2018 Key Investment Themes- HK Stock

2018 Key investment themes- HK Stock

【

In 2017, the global economy continued the momentum of recovery which is supported by strong domestic demand growth in China, U.S and Euro area. U.S. Consumer Confidence Index has hit the highest level since 2000. This is reflected in the surging of corporate earnings. Together with the expectation of tax reform, it is suggested that the U.S. economy can sustain its growth through 2018. On another side, China’s GDP growth is stronger than expected. IMF uplifted its forecast of China’s GDP to expand by 6.8%, compared with its previous forecast 6.7%. Manufacturing PMI of China, which peaked at 55.4% in September, has stood above the 50% level for 17 months consecutively, growth in China, as well as the other advanced economies, is going to bring its momentum forward to 2018.

1. U.S. tax reform –positive Positive to corporate earnings: U.S. tax reform is deemed to be the major driver of the economy of 2018. The spotlight falls on the large reduction of corporate tax from 35% down to 21%. The old economy, including financial, manufacturing and consumption sectors, will be benefited the most from the tax cut which may increase their after-tax profits. Furthermore, the tax cut will also spur the household spending. The U.S. corporate earnings are set to have a positive outlook at the beginning of 2018.

2. U.S. Rate Hike cycle – mild negative Rate hike supported by economic growth: The Fed rate hike is typically a bad CASH Research news for the market. Theoretically, it may reduce the liquidity of the market, [email protected] and thus causes the stocks to decline. However, viewing from the historical Tony Cheung point of view, the stock market tends to go positively with the interest rate (see Senior Research Analyst Fig.1) because the rate hike is usually supported by the positive sentiment of Tel: (+852) 2287-8847 economic growth. It also highly depends on the inflation rate. The inflation [email protected] rate of U.S. is currently below the 2% target of the Fed. Therefore we expect the Fed rate to move at a relatively gradual pace. But the downside risk will be Cynthia Tam a faster than expected acceleration of inflation rate, which may then speed up Senior Research Analyst the rate hike. Tel: (+852) 2287-8466 [email protected] The alarm has not yet rung: Interest rate hike is also posing another concern over the flattening yield curve. The spread between the long and short-term Gary TY Kong Research Analyst rate has been declining and close to the flattest level in a decade. The inverted Tel: (+852) 2287-8487 yield curve had successfully predicted the past 7 recessions since the 1970s*. [email protected] Currently the 3m-10years spread on Treasury yields is at 1.1% down from 1.98% in 2016. Provided that the long-term rate does not change and there would be 3 more interest rate hikes in the coming year, 0.25% increase for each

The above information is provided and distributed by CASH Financial Services Group Limited (“CASH”). The document is for reference only. Neither the information nor opinion expressed shall be construed, expressly or impliedly, as an advice, offer, invitation, advertisement, inducement, recommendation or representation of any kind or form whatsoever. While the information contained herein has been obtained from sources believed to be reliable, CASH or its affiliates do not represent that it is accurate or complete and it should be relied upon. CASH hereby expressly disclaims all liabilities arising out of or incidental to the accuracy and completeness of the contents and information herein contained. The contents and information in this document is subject to change without prior notice to you. As of 2 January 2018, the analyst who provides the above information has financial interests in relation to the above securities. Trade in securities covered by this report may be made only in those jurisdictions where the securities are qualified for trading. This document may not in whole or in part be reproduced or furnished to any person other than the addressee without written consent from CASH and CASH shall not be liable to any such third parties for loss arising from any unauthorized distribution. Securities dealing services are provided by Celestial Securities Limited, a corporation licensed to conduct Type 1 (dealing in securities) regulated activity under the Securities and Futures Ordinance. -1- January 2, 2018

time; it would then be possible for the spread comes to 0-0.25% by the end of 2018. The lead time, however, varies a lot: the shortest period between the inverted yield curve and recession can be only 1 quarter; the longest can be 2 years; the average lead time is 5 quarters. To conclude, if there is really a recession coming, it would take place in the second quarter of 2019 the earliest. If the market takes it into expectation a half year earlier than it really happens, the negative effect on the stock market would start to appear in 2H18.

*An inverted yield curve could be a reliable predictor of recession: Normally investors are looking for a higher yield to compensate the longer period that their money is being locked up. However, if the investors expect the future economy is going through downturn, so that the Fed fund rate has to be lowered to save the economy, they would like to invest their money in a longer maturity rather than reinvesting their money in a much lower rate in a sooner future. With a higher demand on the long-term bond, the long-term yield would be pushed down.

Figure 1. Trend of Fed Fund Target Rate and Asia Stock Performance

Source: Bloomberg, CASH

Figure 2. 3m- 10y spread on Treasury yields

Source: Bloomberg, CASH

3. China financial reform (deleveraging) – mild negative After President Xi further cemented his power in the 19th Communist Party Congress, a stronger execution on deleveraging is widely expected. That said, keeping the liquidity largely stable is still believed to be the major underlying objective of PBoC. We expect the Central government will perform well in striking a balance between stability and deleveraging by putting it in a gradual pace and better coordination.

4. Robust China Economy - positive Strong interest paying capabilities with Supply-side reform and demand recovery: Chinese firms’ capability of paying interest expenses has been improved a lot. In 2017, the EBIT-to-interest expense ratio has been lifted to around 18 times from an average of 5 times in the past decade. This significant improvement can be explained by China’s internal effort on Supply-side reform and the recovery of global economy. The Supply-side reform is letting the zombie companies out and cutting the excess supply, the pricing power of the remaining market players could then be increased; on the demand-side, steady recovery of the global economy has been a very important support of China’s exports. In Nov 2017, China’s export volume has increased by 12.3% YoY, which beats the market forecast of 5.3% YoY. These two internal and external forces have driven up the Chinese companies’ profitability and let the major players in the China market be well-prepared to handle the pressure from deleveraging.

Figure 3. EBIT-to-interest expense ratio of 4,000 China-listed firms excluding financials

Source: Bloomberg, CASH

Strong PMI with consumption upgrade: Despite the tightened regulation on pollutions, China’s PMI in Dec was 51.6, above the 50% level for 17 months consecutively. Among the 12 sub-indicators we tracked, 5 showed an accelerated economic expansion. The strong manufacturing activity shows that the domestic and export demands are still robust.

Meanwhile, final consumption expenditure has become the major driver to the economic growth, which currently accounts for 65% of China’s real GDP growth in the first 3 quarters in 2017. Backed by strong labor demand from the service sector, the household income is on the rise. In the help of e-Commerce platforms, consumption upgrades are expected to be more common nationwide. In November 2017, the growth of China’s e-Commerce sales has increased by 32.4% YoY. With this momentum, the growth in consumption is likely to offset the slowing growth of fixed asset investment caused by the tightening financial condition.

Figure 4. China Manufacturing PMI

53%

52%

51%

50%

49%

48%

47%

Jun-17 Jun-16

Oct-16 Oct-15 Oct-17

Feb-16 Apr-16 Feb-17 Apr-17

Dec-15 Dec-16

Aug-16 Aug-17

China Manufacturing PMI 50% expansion line

Source: Bloomberg, CASH

Figure 5. China Manufacturing PMI

12/31/17 11/30/17 10/31/17 9/30/17 8/31/17 7/31/17 China Manufacturing PMI 51.6 51.8 51.6 52.4 51.7 51.4 New Orders PMI 53.4 53.6 52.9 54.8 53.1 52.8 Employment PMI 48.5 48.8 49 49 49.1 49.2 New Export Orders PMI 51.9 50.8 50.1 51.3 50.4 50.9 Output PMI 54 54.3 53.4 54.7 54.1 53.5 Input Prices PMI 62.2 59.8 63.4 68.4 65.3 57.9 Imports PMI 51.2 51 50.3 51.1 51.4 51.1 Backlogs of Orders PMI 46.3 46.6 45.6 47.4 46.1 46.3 Production and Business Activities Expectation58.7 PMI 57.9 57 59.4 59.5 59.1 Purchasing of Inputs PMI 53.6 53.5 53.2 53.8 52.9 52.7 Inventories of Raw Materials PMI 48 48.4 48.6 48.9 48.3 48.5 Stocks of Finished Goods PMI 45.8 46.1 46.1 44.2 45.5 46.1 Suppliers' Delivery Time PMI 49.3 49.5 48.7 49.3 49.3 50.1 Source: Bloomberg, CASH

Figure 6. China FAI, Value Added of Industry, Retail Sales (YoY)

Source: Bloomberg, CASH

5. Southbound inflow to Hong Kong stock market - positive Despite the higher than average P/E ratio of Hang Seng Index (average of 10-years is 12.33X, currently at 13.7X), it is still lower than that of China-A stock, which is currently at 16.7X (SSE Composite Index), plus the fact that there is a huge demand by mainland investors to achieve a greater diversification by seeking offshore investment opportunities, making the valuation of Hong Kong Stock attractive to the mainland investors. The growth of Southbound flow has been secular since the inauguration of SH-HK connect in November, 2014. In 2018, we believe that the Southbound flow will still be the major driver to support the valuation of stock at 14X level.

Figure 7. 2014-2017 Cumulative Southbound Net Inflow through SH&SZ-HK Connect (HKD bn) 800

700

600

500

400

300

200

100

-100

Jul-16 Jul-15 Jul-17

Jan-17 Jan-15 Jan-16

Sep-15 Sep-16 Sep-17

Nov-14 Nov-15 Nov-16 Nov-17

Mar-15 Mar-16 Mar-17

May-15 May-16 May-17 Cumulative Southbound Inflow Source: Bloomberg, CASH

Our 2018 HSI target is 32,000: Our baseline projection of HSI in 2018 is 32,000, with 13.7X P/E and 10% EPS growth. In the case of upside risk that the southbound flow to Hong Kong is in a faster pace, our Blue Sky projection of HSI is 35,000 with 15X P/E; in the case of downside risk that the financial tightening condition in mainland is stronger than expected, our Grey Sky projection of HSI is 27,000 with 11.5X P/E.

Worst Case Scenario: In the past decade, there had been great slumps in the market for 3 times, in 2008, 2011, 2016 respectively. Among those three slumps, the market reached the bottom when the P/B ratio dropped until 1X-1.06X. Currently the P/B ratio of HSI is 1.38X. In any case that the market counters another financial crisis, the worst case scenario would be that the P/B ratio of HSI falls back to 1X-1.06X. According to Bloomberg BPS forecast, that means 1X-1.06X P/B would let HSI fall to 23,129 – 24,516.

In 2018, investors can pay attention to Handsets Equipment, Cloud and Technology, Macau Gaming, Automobiles, Export and Local Retail sector.

