 91,832 Tax (3,006) (3,401) (2,895) (3,630) Total assets 110,622 117,533 127,224 137,778 Net profit 11,577 10,960 8,241 10,332 A/P 53,574 53,145 54,544 59,375 Net profit to owners 10,981 10,481 7,881 9,881 Short-term debt 3,271 5,993 7,400 7,400 Total current liabilities 62,656 64,715 67,400 68,548 EPS – RMB 1.274 1.216 0.915 1.147 Long-term debt 6,289 2,820 2,820 2,820 DPS – RMB 0.180 0.180 0.130 0.150 Total liabilities 69,286 67,949 70,807 71,994 Owner’s equity 37,494 46,394 52,724 61,484 Minority Interests 3,842 3,190 3,550 4,002

Ratios - % FY10 FY11 FY12E FY13E Cash Flow - RMBm FY10 FY11 FY12E FY13E Revenue growth 33.4 7.4 (5.2) 13.5 Pre-tax profit 14,583 14,361 11,137 13,963 Op. profit growth 71.6 (0.9) (22.9) 25.2 Depn. & amortization 3,985 3,114 3,503 3,923 EPS growth 75.7 (4.6) (24.8) 25.4 Δ WC 2,665 (2,505) (1,165) 652 GPM 21.5 20.1 17.6 18.5 Operating cash flow 17,903 9,216 9,187 13,524 Op. margin 11.7 10.6 8.6 9.6 Capex (3,927) (6,072) (10,000) (8,500) NPM 9.0 8.0 6.3 7.0 Investing cash flow (6,078) (535) (10,000) (8,500) Net Debt/Equity Net cash Net cash Net cash Net cash Δ in borrowings (2,500) (701) 1,407 0 ROA 16.3 13.2 9.7 11.6 Issued share 0 0 0 0 ROE 33.9 25.0 15.9 17.3 Dividend (776) (1,551) (1,551) (1,120) A/R T/O – days 45.1 52.1 58.7 52.9 Financing cash flow (3,305) (3,189) (144) (1,120) Inventory T/O - days 43.1 45.9 47.2 47.3 Net cash flow 8,520 5,492 (957) 3,904 A/P T/O - days 114.0 116.8 119.7 113.3 End cash 25,889 31,381 30,424 34,328

Sources: The Company and Sun Hung Kai Financial

Sun Hung Kai Financial Institutional Research 17 Dongfeng Motor (489.HK) – Initiation of Coverage 10 January 2013

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Research Analyst Conflicts Financial Interests: The research analyst(s) who prepared this report and/or his/her/their associates has/have no financial interests in relation to listed corporation(s) covered in this report.

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Guide to Sun Hung Kai Financial stock ratings: . Buy – We expect return of 15% or better over the next 12 months. . Neutral – We expect return within –10% to 10% over the next 12 months. . Sell – We expect return of –10% or worse over the next 12 months.

Institutional Equities Contacts Address: 42/F, The Lee Gardens, 33 Hysan Avenue, Causeway Bay, Hong Kong Phone: Research (852) 3929 6162 Fax: (852) 3929 6153 Sales (852) 3920 2672 Web: http://www.shkfg.com

Research Stephen Yang, CFA [email protected] (852) 3929 6154 Nicholas Studholme [email protected] (852) 3929 6156 Vik Chopra [email protected] (852) 3929 6165 Eva Yip, CFA [email protected] (852) 3929 6159 Stuwart Chen [email protected] (852) 3929 6164 Edward Chung [email protected] (852) 3929 6158 Doris Ma [email protected] (852) 3929 6162

Sales Richard Seaward [email protected] (852) 3920 2676 Jack Li, CFA [email protected] (852) 3920 2650 Andrew Scott [email protected] (852) 3920 2677 Charles Streeter [email protected] (852) 3920 2675 Craig Hodge [email protected] (852) 3920 2674 Katina Wong [email protected] (852) 3920 1705 Cherain Wong [email protected] (852) 3920 2671

Sun Hung Kai Financial Institutional Research 18