Table of Contents Handsets Equipment Sector ...... 9

CAMERA MODULE ...... 9 Multiple growth engines in camera modules market ...... 10 Tech know-how is the key in stock pick ...... 12 SUNNY OPTICAL (2382.HK, TP: HK$140) ...... 15 The Cloud industry ...... 20

WHAT IS CLOUD? ...... 21 TENCENT (700.HK, TP: HK$477.2) ...... 29 Macau Gaming Sector ...... 35

INTRODUCTION ...... 36 WHAT FACTORS TO KEEP AN EYE ON? ...... 38 STATISTICS AT A GLANCE ...... 43 GALAXY MACAU (00027.HK, TP: HK$70) ...... 47 WYNN MACAU (01128.HK, TP: HK$29) ...... 49 Automobile Sector ...... 52

INTRODUCTION ...... 54 MARKET OVERVIEW ...... 54 WHAT ARE THE HIGHLIGHTS IN THE COMING YEARS? ...... 58 GEELY AUTOMOBILE (00175.HK, TP: HK$35) ...... 64 BRILLIANCE CHINA (01114.HK, TP: HK$26) ...... 67 NEXTEER (01316.HK, TP: HK$22) ...... 69 China Export Sector ...... 71

CHINA EXPORT GROWTH ...... 72 Export growth is regaining momentum ...... 72 The cycle is far from an end ...... 73 China’s rate hike cycle will be relatively slow ...... 74 Trump’s tax cut plan...... 75 TECHTRONIC IND. (0669.HK, TP: HK$65) ...... 77 HK Retail Sector ...... 81

STATISTICS AT A GLANCE ...... 82 Visitor arrivals ...... 82 Hong Kong Retail sector...... 84 Rental in Hong Kong ...... 86 Same-store sales growth (SSSG) ...... 87 INFRASTRUCTURE PROJECTS IN HONG KONG ...... 90 HK-Zhuhai-Macao Bridge (HZMB) ...... 90 Guangzhou-Shenzhen-HK Rail Link ...... 91 LUK FOOK (0590.HK, TP: HK$37) ...... 93 SA SA INT’L (0178.HK, TP: HK$3.5) ...... 95

Handsets Equipment Sector

Given dual camera, larger aperture, wide-angle, miniaturization (MOB, MOC) as a key sector driver in 2017, our top picks (2382.HK) has risen more than 180% since 2017. Market was recently concerned about the cut down of production order by Chinese smartphone brands and Apple due to demand weakness, taking into account of the potential cut down in old features price (by negotiating with component suppliers) or giving up some specs (by lowering pixel resolution), share price of smartphone components stocks has plummeted. However, we still think companies with superior cam modules technique and 3D sensing capabilities can be relatively resilient, strong fundamentals remain intact. We continue to recommend Sunny as our top pick in 2018 given its rich experience in lens production and 3D sensing.

Camera module A camera module is a device which is used to convert an optical image into electronic video signals. And these electronic signals are then converted into digital data on the display of a digital imaging device so that users can store as a digital image. Rising demand for smartphones, tablets and other mobile devices will drive demand for camera modules, which can be regarded as a core component and a differentiating factor of a digital camera. We see that the camera module applications have been expanding beyond their traditional use to a wider angle, including security, aerospace, industrial, automotive, medical devices and other fields due to its cost and performance advantages.

Figure 8. Camera module

Source: Bloomberg, CASH

Multiple growth engines in camera modules market

Growth in global camera modules market According to MarketsandMarkets, the global camera modules market is expected to grow from USD 19.21 Billion in 2014 to USD 36.95 Billion by 2020, at a CAGR of 10.8%. There are several growth engines for the global camera modules market: (1) Cameras have become one of the important parameters for mobile device manufacturers as the purchasing decision of end users now depends more and more on the camera type and pixel size. Also, (2) it is expected that the growing market for advanced driver assistance systems (ADAS) in the automotive sector is boosting the demand for image sensors, and also the camera modules. ADAS needs image sensors to provide safety features including parking assistance, lane-departure warning, and collision avoidance systems. Moreover, (3) the hottest theme under AI era – Machine Vision, is also one of the applications where camera modules are increasingly being used for flaw detection, positioning, identification, verification, and measurement of the products in various industries.

Figure 9. Camera Module Production Process

Source: Cowell

Migration to higher pixels According to IBS, global shipments of mid to high resolution camera modules, characterized by a pixel count of 5 megapixels and above, amounted to 725m units in 2013. It is projected to jump to 5,182m units in 2020, representing a 2013-2020 CAGR of 32.4%. Camera modules with high resolution, characterized by a pixel count of 8 megapixels, 12 megapixels, 16 megapixels and above, recorded unit volume of 342m in 2013. They are expected to increase to 3,931m units in 2020, representing a 2013-2020 CAGR of 41.7%, reflecting surging demand for high resolution cameras in smartphones, tablets and other automotive applications.

Dual cam is the trend Apple’s aggressive push in dual-cams will drive Android smartphones to adopt dual cameras in the coming years. Given consumers’ stronger demand for high quality images, we think dual camera will gradually become a standard specification for mid to high-priced smartphones (RMB2,000-4,000). Dual camera penetration rate among the global brands remained low at c.5% in 2016 (2015: <1%). It is estimated that global dual-cam penetration (rear) will reach c.16% in 2017 and c.30% in 2018 (See figure). For front cam, dual-cam penetration will reach c.3% in 2017 and c.5% in 2018. Global’s handset lens sets shipment will grow by 30% to 3.69bn units in 2018. We think that will push up the ASP for camera modules in the next few years.

Figure 10. Global handset lens sets demand (in mn units) and dual cam penetration from 2014 to 2020E

Source: IDC, IHS, CASH

Tech know-how is the key in stock pick

Focus on technical capability inside a fragmented market The global camera module market is relatively scattered. In 1H16, the top three suppliers Sunny Optical(2382.HK), O-film(002456.SZ), Foxconn occupied 8.9%, 8.7% and 5.0% of the market share, with the top 12 suppliers accounting for 60% of the total market share. We think those with higher technology capability (eg. Dual camera, larger aperture, wide-angle, miniaturization (MOB, MOC), etc) can lead the market.

Figure 11. Camera module market share

Source: EEWorld, CASH

Figure 12. Players of the camera module industry (2015)

Source: Yole Developpement, CASH

Mold-on-board (MOB) and Mold-on-chip (MOC) These technologies can achieve smaller form factor, better heat dissipation, higher resistance to drops, less contamination during transportation, higher yield rate with higher precision and cost close to traditional process. We guess the cumulative shipment with MOB process is around 10% of the Sunny’s mix currently. Also, the space of front camera module is required to reduce as the smartphone display becomes larger, Sunny has developed “steps-like” and “D-cut” lens packaging form factors. Steps-like has a smaller surface area at the top stepping down to a wider base with D-cut design even narrower to fit in the small space next to the 18:9 screen (See figure). Also, in order to raise resolution, more pieces of lens are being used. Sunny is developing a 7 pieces lens set which will be ready for sample by 4Q17 with hybrid solution (plastic and glass).

Figure 13. Lens and module design miniaturization with larger screen ratio

Source: CASH

Figure 14. Valuation and financial ratios of Handset equipment related stocks Stock Code Price ($LC) TP %upside 18 EPS YoY 19 EPS YoY 18PE 19PE 18ROE 19ROE 18PB 19PB AAC Tech 2018 HK Equity 139.40 NA NA 36.55 22.60 19.43 15.85 34.74 33.27 6.15 4.86 GoerTek 002241 CH Equity 17.35 NA NA 26.69 16.50 19.34 16.60 19.63 18.86 3.57 3.02 Sunny Optical 2382 HK Equity 99.90 140.00 40.1% 45.14 33.16 23.84 17.90 44.48 41.49 9.04 6.49 Q Tech 1478 HK Equity 11.00 NA NA 46.37 24.62 13.76 11.04 31.42 30.65 3.73 2.84 Cowell 1415 HK Equity 2.64 NA NA 22.41 4.23 4.76 4.57 16.10 14.44 0.72 0.64 Crystal Optech 002273 CH Equity 23.59 NA NA 50.00 42.01 26.93 18.96 15.27 17.43 3.95 3.23 O-Film 002456 CH Equity 20.59 NA NA 46.52 30.25 25.74 19.76 19.62 20.66 4.77 3.99 ASM Pacific 522 HK Equity 108.90 NA NA 0.76 11.31 16.53 14.85 24.16 23.05 3.60 3.18 BYD Electronic 285 HK Equity 17.02 NA NA 19.36 13.75 10.00 8.79 20.04 19.10 1.87 1.58 FIH 2038 HK Equity 2.38 NA NA 136.00 44.44 33.84 23.43 3.22 3.87 0.72 0.70 Tongda Group 698 HK Equity 2.00 NA NA 30.90 20.17 8.58 7.14 22.98 23.63 1.85 1.56 Janus 300083 CH Equity 7.59 NA NA 43.95 29.91 11.82 9.10 14.37 15.85 1.63 1.39 EWPT 300115 CH Equity 20.07 NA NA 50.86 38.53 13.42 9.69 24.43 26.21 3.12 2.49 Truly Int'l 732 HK Equity 3.38 NA NA 254.76 40.60 11.34 8.07 11.19 12.71 1.25 1.08 Lens 300433 CH Equity 29.85 NA NA 53.52 23.62 22.82 18.46 18.70 19.29 4.12 3.50 Speed 300322 CH Equity 11.82 NA NA 32.28 26.79 56.56 44.60 8.69 9.66 6.86 6.08 Huatian Tachnology002185 CH Equity 8.52 NA NA 31.15 31.09 24.99 19.06 11.79 13.36 2.97 2.59 Sunwoda 300207 CH Equity 9.76 NA NA 34.35 18.61 15.79 13.32 25.43 23.15 3.47 2.83 Median 40.25 25.71 17.93 15.35 19.63 19.19 3.52 2.84 Average 53.42 26.23 19.97 15.62 20.35 20.37 3.52 2.89 Source: Bloomberg , CASH

Sunny Optical (2382.HK, TP: HK$140) Handset equipment Key Investment Themes Relative low threats from peers: We believe market will continue to recognize Sunny’s leading position. Also, its peer Q-Tech (1478.HK) who recently got the orders from Huawei, has revised down full-year HCM shipment growth to 10% YoY (from 25% YoY) due to capacity constraints, in contrast, we believe Sunny should sustain decent performance with its technology leadership and high automation level, outperform its peers.

Broader 3D sensing adoption: Apple announced iPhone X on 12 Sep with the 3D sensing structure (called ‘TrueDepth camera system’). The structure includes one emitter (dot projector) and one receiver (infrared camera) working in conjunction with a proximity sensor, an ambient light sensor, and a flood illuminator. The TrueDepth camera system maps the face with 30,000 invisible dots flashed on the visage and the information will then be recognized by infrared camera and feed the iPhone X's neural network, creating a mathematical model of the user's face. We think Android camp will probably follow suit. To our understanding, Sunny Optical, which is the main supplier in Android camp, is good at Time of Flight (ToF) (one of the 3D sensing solutions) applications through its past experience in Google's Project Tango and Lenovo smartphones. Also, the company has started mass production of both ToF and structured light modules (another 3D sensing solution) for industrial and smart home device. Sunny will be one of the biggest beneficiaries under 3D sensing trend.

Rising penetration of dual-cams: It is deemed that Apple’s aggressive push in dual-cams will drive Android smartphones to adopt dual cameras in the coming years. Also, given consumers’ stronger demand for high quality images, we think that dual camera will become a standard specification for mid- to high-priced smartphones. Dual camera penetration rate among the global brands remained low at c.5% in 2016 (2015: <1%). It is estimated that global dual-cam penetration (rear) will reach c.16% in 2017 and c.30% in 2018 (See figure). For front cam, dual-cam penetration will reach c.3% in 2017 and c.5% in 2018. Global’s handset lens sets shipment will grow by 30% to 3.69bn units in 2018. We think that will push up the ASP for camera modules in the next few years.

Accelerating penetration of ADAS towards 2020: According to Reportbuyer, China's automotive lens OEM market size reached 10 million pieces in 2015 (1.23 million pieces of front view automotive lens and 8.77 million pieces of rear view) , accounting for 20.6% of the global market. By 2020, China's automotive lens OEM market size will report 38.65 million pieces, imply a 5-year CAGR of around 31%. Sunny Optical is the world's largest supplier of automotive lenses, serving Mobileye, Gentex, TRW, Valeo, Bosch, Continental, Delphi, Magna, among others. In 2015, Sunny Optical realized the shipment of 16.516 million pieces and enjoyed the market share of 34.1%, deemed to be the largest beneficiary.

Retain Buy with target price up to HKD140: We forecast Sunny’s 2018 earnings growth will be around 70% based on product tech upgrade and market share expansion. We reiterate buy with TP raised to HKD140 from HKD137.2 based on 2018 PE of 30x and 2018E EPS growth of ~70%, implying a 40% upside. We believe Sunny will continue to have upside earning revisions and re-rate from the current PE given its long-term growth on dual-cams, 3D sensing ability, and strengthened market position in vehicles lens market.

Background Sunny Optical, which was established in 1984, is a leading supplier of optical-related products in China with strong design and production capabilities (manufacture both lenses (5MP/8MP/13MP/16MP/20MP) and modules (5MP/8MP/13MP/16MP/OIS and 3D). The group is mainly engaged in three business segments: 1) Optical components (Defocus Control lens, handset lens and vehicle lens); 2) Optoelectronic products (handset camera modules); 3) Optical instruments (microscopic instruments and analytical instruments). It has a diversified customer mix, including Huawei, Samsung, Xiaomi, OPPO, Lenovo with 5 production bases in China, as well as R&D centers in China, Singapore, South Korea and the US.

Figure 15. Sunny Optical’s revenue exposure in 1H2017

Source: CASH, Company data

Figure 16. Compact Camera Module Shipment Figure 17. Handset Lens Shipment (in mn units) (in mn units)

Source: Company data, CASH

Figure 18. Vehicle Lens Shipment (in mn units)

Source: Company data, CASH

Sunny Optical 2382.HK, Buy, TargetPrice: 140 Income Statement (thousands RMB$) Balance Sheet (thousands RMB$) Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Revenue 10,696 14,612 24,011 35,122 56,293 Cash & equivalents 187 467 2,888 6,766 13,800 Cost of goods sold -8,933 -11,932 -19,160 -27,374 -42,830 Marketable securities 1,926 2,302 2,302 2,302 2,302 Gross profit 1,763 2,680 4,851 7,748 13,464 Accounts receivable 3,003 3,716 6,408 9,373 15,023 SG&A -884 -1,205 -1,953 -2,845 -4,545 Inventories 897 2,828 2,703 3,862 6,042 R&D -502 -694 -1,134 -1,659 -2,659 Other current assets 5 5 9 14 22 Other expense -29 -26 -26 -26 -26 Total current assets 6,017 9,318 14,310 22,316 37,189 Employee share expense 0 0 0 0 0 LT investments 194 177 177 177 177 Operating profit 880 1,475 2,897 4,902 8,918 Fixed assets 1,141 1,794 1,558 1,073 117 EBITDA 1,126 1,792 3,433 5,686 10,175 Goodwill 0 0 0 0 0 Depreciation -246 -317 -536 -784 -1,257 Other intangible assets 0 0 0 0 0 Amortization -0 -0 -0 -0 -0 Other LT assets 284 348 348 348 348 EBIT 880 1,475 2,897 4,902 8,918 Total assets 7,637 11,637 16,393 23,915 37,831 Net interest expense -16 -16 -27 -40 -63 ST debt 683 904 1,285 1,667 1,667 Associates & JCEs -2 -12 -12 -12 -12 Accounts payable 2,914 5,573 7,600 10,858 16,988 Other income 0 0 0 0 0 Other current liabilities 142 181 298 425 666 Earnings before tax 862 1,447 2,858 4,850 8,843 Total current liabilities 3,739 6,658 9,183 12,950 19,320 Income tax -99 -175 -336 -571 -1,041 LT debt 0 0 1 250 1,401 Net profit After tax 763 1,272 2,522 4,279 7,802 Convertible debt 0 0 0 0 0 Minority interests -2 -3 -3 -3 -3 Other LT liabilities 52 65 65 65 65 Other items 0 0 0 0 0 Total liabilities 3,791 6,723 9,249 13,265 20,787 Preferred dividends 0 0 0 0 0 Minority interest 14 18 16 13 10 Normalised NPAT 761 1,269 2,519 4,277 7,799 Preferred interest 0 0 0 0 0 Extraordinary items 0 0 0 0 0 Common stock 105 105 105 105 105 Reported NPAT 761 1,269 2,519 4,277 7,799 Retained earnings 2,713 3,949 6,015 9,523 15,921 Dividends -170 -228 -453 -769 -1,402 Proposed dividend -170 -228 -453 -769 -1,402 Transfer to reserves 591 1,041 2,066 3,508 6,397 Other equity and reserves 1,013 841 1,008 1,008 1,008 Total shareholders' equity 3,845 4,913 7,144 10,650 17,044 Total equity & liabilities 7,636 11,637 16,393 23,915 37,831

Cashflow statement (thousands RMB$) Key Ratios Year-end 31 Dec FY16 FY17E FY18E FY19E Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Net income 1,269 2,519 4,277 7,799 Profitability (%) Depreciation 317 536 784 1,257 Gross margin 16.5% 18.3% 20.2% 22.1% 23.9% Amortization 0 0 0 0 EBITDA margin 10.5% 12.3% 14.3% 16.2% 18.1% Change in Net Working Capital -323 -427 -743 -1,468 EBIT margin 8.2% 10.1% 12.1% 14.0% 15.8% Cashflow from operations 1,616 2,628 4,318 7,588 Net Margin 7.1% 8.7% 10.5% 12.2% 13.9% Capital expenditures -400 -300 -300 -300 Effective tax rate 11.5% 12.1% 11.8% 11.8% 11.8% Other non current assets -47 0 0 0 Dividend payout 22.3% 18.0% 18.0% 18.0% 18.0% Other non current liabilities 13 0 0 0 ROE 19.9% 26.0% 35.4% 40.2% 45.8% CF from investing acts -1,260 -300 -300 -300 ROA 10.0% 10.9% 15.4% 17.9% 20.6% CF after investing acts 356 2,328 4,018 7,288 Liquidity (x) Equity issue -167 164 -3 -3 Current ratio 1.61 1.40 1.56 1.72 1.92 Debt issue 221 382 631 1,151 Interest coverage 55.00 91.17 109.08 123.82 140.75 Convertible debt issue 0 0 0 0 Leverage Dividends -228 -453 -769 -1,402 Net Debt/EBITDA (x) 0.00 0.24 net cash net cash net cash CF from financial acts -81 93 -140 -254 Net Debt/Equity (%) 0.00 0.09 net cash net cash net cash Net cashflow 274 2,421 3,878 7,034 Activity (days) Beginning cash 187 467 2,888 6,766 Days receivable 102.5 92.8 97.4 97.4 97.4 Adjustments 6 0 0 0 Days inventory 30.6 70.7 41.1 40.1 39.2 Ending cash 467 2,888 6,766 13,800 Days payable 99.5 139.2 115.5 112.8 110.2 Ending net debt 437 -1,602 -4,849 -10,732 Cash cycle 33.6 24.3 23.0 24.7 26.4 Source: Company data, CASH Source: Company data, CASH

The Cloud industry

Another big theme in 2018 is the AI. During the upcoming AI era, deep learning (a way through which machine can learn) involves massive data computation. With more data, higher computation power and bigger models, the machine can learn better. Hence, we believe the three building blocks of AI are (1) Big Data, which provides the training data for the machines, (2) Semiconductors, which provides the massive computing power, and (3) Algorithm, which makes the entire machine trainable. We think one of the ways that AI stocks will monetize is providing cloud service.

Gartner estimates global public cloud service market has reached USD209bn in 2016 and is expanding at 16% CAGR to US$383bn in 2020. The highest growth will come from IaaS, which is projected to grow with a CAGR of 30% during 2016-2020 (SaaS: 18%) (See figure). Gartner predicts more cloud growth in the infrastructure compute service space (IaaS), driven by additional demand from the migration of infrastructure to the cloud and increased demand from increasingly compute-intensive workloads due to AI adoption, analytics and Internet of Things (IoT) both in the enterprise and startup spaces. For example, Cisco quantified and analysed the impact of hyperscale data centers. These data centers will grow from 259 in 2015 to 485 by 2020. Furthermore, the growth of PaaS is also driving the growth in adoption of IaaS. Among the HK stock universe, we think market will begin to price in the potential of Tencent Cloud under Tencent (700.HK) with its leading position and strong growth.

Figure 19. Forecast of cloud computing as a service market revenue worldwide from 2014 to 2020, by type (in bn USD)

Source: Gartner, CASH

What is Cloud? Cloud is a broad collection of services, organizations can choose where, when, and how they use Cloud Computing. Three types of Cloud Computing services commonly referred to as Software as a Service (SaaS), Platform as a Service (PaaS) and Infrastructure as a Service (IaaS) (See Figure).

Figure 20. Definition of Cloud SaaS provides standard software applications used by a number of users like customer Software as a relationship management applications like Salesforce, productivity software suites (eg. service Google Apps), and storage solutions (eg. Box and Dropbox), Enterprise Resource Planning (ERP) (eg. Kingdee), etc Platform as a PaaS provides a platform on which software can be developed and deployed. Examples of service PaaS providers include Heroku, Google App Engine, and Red Hat's OpenShift. Infrasturcture IaaS provides datacenters, bandwidth, load balance, virtual server space and hardware as a service Source: ComputeNext, CASH

Public Cloud and Private Cloud Cloud can also be classified into Public Cloud and Private Cloud. Public Cloud means infrastructure that is managed by third-party providers where customers are not required to purchase storage hardware and charged based on usage or time basis Private cloud is usually used by large enterprises and it is protected by firewall (not shared with the public) where customers need to provide the hardware in general. This cloud type can be tailored to specific needs of enterprises.

Figure 21. Public and Private Cloud in China

Source: ChinaNetCenter, CASH

The optimal solution for SMEs is the public cloud providing cost-effective /standardized/reliable service offerings with rapid deployment. For large enterprises, private cloud is more suitable because of the handling and processing of sensitive information and the need for security. But in the long run, we believe public clouds will become much more cost effective than private clouds given the price cuts by giant cloud service providers in view of enterprises. As most of the enterprises don’t have the ability to scale their own private clouds while staying price competitive with the giants, private cloud market will probably shrink gradually.

Cloud market fits the ‘winner takes all’ logic In US, according to Synergy, in Q1 2017, Google, IBM, Alibaba, Microsoft and Oracle all achieved growth rates substantially higher than that of AWS. However, AWS revenues are significantly bigger than the other five combined. While Google and Alibaba achieved annual growth rates exceeding 80 percent, we see the niche cloud providers like Rackspace and Salesforce have lower growth rates and maintain strong positions in their corresponding market (See figure). Overall, the cloud market fits the ‘winner takes all’ logic (Higher market share, higher growth rate).

The reason is that (1) large cloud platform by tech giants can get large datasets for more accurate AI services with their AI system improved through the uses of billions of actual consumers if open sourced. (2) On the other side, the world’s largest datacenters, called the Super Seven (Alibaba, Amazon, Baidu, Google, Facebook, Microsoft, and Tencent) whose servers equip proprietary machine learning algorithms with thousands or even tens of thousands of speedy hardware, creating a strong computing power and a high barrier of entry. (3) Large giants can scale their cloud offerings, and they are able to aggressively cut prices thanks to economies of scale.

Figure 22. Global Cloud provider Competitive Positioning

Source: Synergy Research Group, CASH

According to Synergy, the U.S. still accounts for 45% of major cloud and internet data center sites globally. The other prominent nations are China

(including HK) and Japan, with 9% and 7% respectively (See figure). We see ample room for improvements given a huge population in China (1.38 billion compared with 0.326 billion in US).

Figure 23. Hyperscale Data Center locations by country in 4Q2016

Source: Synergy Research Group, CASH

As we have discussed, the leader of Cloud market in China is Alibaba (BABA.US) (with RMB6.66bn revenue in FY2017 increased 121% YoY and 31% market share in IaaS in 2016). (Please read AI industry: Get ready for Revolutionary Tide for details: http://www.cashon-line.com/Resources/ipo/AI%20industry(eg)_170511.pdf (See figure)

AliCloud is good at creating a comprehensive SaaS ecosystem with a large customer base, covering payment (Alipay), financial service (Ant Financial), e-commerce (Hundsun), logistics (Cainiao Network), as well as O2O service (AMAP, Didi, etc.). Alibaba can easily integrate its AI services (speech/text/facial recognition/machine learning) into own SaaS.

Figure 24. China Public Cloud IaaS market share in 2016

37% Alibaba 41% China Telecom Tencent Kingsoft Others

6% 7% 9%

Source: IDC,CASH

Security capability is a key sorting criteria One of the top cloud computing concerns is SECURITY. Digital transformation has attracted the interest of criminals and hackers, constituting a large threat to enterprises’ digital assets. For example, in May 2017, WannaCry blackmail virus raised public awareness to improve security of IT systems for a number of firms. In the long run, we think tech giants with the capability to build a sound cloud environment can outperform. Alibaba Cloud, Tencent Cloud, AWS, Azure, Huawei Cloud and Kingsoft Cloud among the most secured in the China region according to IDC MarketScape report.

China Cloud service providers will dominate in mainland market In China, we believe partnering with local cloud service providers is the only way to enter the China market for global cloud leaders including AWS, Microsoft Azure, and IBM. We see that AWS partnered with Sinnet (300383.SZ) in late 2013 while Azure cooperated with 21Vianet (VNET.US) in early 2014. IBM and Wanda also announced to jointly enter public cloud market in March 2017. However, the growth potential of global cloud leaders in China seems to be limited by tighter government regulation relative to standalone Chinese cloud providers despite having superior technology. It is probable that AWS and Azure may lose their market share to Alicloud and Tencent Cloud over next few years.

Tencent Cloud growth is catching our eyeball Tencent’s s revenue from "other" businesses, mainly from payment-related and cloud services, more than doubled in 2017, we expect. Tencent Cloud expanded its global coverage and now operates in 36 zones around the world. Tencent accelerated investments in public cloud starting in late 2016. We think Tencent’s inherent advantages in the cloud business include (1) expertise in the gaming and social (video) sectors in providing customized cloud solutions (data storage and processing, etc) (2) strong user experience (easy and safe to use) and (3) large client base. All these can help Tencent to capture more market share and become the No.2 public cloud vendor in China in the future, surpassing China Telecom.

Figure 25. Tencent Cloud product offering

Source: Tencent, CASH

Tencent gaming cloud services with Kingsoft support In 2011 Tencent acquired 15.68 % stakes of Kingsoft in strategic investment. In 2012, Kingsoft set up a cloud storage and computing subsidiary. In 2014, the company adopted an All-in Strategy in 2014 with the focus on market share expansion during the early stage. Then, Kingsoft gains support from Xiaomi and expands its product offerings from cloud storage to cloud computing, with emphasis providing quality, fast and stable online gaming services. The company also tries to expand its cloud computing business through strategic investments such as Xunlei and 21Vianet in Apr and Nov 2014 respectively. And again Tencent acquired a 9.9% stake in China-based mobile and PC games developer Seasun under Kingsoft in 2017. We think Tencent ‘s gaming cloud business is strong in fundamental.

Figure 26. Kingsoft Cloud product offering

Source: Kingsoft,CASH

Figure 27. Valuation and financial ratios of Internet related stocks Stock Code Price ($LC) TP %upside 18 EPS YoY 19 EPS YoY 18PE 19PE 18ROE 19ROE 18PB 19PB Google GOOGL US Equity 1055.95 NA NA 14.02 20.95 21.44 17.73 16.08 15.13 3.78 3.16 Facebook FB US Equity 177.92 NA NA 17.54 19.83 21.55 17.99 22.68 21.40 5.40 4.32 Amazon AMZN US Equity 1186.10 NA NA 35.20 52.54 75.06 49.21 13.17 12.85 15.98 11.80 Microsoft MSFT US Equity 85.72 NA NA 10.59 15.61 22.87 19.78 30.07 28.77 5.79 4.85 IBM IBM US Equity 154.04 NA NA 0.85 3.42 11.07 10.70 60.79 65.48 6.20 6.10 Twitter TWTR US Equity 24.31 NA NA 10.12 15.75 53.19 45.95 5.75 6.43 3.46 3.29 Baidu BIDU US Equity 234.74 NA NA 9.09 27.53 25.17 19.73 16.14 17.75 4.06 3.40 Alibaba BABA US Equity 172.30 NA NA 29.04 27.97 25.36 19.82 22.08 22.76 6.10 4.68 Tencent 700 HK Equity 406.00 477.20 17.5% 30.67 28.14 37.57 29.32 30.13 29.20 10.05 7.61 Average 17.46 23.53 32.59 25.58 24.10 24.42 6.76 5.47 Median 14.02 20.95 25.17 19.78 22.08 21.40 5.79 4.68 Source: Bloomberg, CASH

Tencent (700.HK, TP: HK$477.2) China Cloud and Technology Key Investment Themes Strong game pipelines with quality IPs ahead: VAS revenue in 3Q grew 51% YoY and 14% QoQ to Rmb41.12bn (where online gaming revenue +48% YoY to Rmb26.84bn). For the mobile game pipelines, we are optimistic about the coming game launch Glorious Mission（光榮使命）, DnF Mobile（地下城與勇士手機版）, Lineage II Revolution（天堂 II – 革命）, JX 3（劍網 3）, etc. Tencent and Seasun announced the beta testing of JX Mobile 3 has already started in Dec 2017.

Survival shooter game will be the next move in gaming section: We think Tencent is excited to see a new series of survival shooter games set off by PC game PlayerUnknown's Battlegrounds (PUBG)（絕地求生）(100-player and last-man-standing mode) and the company is now maintaining a constant dialogue with PUBG’s original creator Bluehole, and plans to launch a series of games in this category. Online reservation has started for Tencent’s mobile game Glorious Mission（光榮使命）since the announcement on Nov 8, 2017. We see that first round of beta testing will kick off on Nov 21. Tencent’s mobile Cross Fire has also rolled out a PUBG-like update called Deserted Island（荒島特訓）on Nov 15 with players parachuting onto an island for battle in the game. We are impressed that both games received over 20mn registrations within the first week of availability.

E-sports and content updates: League of Legend (LoL)（英雄聯盟）World Championship 2017 event held in China, DnF’s National Day update and DnF-themed cartoon series were all fostering its momentum in 3Q17. ARPU broadly grew QoQ and YoY particularly for LoL, DnF and Cross Fire in Q3, showing a great success in enhancing user engagement through e-sports and content upgrade.

Recent gaming momentum sustained: Tencent showcases a strong momentum in ranking again in Nov 2017 with its 4 games ranking in the top 10 in terms of grossing on iOS games in China, same as that in Sep 2017 and Oct 2017.

Robust advertising revenue: Advertising revenue in 3Q soared 48% YoY and 13% QoQ to Rmb11.04bn, with media ad +29% YoY to Rmb4.12bn and social ad +63% YoY to Rmb6.92bn. Driven by traffic growth, Tencent Video saw a very strong growth (revenue up more than 100% YoY in 3Q17). Tencent’s strategy in the future is to expand breadth and depth of content (including drama, variety show, animation, movie and documentary) while investing heavily in the talent pool (producers, screen writers and editors) and key IP collections in order to succeed in original content for the long term sustainable development. We think this strategy will further enhance user stickiness and also pave a road for future monetarization. On the other hand, we think social advertising can further be boosted by success of Weixin Moments in delivering good results in targeting advertising through AI technology and penetrating into more small advertisers who sell products or services to small groups of users.

Other revenue: Other revenue in 3Q grew 143% YoY and 25% QoQ to Rmb12.04bn, driven by cloud and payment. Monthly offline payment volume increased 280% YoY in 3Q17 and Tencent empowered retailers to integrate online and offline resources including marketing, sales, payment and loyalty programs. Also, Tencent reiterated several the “AI in all” strategy and the AI benefits include (1) improving recommendation to users in content, (2) better targeting advertising, and (3) better analyzing client’s credit condition in financial business.

Key risks: 1) Faster-than-expected PC game slowdown; 2) delay in new game launch; 3) regulatory policy risks; 4) slowdown in China’s economy, which might negatively affect advertising demand.

Retain Buy with target price up to HK$477.2: We assumed 2017-2019 earnings CAGR growth 38.5% based on strong game pipelines, robust advertising revenue and cloud revenue. We reiterate buy with TP raised 15% to HK$477.2 based on target PE of 44X and 2017-2019 EPS CAGR growth of 38.5%, implying a 17.5% upside.

Background Founded in 1998, Tencent has the largest instant messaging and social network platform in China, with the highest monthly active-users, MAU (Weixin: 889.3m; Mobile QQ: 652.5m in 4Q16). Tencent mainly monetises through PC games, Mobile games, social networks (including monthly subscription fee for VIP privileges in QQ Music, Video, Reading, and Anime & Manga), brand ads and performance ads, and others (like payment and cloud services). Pony Ma (馬化騰), Chief Executive Officer, is one of the core founders.

Figure 28. Top 10 iOS Mobile Games in China in Oct 2017 (in grossing) Ranking Game Title Publisher 1 Honor of Kings Tencent 2 Fantasy Westward Journey NetEase 3 New Ghost NetEase 4 The Legend of Sword and Fairy 5 Jgyou 5 Novoland the Castle in the Sky Perfect World 6 Onmyoji Netease 7 Legacy TLBB Tencent 8 Fate/ Grand Order SoftWorld/ Sony/ bilibili 9 King of Chaos Tencent 10 Contra: Return Tencent

Source: CASH, Company data

Figure 29. Top 10 iOS Mobile Games in China in Nov 2017 (in grossing) Ranking Game Title Publisher 1 Honor of Kings Tencent 2 Fantasy Westward Journey NetEase 3 Westward Journey Online NetEase 4 New Ghost NetEase 5 Onmyoji NetEase 6 King of Chaos Tencent 7 Archangel Sword H5 37 games 8 Legacy TLBB Tencent 9 JX online Tencent 10 Vitality God Wanda Cinemas

Source: CASH, Company data

Figure 30. WeChat MAU (in million users)

Source: CASH, Company data

Figure 31. WeChat MAU (in million users)

Source: Baike.com, CASH

Figure 32. Tencent’s revenue breakdown in 9M2017

Source: CASH, Company data

Tencent 700.HK, Buy, TargetPrice: 477.2 Income Statement (million RMB$) Balance Sheet (million RMB$) Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Revenue 102,863 151,938 242,154 344,965 476,872 Cash & equivalents 43,438 71,902 161,734 271,127 419,721 Cost of goods sold -41,631 -67,439 -123,140 -175,932 -247,973 Marketable securities 54,731 750 750 750 750 Gross profit 61,232 84,499 119,014 169,033 228,898 Accounts receivable 7,061 10,152 16,398 23,360 32,293 SG&A -20,605 -28,382 -33,142 -59,267 -89,499 Inventories 222 263 555 793 1,117 R&D -9,290 -11,845 -18,071 -27,931 -38,611 Other current assets 49,926 66,087 111,430 158,740 219,438 Other expense 4,213 6,213 19,796 19,796 19,796 Total current assets 155,378 149,154 290,867 454,770 673,319 LT investments 6,833 10,702 10,702 10,702 10,702 Operating profit 40,627 56,117 85,872 109,766 139,399 Fixed assets 9,973 13,900 25,937 43,084 66,788 EBITDA 47,301 68,858 103,881 135,420 174,864 Depreciation -3,159 -3,716 -6,680 -9,516 -13,154 Other intangible assets/Goodwill 13,439 36,467 39,141 37,004 28,697 Amortization -3,515 -9,025 -11,329 -16,139 -22,311 Other LT assets 121,195 185,676 185,676 185,676 185,676 EBIT 40,627 56,117 85,872 109,766 139,399 Total assets 306,818 395,899 552,322 731,236 965,182 Net interest expense -1,618 -1,955 -2,681 -3,554 -4,664 ST debt 11,429 12,278 13,000 14,000 14,000 Associates & JCEs -2,793 -2,522 1,429 1,429 1,429 Accounts payable 15,700 27,413 48,247 68,931 97,157 Other income 0 0 0 0 0 Other current liabilities 97,277 61,506 112,306 160,454 226,158 Earnings before tax 36,216 51,640 84,620 107,641 136,164 Total current liabilities 124,406 101,197 173,553 243,385 337,315 Income tax -7,108 -10,193 -17,018 -21,187 -26,801 LT debt 12,922 57,549 79,058 107,788 145,603 Net profit After tax 29,108 41,447 67,602 86,454 109,363 Convertible debt 0 0 0 0 0 Minority interests -302 -352 -143 -143 -143 Other LT liabilities 47,390 50,906 50,906 50,906 50,906 Other items 0 0 0 0 0 Total liabilities 184,718 209,652 303,517 402,079 533,823 Preferred dividends 0 0 0 0 0 Minority interest 2,065 11,623 11,480 11,337 11,195 Normalised NPAT 28,806 41,095 67,459 86,311 109,220 Preferred interest 0 0 0 0 0 Extraordinary items 0 0 0 0 0 Common stock 0 0 0 0 0 Reported NPAT 28,806 41,095 67,459 86,311 109,220 Retained earnings 100,012 136,743 199,444 279,938 382,283 Dividends -2,640 -3,699 -4,758 -5,817 -6,876 Proposed dividend -2,640 -3,699 -4,758 -5,817 -6,876 Transfer to reserves 26,166 37,396 62,701 80,494 102,344 Other equity and reserves 20,023 37,881 37,881 37,881 37,881 Total shareholders' equity 122,100 186,247 248,805 329,157 431,358 Total equity & liabilities 306,818 395,899 552,322 731,236 965,182

Cashflow statement (million RMB$) Key Ratios Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Net income 41,095 67,459 86,311 109,220 Profitability (%) Depreciation 3,716 6,680 9,516 13,154 Gross margin 59.5% 55.6% 49.1% 49.0% 48.0% Amortization 9,025 11,329 16,139 22,311 EBITDA margin 46.0% 45.3% 42.9% 39.3% 36.7% Change in Net Working Capital 10,630 19,753 14,323 23,974 EBIT margin 39.5% 36.9% 35.5% 31.8% 29.2% Cashflow from operations 65,518 105,221 126,289 168,659 Net Margin 28.3% 27.3% 27.9% 25.1% 22.9% Capital expenditures -12,100 -18,716 -26,663 -36,858 Effective tax rate 19.6% 19.7% 20.1% 19.7% 19.7% Other non current assets -68,350 -14,003 -14,003 -14,003 Dividend payout 9.2% 9.0% 7.1% 6.7% 6.3% Other non current liabilities 3,516 0 0 0 ROE 24.2% 23.7% 28.5% 27.2% 26.0% CF from investing acts -70,923 -32,719 -40,666 -50,861 ROA 9.4% 10.4% 12.2% 11.8% 11.3% CF after investing acts -5,405 72,502 85,623 117,798 Liquidity (x) Equity issue 27,416 -143 -143 -143 Current ratio 1.25 1.47 1.68 1.87 2.00 Debt issue 45,476 22,231 29,730 37,815 Interest coverage 25.11 28.70 32.03 30.89 29.89 Convertible debt issue 0 0 0 0 Leverage Dividends -3,699 -4,758 -5,817 -6,876 Net Debt/EBITDA (x) net cash net cash net cash net cash net cash CF from financial acts 31,443 17,330 23,770 30,796 Net Debt/Equity (%) net cash net cash net cash net cash net cash Net cashflow 26,038 89,832 109,393 148,594 Activity (days) Beginning cash 43,438 71,902 161,734 271,127 Days receivable 25.1 24.4 24.7 24.7 24.7 Adjustments 2,426 0 0 0 Days inventory 0.8 0.6 0.8 0.8 0.9 Ending cash 71,902 161,734 271,127 419,721 Days payable 55.7 65.9 72.7 72.9 74.4 Ending net debt -19,087 -2,075 -69,676 -149,339 -260,118 Cash cycle -29.9 -40.8 -47.2 -47.4 -48.8 Source: Company data, CASH Source: Company data, CASH

Macau Gaming Sector

VIP segment became the key GGR driver in 2017: According to DICJ, the accumulated Macau GGR amounted to MOP266billion in 2017, representing 19.1% YoY growth. The better-than-expected result was explained by the relatively gentle anti-graft campaign and capital flow control in 2017. Meanwhile, the abundant junket liquidity, with increasing numbers of new VIP rooms opened by small-to-large junket operators, also contributed to the VIP GGR rally.

Visitation growth will support mass gaming segment: In March 2017, Premier Li Keqiang announced the plan for the “development of a city cluster in the Guangdong-Hong Kong-Macau Greater Bay Area. Meanwhile, HZM Bridge, which is likely to start operations by 2018, will favor long-term visitation growth. It is believed that Macau's long-term visitation will grow from 2.5% CAGR in 2012-16 to >5% CAGR in 2017-20E.

We are cautiously optimistic: The sector is now trading at above +1 s.d of the forward EV/EBITDA. Our view is that, a broad-based sector re-rating is less likely in short term. Any upside potential to the share prices of companies have to be driven by individual earnings growth. Overall, we are cautiously optimistic towards the industry sector in long term, given that 1) junket liquidity remains abundant, 2) visitation growth will be supported by infrastructure improvement, 3) China's tier-3 property prices remain strong, which favors VIP gaming. Looking forward, we expect VIP/ Mass GGR growth to be at 21%/ 14% in 2018, leading to a 18% growth in total GGR.

We prefer Galaxy (27.HK, TP: HK$70) and Wynn Macau (1128.HK, TP: HK$29): We see Galaxy and Wynn continues to be the key beneficiary of the GGR rally. Both of them gained market shares from their competitors since the 2016 trough. In short term, the industry will continue to benefit from the abundant junket liquidity. GEG and Wynn have upside potentials to achieve higher rolling chip volumes, given their strong relationship with junket operators. For GEG, its strong cash position will allow the Company to expand in the international market. With the improving mix of gaming/non-gaming business, its EBITDA margin can be enhanced. For Wynn, it is likely to record higher FCF in the following years, and thus allowing dividend raises.

Introduction VIP segment became the key GGR driver in 2017. Our top picks (27.HK; 1128.HK), together with Melco (200.HK) kept hitting 3-year- high. According to DICJ, the accumulated Macau GGR amounted to MOP266billion in 2017, representing 19.1% YoY growth. The better-than-expected result was explained by the relatively gentle anti-graft campaign and capital flow control in 2017. Meanwhile, the abundant junket liquidity, with increasing numbers of new VIP rooms opened by small-to-large junket operators, also contributed to the VIP GGR rally. VIP/Mass GGR recorded 17%/8% YoY in 1Q17; 35%/7% YoY in 2Q17; 35%/7%YoY growth in 3Q17 (see Figure 33). Even if we take the premium VIP classification into account*, VIP GGR growth still outpaced Mass GGR growth significantly.

*Some mass table were classified as VIP to circumvent the mass-table smoking ban.

Figure 33. Industry GGR grew significantly in 2017

MOP mn 30,000 +22.1% 25,000 +17.8% +23.7% +29.2%+20.4% +22.6% +18.1% +16.1% +14.6% +16.3% +25.9% 20,000 +3.1%

15,000

10,000

5,000

0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2016 GGR 2017 GGR

Source: DICJ, CASH

Figure 34. VIP/ Mass GGR growth Figure 35. VIP/ Mass GGR growth (DICJ unadjusted data) (combined data of six concessionaires)

Source: DICJ, CASH

Figure 36. Industry 12M forward EV/EBITDA

Source: Bloomberg

The sector is now trading at above +1 s.d of the forward EV/EBITDA. Our view is that, a broad-based sector re-rating is less likely in short term. Any upside potential to the share prices of companies have to be driven by individual earnings growth. Overall, we are cautiously optimistic towards the industry sector in long term, given that 1) junket liquidity remains abundant, 2) visitation growth will be supported by infrastructure improvement, 3) China's tier-3 property prices remain strong, which favours VIP gaming.

Looking forward, we expect VIP/ Mass GGR growth to be at 21%/ 14% in 2018, leading to a 18% growth in total GGR. What factors to keep an eye on? Smaller sized junkets back in the game: Sharp VIP GGR growth in 2017 can be partially explained by the resurgence of smaller junket operators, which includes Qian Jin VIP, Eastern Club, Benny Club and Ka Sing Club etc. Over 40 new junket rooms were opened in Macau during the past 16 months. One of the top-five VIP gaming promoters, David Group, which had scaled back its Macau operations in 2015, becomes one of the most aggressive mid-sized junkets. It had opened VIP rooms in Wynn Peninsula, Studio City and Galaxy Macau so far. David Group is looking to open another junket room at MGM Cotai later on.

China's tier-3 property prices being a critical factor for VIP segment: Real estate market has long been a determining factor for Macau VIP gaming business as junkets tend to rely on property as collateral for extending credit to gamblers. As shown in Figure 37, the third-tier-city property price shows high correlation with VIP GGR. Figure 37. VIP GGR correlates with China’s third-tier-city property price

Source: Bloomberg, CASH

President Xi at the 19th Congress reiterated that ‘houses are built to be inhabited, not for speculation’, implying that the existing property restrictions will continue to be strictly implemented in 2018. We believe the current home purchase restrictions are unlikely to be loosened in the near term. However, given the effectiveness of the current policies, the chance for further tightening is little. We expect the momentum of the third- tier-city property market, which has a high correlation with the VIP GGR, to continue.

Visitation growth will support mass gaming segment: In March 2017, Premier Li Keqiang announced the plan for the “development of a city cluster in the Guangdong-Hong Kong-Macau Greater Bay Area. The 56,500 square kilometre Bay Area encompasses 11 cities – Hong Kong, Macau, Guangzhou, Shenzhen, Zhuhai, Foshan, Zhongshan, Dongguan, Huizhou, Jiangmen and Zhaoqing.

Figure 38. Statistics of Greater Bay Area (LHS), 2016 GDP of Bay Area cities (USD bn) (RHS)

Source: SCMP, Guangdong-HK-Macau Greater Bay Area Forum, Tencent

The 55-km HK-Zhuhai-Macau Bridge can shorten travel time between HK and Macau from 1 hour by ferry to 40 mins by road. Meanwhile, HZM Bridge, which is likely to start operations by 2018, will favour long-term visitation growth. It is believed that Macau's long-term visitation will grow from 2.5% CAGR in 2012-16 to >5% CAGR in 2017-20E. Overall, the Macau government aims to welcome 40m visitors annually by 2025, which would be easy to achieve given the >5% CAGR.

Figure 39. Total visitor arrivals

Source: DSEC, CASH

Figure 40. Structure of visitor arrivals

Source: DSEC, CASH

Figure 41. Correlation between Mass GGR and Visitation

Source: DSEC, DICJ, CASH

Potential Risk Tighter credit environment: It is deemed that the liquidity environment will change in 2018 as the Fed reduces its balance sheet and the European Central Bank (ECB) starts to taper its quantitative easing program. Meanwhile, the PBOC is continuing its deleveraging effort. Both 3M SHIBOR and 7-day repo rates edged up in 2017. Credit environment can affect VIP gaming business as junkets tend to be more cautious in the loans they extend if the monetary policy becomes tight.

Figure 42. SHIBOR goes up

Source: Bloomberg, CASH

VIP GGR growth sustainability- a factor to be mindful of… VIP business is more likely to be affected by external factors, such as China monetary conditions and regulatory changes (e.g. capital controls, junket regulations, smoking ban). As mentioned before, the robust VIP GGR growth in 2017 can be partially explained by the junkets business expansion. It is worthwhile to be mindful of the higher risks implied as smaller junkets tend to carry higher credit/collection risks given their relatively loose credit policy, compared to the bigger gaming promoters.

Tighter junket regulations will affect the VIP segment, but the impact is deemed to be mild… Over the past 2 years, Macau's government has gradually stepped up regulation on junket operations, which include closer monitoring of junkets' credit records and prohibiting junkets from taking deposits from the public. We believe a tighter regulations would have little impact on VIP GGR, due to the industry consolidation (Top 5 junkets controlling over 85% of the market) and the change in business strategy of junkets over the past few years. The above information is provided and distributed by CASH Financial Services Group Limited (“CASH”). The document is for reference only. Neither the information nor opinion expressed shall be construed, expressly or impliedly, as an advice, offer, invitation, advertisement, inducement, recommendation or representation of any kind or form whatsoever. While the information contained herein has been obtained from sources believed to be reliable, CASH or its affiliates do not represent that it is accurate or complete and it should be relied upon. CASH hereby expressly disclaims all liabilities arising out of or incidental to the accuracy and completeness of the contents and information herein contained. The contents and information in this document is subject to change without prior notice to you. As of 2 January 2018, the analyst who provides the above information has financial interests in relation to the above securities. Trade in securities covered by this report may be made only in those jurisdictions where the securities are qualified for trading. This document may not in whole or in part be reproduced or furnished to any person other than the addressee without written consent from CASH and CASH shall not be liable to any such third parties for loss arising from any unauthorized distribution. Securities dealing services are provided by Celestial Securities Limited, a corporation licensed to conduct Type 1 (dealing in securities) regulated activity under the Securities and Futures Ordinance. -41- January 2, 2018

These larger-sized junkets have stronger balance sheets, at the same time, they no longer over-rely on a few high-net-worth clients. The practice of diversifying client base improves operators’ capability to deal with regulatory changes, and helps to reduce debt collection risk, mentioned by an industry insider to GGRAsia.

Other Highlights Impact of smoking ban: Macau requires casinos to have smoking ban on all gaming tables with effect from January 1, 2019. That is to say, the partial smoking ban is extended from mass gaming floors to VIP ones. The industry is expecting a lower GGR growth for 2019 as smoking ban may shorten the length of play as gamblers need to take cigarette breaks. The smoke ban may have more impact on companies that have higher proportion of premium mass areas (reclassified as VIP), which account for 10% of Macau GGR in 2017. But we observe that this factor has already been taking into account by analysts when calculating the GGR estimation.

License renewal: The current gaming concessions of SJM and MGM will expire in 2020, while the 20-year gaming licenses granted to Melco, Sands China, Wynn and Galaxy Entertainment Group are all set to expire in 2022. It's likely that during this period, the industry player will tend to suit the government's policy of positioning Macau as a world-class destination for travel and leisure, by committing more to non-gaming development.

Statistics at a glance Wynn became the market share winners among the 6 major operators, with its market share increased from 10% in 1Q16 to 16% in 3Q17. The opening of Wynn Palace in Aug 16 and its outstanding performance contributes to the success story. Together with Wynn’s VIP-inclined business model, Wynn can fully enjoy the VIP GGR rally in 2017. So, who are the market share losers in 2017? They are MGM and SJM, with the latter losing market share by 500bps in two years’ time, from 20% in 1Q16 to 15% in 3Q17. It is due to the fact that MGM and SJM are relatively late to Cotai when compared to their peers.

Figure 43. Cotai map

Source: Google data, CASH

Figure 44. VIP market share Mass + Slot market share Total GGR market share – 3Q 2017 – 3Q 2017 – 3Q 2017

Source: Company data, CASH

Figure 45. VIP market shares since 2014

Source: Company data, CASH

Figure 46. Mass + Slot market shares since 2014

Source: Company data, CASH

Figure 47. Total market shares since 2014

Source: Company data, CASH

Figure 48. VIP GGR YoY change of gaming concessionaires

Source: Company data, CASH

Figure 49. Mass + Slot GGR YoY change of gaming concessionaires

Source: Company data, CASH

Figure 50. Total GGR YoY change of gaming concessionaires

Source: Company data, CASH

Figure 51. Valuation and financial ratios of Macau Gaming related stocks Stock Code Price ($LC) TP %upside 18 EPS YoY 19 EPS YoY 18PE 19PE 18EBITDA% 19EBITDA% 18EV/EBITDA 19EV/EBITDA 18Div yield SANDS CHINA LTD 1928 HK Equity 40.35 NA NA 17.19 11.11 22.95 20.66 10.93 8.17 16.81 15.54 5.17 GALAXY ENTERTAIN 27 HK Equity 62.70 70.00 11.6% 14.27 5.88 25.09 23.70 12.04 5.49 17.41 16.51 1.21 WYNN MACAU LTD 1128 HK Equity 24.75 29.00 17.2% 37.84 15.66 24.53 21.21 16.49 8.64 16.54 15.23 3.72 SJM HOLDINGS LTD 880 HK Equity 7.00 NA NA -1.61 6.56 22.95 21.54 8.32 39.27 9.09 6.52 2.47 MELCO INTL DEV 200 HK Equity 23.00 NA NA 32.00 20.65 18.34 15.20 9.90 1.13 8.21 8.12 0.28 MGM CHINA 2282 HK Equity 23.65 NA NA 13.29 49.02 33.03 22.16 39.82 22.16 17.97 14.71 1.68 Median 15.73 13.39 23.74 21.37 11.49 8.41 16.68 14.97 2.08 Average 18.83 18.15 24.48 20.74 16.25 14.14 14.34 12.77 2.42 Source: Bloomberg , CASH

Galaxy Macau (00027.HK, TP: HK$70) Gaming Sector Key Investment Themes Achieve outstanding performance despite new competition: Galaxy achieved satisfactory result in both Galaxy Macau™ and StarWorld, with the 1Q-3Q EBITDA rose 27% and 45% respectively. Apart from being able to defend its VIP business, Galaxy successfully gained mass market share amid rising competition from new property openings. In fact, Galaxy has expanded its mass market share to the highest level of its operating history. (approx.21% in 2017 vs 15% in 2014)

Excellent execution capability and strong relationship with junkets: By being flexible in its operation, e.g. optimizing table allocation among VIP and premium mass area, GEG can always adjust its business according to market trend. What’s more, Galaxy has a strong junket network. Previously in mid-17, David Group has opened a new VIP gaming room at Galaxy Macau. Meanwhile, Galaxy has strong bonding with Suncity, i.e. Macau’s largest junket operators, ever since Suncity’s operation in Macau. With the increasing junket liquidity, Galaxy will continue to benefit from the increasing rolling chip volume.

Actively pursuing growth opportunities: Apart from the Galaxy Phase3, 4 (to be opened in 2019) and the Hengqin development, GEG formed strategic partnership with Monte- Carlo SBM to explore international opportunities, including Japan. What’s more, GEG plans to invest as much as USD500m to build an integrated casino-resort in Philippines. We see Galaxy’s expansion into the Philippines as another step to diversify its business and as a strategic action to capture the Asia pacific market growth. Having the net cash position (HKD28.5bn as of 3Q17) and FCF of >HKD9bn p.a., the investment is expected to be financed out of Galaxy’s cash.

Reiterate “Buy” with Dec-18 TP raise to HK$70: We see Galaxy to be on track to deliver strong earning in 2018E given its flexibility to adjust business according to market trend. As a VIP market leader, GEG will continue to benefit from the industry rally due to its strong junket network. We forecast the FY17/18 /19 EBITDA to be at HKD13.2 billion/15.9 billion/17.9 billion, represents 28%/21%/ 12% YoY growth, with 14.5X forward EV/EBITDA. We upgrade the TP to HKD70.

Galaxy Entertainment 27.HK, Buy, Target Price: HKD70 Income Statement (HKD mn) Balance Sheet (HKD mn) Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Revenue 50,991 52,826 61,989 72,285 80,809 Cash & equivalents 7,979 6,803 11,358 20,184 29,294 EBITDA 8,736 10,348 13,212 15,969 17,928 Bank Deposits 462 13,152 13,455 13,764 14,081 Depreciation (2,766) (3,252) (3,212) (3,015) (2,921) Accounts receivable 2,184 1,583 2,256 2,631 2,941 Amortisation (321) (320) (272) (281) (300) Inventories 151 158 155 155 155 EBIT 5,650 6,775 9,728 12,673 14,707 Other current assets 423 334 342 350 358 Net interest income 84 106 215 354 513 Total current assets 11,199 22,032 27,566 37,084 46,829 Associates & JCEs 61 72 74 76 77 LT investments 42 42 43 44 45 Other income (1,586) (605) (605) (605) (605) Fixed assets 35,691 33,502 32,460 32,336 33,455 Earnings before tax 4,209 6,348 9,412 12,497 14,692 Intangible assets 1,341 1,138 1,177 1,257 1,280 Income tax (82) (77) (94) (100) (118) Other LT assets 7,081 9,547 9,766 9,991 10,221 Net profit After tax 4,126 6,271 9,317 12,397 14,574 Total assets 55,354 66,261 71,012 80,712 91,830 Minority interests 35 12 48 64 75 ST debt 719 5,609 3,410 3,381 2,808 Other items 0 0 0 0 0 Accounts payable 11,458 12,660 12,951 13,249 13,553 Preferred dividends 0 0 0 0 0 Other current liabilities 68 53 53 54 55 Normalised NPAT 4,126 6,271 9,317 12,397 14,574 Total current liabilities 12,245 18,321 16,414 16,684 16,417 Extraordinary items 0 0 0 0 0 LT debt 671 526 642 1,364 2,513 Income attr. to shareholders 4,161 6,283 9,366 12,461 14,650 Other LT liabilities 725 551 563 576 590 Dividends (1,787) (1,408) (2,788) (3,709) (4,361) Total liabilities 13,641 19,398 17,620 18,624 19,519 Transfer to reserves 2,374 4,876 6,578 8,752 10,289 Minority interest 612 518 470 405 330 Common stock 19,952 20,106 20,106 20,106 20,106 EPS (HKD) 0.98 1.47 2.17 2.89 3.40 Retained earnings 21,149 26,239 32,817 41,569 51,858 DPS (HKD) 0.29 0.44 0.65 0.86 1.01 Proposed dividend 1,787 1,408 2,788 3,709 4,361 shares outstanding (m) 4255.53 4266.23 4307.17 4307.17 4307.17 Total shareholders' equity 41,713 46,863 53,393 62,081 72,294 Total equity & liabilities 55,354 66,261 71,012 80,705 91,814

Cashflow statement (HKD mn) Key Ratios Year-end 31 Dec FY16 FY17E FY18E FY19E FY15 FY16 FY17E FY18E FY19E Net profit After tax 6,271 9,317 12,397 14,574 Profitability (%) Non-cash item 3,573 3,484 3,296 3,221 EBITDA margin 17.1% 19.6% 21.3% 22.1% 22.2% Change in working capital 2,701 (688) (393) (329) EBIT margin 11.1% 12.8% 15.7% 17.5% 18.2% Cashflow from operations 12,732 12,113 15,300 17,467 Net Margin 8.2% 11.9% 15.1% 17.2% 18.1% Capital expenditure (2,053) (2,170) (2,891) (4,040) Dividend payout 29.7% 29.9% 29.8% 29.8% 29.8% Free cashflow 10,679 9,943 12,409 13,426 ROE 10.5% 14.4% 18.9% 21.7% 21.9% Add: Dec in other LT assets (2,465) (220) (225) (230) ROA 7.8% 10.3% 13.6% 16.3% 16.9% Add: Inc in other LT liabilities (320) 13 13 13 Adjustment 0 (311) (362) (324) Liquidity (x) CF from investing acts (17,337) (2,687) (3,465) (4,581) Current ratio 0.9 1.2 1.7 2.2 2.9 Cash dividend (1,447) (2,541) (3,230) (4,027) Interest coverage 172.4 155.1 52.9 89.3 88.6 Equity issue 109 0 0 0 Debt issue 4,800 (2,082) 693 576 Leverage Convertible debt issue 0 0 0 0 Net Debt/EBITDA (x) Net Cash Net Cash Net Cash Net Cash Others 0 (247) (471) (325) Net Debt/Equity (%) Net Cash Net Cash Net Cash Net Cash CF from financial acts 3,450 (4,871) (3,009) (3,776) Net cashflow (1,155) 4,555 8,826 9,109 Activity (days) Beginning cash 7,979 6,803 11,358 20,184 Days receivable 13.0 11.3 12.3 12.6 Adjustments (20) 0 0 0 Days inventory NM NM NM NM Ending cash 6,803 11,358 20,184 29,294 Days payable NM NM NM NM Ending net debt (669) (7,306) (15,440) (23,973) Cash cycle NM NM NM NM Source: Company data, CASH Source: Company data, CASH

Wynn Macau (01128.HK, TP: HK$29) Gaming Sector Key Investment Themes More upside yet to come: Wynn Palace performed really well since it opened in Aug 2016, however, we see room for upside from its table yield. For mass gaming, the yield (USD10.5k/table/day) is still 8% below that of Wynn Peninsula(USD11.4k/table/day). The mass drop per table is 17% below that of Wynn Peninsula. With the Cotai property benefits from the improved traffic arrangement and its proximity to the new Cotai Ferry terminal, the VIP rolling volumes and mass table drop have rooms for increment.

Continuous VIP ramp favored by junket expansion: Wynn became the market share winner in 2017, as it was able to attract junkets to open new rooms in its properties. Its VIP market share rose from 16% before Palace opening to the current 21%. Apart from having mid-size junkets, such as MegStar and David Group, opened new VIP rooms in Wynn, the existing junket operators are going to expand its business in the coming months.

Potential to increase dividend: With the lower capex growth post Palace opening, we forecast the FCF to grow 44%/20% YoY to HKD7.2bn and HKD8.6bn in 2018/19, putting the stocks at 5.6%/6.7% 2018/19 FCF yield, an attractive valuation. Stronger cash flows can allow the company to distribute more dividends. Assuming 90% payout, we expect DPS to be at HKD1.11/1.31 in 2018/2019.

Reiterate “Buy” with TP up to HK$29: Having a VIP- focused business model and strong junket networks, Wynn will continue to be the greatest beneficiary of the industry rally. With the improving transport arrangement and upside potential of table yield, Wynn Palace will continue to be the growth driver of the Group. We forecast EBITDA to rose 27%/12% in 2018/19E to HKD9.6b and HKD10.7b. We set the TP up to HKD29, with 16X EV/EBITDA.

Figure 52. Wynn Macau’s VIP GGR share Figure 53. Wynn Macau’s Mass GGR share

Source: Company data, CASH

Figure 54. Wynn Macau’s Total GGR share Figure 55. FCF yield and Dividend Yield of Wynn

Source: Company data, CASH

Figure 56. VIP table yield Figure 57. Mass table yield

Source: Company data, CASH

Wynn Macau 1128.HK, Buy, Target Price: HKD29 Income Statement (HKD mn) Balance Sheet (HKD mn) Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Revenue 19,096 22,099 35,201 40,715 44,502 Cash & equivalents 6,731 2,591 1,460 3,580 9,917 EBITDA 4,032 3,856 7,532 9,556 10,675 Accounts receivable 458 733 1,056 1,221 1,335 Depreciation (905) (1,496) (1,972) (1,946) (1,922) Inventories 180 338 265 290 320 Amortisation (95) (95) (95) (95) (95) Other current assets 661 306 469 479 418 EBIT 3,032 2,265 5,465 7,514 8,658 Total current assets 8,030 3,968 3,251 5,570 11,990 Net interest income (564) (814) (952) (1,015) (1,032) LT investments 0 0 0 0 0 Associates & JCEs 0 0 0 0 0 Fixed assets 31,072 35,858 35,386 34,940 34,518 Other income (51) (3) (3) (3) (3) Intangible assets 1,879 1,783 1,687 1,592 1,497 Earnings before tax 2,417 1,448 4,510 6,497 7,623 Other LT assets 905 938 812 885 878 Income tax (6) (12) (45) (65) (76) Total assets 42,284 42,945 41,534 43,385 49,282 Net profit After tax 2,410 1,436 4,465 6,432 7,547 ST debt 0 0 700 3,000 7,000 Minority interests 0 0 0 0 0 Accounts payable 1,621 1,693 2,907 3,362 3,675 Other items 0 0 0 0 0 Other current liabilities 4,288 6,137 5,278 5,234 5,550 Preferred dividends 0 0 0 0 0 Total current liabilities 5,909 7,829 8,885 11,596 16,225 Normalised NPAT 2,410 1,436 4,465 6,432 7,547 LT debt 31,318 32,170 28,500 27,000 27,000 Extraordinary items 0 0 0 0 0 Other LT liabilities 955 493 505 516 528 Income attr. to shareholders 2,410 1,436 4,465 6,432 7,547 Total liabilities 38,181 40,492 37,890 39,113 43,753 Dividends (3,112) (2,176) (4,018) (5,789) (6,792) Minority interest 0 0 0 0 0 Transfer to reserves (702) (740) 446 643 755 Common stock 5 5 5 5 5 Retained earnings 3,986 2,395 2,842 3,485 4,239 EPS (HKD) 0.46 0.28 0.86 1.24 1.45 Proposed dividend 0 0 4,018 5,789 6,792 DPS (HKD) 0.60 0.42 0.77 1.11 1.31 Total shareholders' equity 4,102 2,453 3,644 4,272 5,528 shares outstanding (m) 5186.78 5180.19 5196.02 5196.02 5196.02 Total equity & liabilities 42,284 42,945 41,534 43,385 49,282

Cashflow statement (HKD mn) Key Ratios Year-end 31 Dec FY16 FY17E FY18E FY19E FY15 FY16 FY17E FY18E FY19E Net profit After tax 1,436 4,465 6,432 7,547 Profitability (%) Non-cash item 1,591 2,068 2,042 2,017 EBITDA margin 21.1% 17.4% 21.4% 23.5% 24.0% Change in working capital 1,842 (58) 212 545 EBIT margin 15.9% 10.2% 15.5% 18.5% 19.5% Cashflow from operations 5,843 6,474 8,685 10,109 Net Margin 12.6% 6.5% 12.7% 15.8% 17.0% Capital expenditure (6,784) (1,500) (1,500) (1,500) Dividend payout 129.1% 151.6% 90.0% 90.0% 90.0% Free cashflow (941) 4,974 7,185 8,609 ROE 43.3% 43.8% 146.4% 162.5% 154.0% Add: Dec in other LT assets 63 127 (73) 7 ROA 6.3% 3.4% 10.6% 15.1% 16.3% Add: Inc in other LT liabilities (461) 11 12 12 Adjustment 425 0 0 0 Liquidity (x) CF from investing acts (6,757) (1,362) (1,562) (1,482) Current ratio 1.4 0.5 0.4 0.5 0.7 Cash dividend (3,109) (3,273) (5,804) (6,291) Interest coverage 5.1 2.7 5.7 7.4 8.2 Equity issue 0 0 0 0 Debt issue 773 (2,970) 800 4,000 Leverage Convertible debt issue 0 0 0 0 Net Debt/EBITDA (x) 7.67 3.68 2.76 2.26 Others (893) 0 0 0 Net Debt/Equity (%) 1206% 761% 618% 436% CF from financial acts (3,229) (6,243) (5,004) (2,291) Net cashflow (4,143) (1,131) 2,120 6,337 Activity (days) Beginning cash 6,731 2,591 1,460 3,580 Days receivable 9.8 9.3 10.2 10.5 Adjustments 3 0 0 0 Days inventory NM NM NM NM Ending cash 2,591 1,460 3,580 9,917 Days payable NM NM NM NM Ending net debt 29,578 27,740 26,420 24,083 Cash cycle NM NM NM NM Source: Company data, CASH Source: Company data, CASH

Automobile Sector

Mild growth in 2018: The sales growth of China Passenger vehicles was muted in 2017 (+1.9% ytd), due to the fact that demand was pulled forward in 2016 and therefore created a high base. Looking forward, we expect China’s PV sales growth to be at 2% in FY18, considering the fact that the tax rate will resume to the normal 10 percent level starting from Jan 2018.

Gov. policies changing the industry landscape. Government policies will continue to play a significant role in changing the industry landscape. Topics such as NEV subsidy threshold, CAFC & NEV credit policy, timeline to phase out NEV tax rebate, and etc. will continue to be the important issues for the coming years.

Continuous consumption upgrade: In recent years, there is a narrowing gap between local brand and JV brand positioning. More local brands are trying to enter the mid-to-high range SUV segment (Rmb150k per unit) to find their next growth driver. Amongst all, we like Geely’s Lynk. What’s more, we expect large-sized engine vehicles (above 1.6L engine PV) to likely outperform small-sized engine vehicles as the former has no exposure to the purchase tax rebate and therefore not much front loading in 2016 and 2017. We expect luxury brands and SUVs to have stronger momentum in the following years.

Electrification to be the definite trend: According to IEA, China was by far the largest electric car market in 2016, accounting for more than 40% of the NEV sold globally and more than double the amount sold in the United States. According to the recent speech by Deputy Minister Xin Guobin of the MIIT, discussions are being held concerning the timeline to phase out ICEs. Electrification is a definite trend.

We like Geely (175.HK, TP: HK$35); Brilliance (1114.HK, TP: HK$26) and Nexteer (1316.HK, TP: HK$22): We believe Geely will continue to have upside earning revisions and re-rate from the current PE given its growth on new cars launch, and strengthened market position in China automobiles market. For Brilliance China, we believe recent share price correction provides good buying opportunity. We remain upbeat on Brilliance China ’s outlook based on its strong model cycle and future minibus business growth. For Nexteer, the

conversion from conventional HPS (hydraulic power steering) to high margin EPS (electric power steering) will raise ASP and profit margin. Meanwhile, its EPS is a key enabler of ADAS and autonomous driving. By forming partnership with international players, such as Continental AG, GM – CRUISE, and WABCO, Nexteer is well positioned for the EV revolutionary tide.

Introduction In 2017, the stock value of our top pick Geely (175.HK) has tripled, outperforming its peers and HSI. Geely’s success can be explained by its robust sales growth, market share gain and the new Lynk brand which became the share price catalyst.

The sales growth of China Passenger vehicles was muted in 2017 (+1.9% ytd). As in 2016, demand was pulled forward before the removal of the tax stimulus and therefore created a high base. On the contrary, tax rate has been raised from 5 percent to 7.5 percent in 2017, meanwhile the tax rate will resume to the normal 10 percent level starting from Jan 2018.

Looking forward, the government policies will continue to play a significant role in changing the industry landscape. Topics such as NEV subsidy threshold, CAFC & NEV credit policy, timeline to phase out NEV tax rebate, and etc. will continue to be the important issues for the coming years. Market Overview Passenger Vehicle (PV) market recorded 1.9% YoY sales growth in 2017 ytd, amounted to 22million units. The volume growth was muted when compared to that of 2016.

The reason of 2016 high base: There was demand pulled forward, esp. in 4Q2016, before the removal of the tax stimulus as people knew the tax rate would raise to 7.5 percent in 2017.

In 2017, sedan continued to be the major vehicle type, followed by SUV. The accumulated sales of sedan, SUV, MPV and Crossover PV were 10.65m; 9.09m; 1.86m; 0.49m units respectively.

Looking forward, we estimate China’s PV sales growth to be at 2% in FY18, considering the fact that the tax rate will resume to the normal 10 percent level starting from Jan 2018.

Figure 58. PV sales in 2011-2017E

Source: CAAM, CASH

SUV continues to be the key contributor The SUV market had sustained solid growth, posting 15% growth in sales in 2017 ytd. The segment contributed over 41% sales of the overall PV market, within which more than half came from local brands. Haval H6 of GWM remains the best- selling SUV, however, other models such as GS4 of GAC Motor and Boyue of Geely becomes more and more competitive. Looking forward, we expect SUV demand to remain robust, supported by the customers’ preference and the growing demand from lower-tier cities. SUVs will continue to be the major growth driver of China’s auto industry and gain share from sedans and MPVs.

Figure 59. Sales distribution in 2017YTD

Source: CAAM, CASH

Figure 60. PV sales growth by segment

Source: CAAM, CASH

Figure 61. SUV sales continues to grow

Source: CAAM, CASH

Market Share SAIC, DF, FAW remains the largest automobile groups in China. According to the CAAM data, these three Groups recorded 6.18m; 3.67m; 3.12m units of sales in Jan-Nov17, representing 24%;14% and 12% of the industry sales. The market shares of the three biggest groups were relatively stable, meanwhile, Geely kept gaining market share in these few years. From Jan 2016 onwards, Geely’s market share rose from 2% to 5%.

Figure 62. Sales units (by Group)

Source: CAAM, CASH

Figure 63. Market shares distribution

Source: CAAM, CASH

What are the highlights in the coming years? 1. Vehicle purchase tax resumes to 10% in 2018 2. Extension of tax rebate for NEV purchase, but higher threshold for NEV subsidy 3. CAFC and NEV credit policy 4. Continuous consumption upgrade 5. Electrification to be the definite trend

1. Vehicle purchase tax resumes to 10% in 2018 Since 2015, China halved sales tax on cars with engine sizes less than 1.6L to 5 percent. While the tax rate was raised from 5 percent to 7.5 percent in 2017, the tax rate will resume to the normal 10 percent level starting from Jan 2018. Looking forward, we expect large-sized engine vehicles (above 1.6L engine PV) to likely outperform small-sized engine vehicles as the former has no exposure to the purchase tax rebate and therefore not much front loading in 2016 and 2017. In fact, we see 1.6L-or-below- engine PV losing its sales momentum starting from Mar17, and recorded negative YoY growth since then. The sales proportion of 1.6L-or-below- engine PV fell from 72% in 2016 to 68% 2017ytd. We expect luxury brands and SUVs to have stronger momentum in the following years.

Figure 64. PV sales growth by engine size

Source: CAAM, CASH

2. Extension of tax rebate for NEV purchase, but higher threshold for NEV subsidy

PRC government continues to exempt the 10 per cent purchase tax on new-energy vehicles at least through 2020.

However, according to industry news, there will be higher threshold for NEV subsidy in 2018. The version on 2018 NEV subsidy adjustment is expected to be much stricter on pure electricity range (R), battery energy density and energy consumption than the previous ones. Meanwhile, China's Ministry of Finance is planning for a policy to urge the local government to cancel subsidies for NEV.

Figure 65. NEV subsidies – requirement on pure electricity range (R)

*Subsidies on BEV as well as PHEV has declined by 20 percent in 2017 and a cap has been placed on the subsidies at local-government levels, which requires the local government subsidies to be less than 50% of the central government subsidies. Source: NDRC, d1ev, CASH

Figure 66. NEV subsidies – requirement on energy density (Wh/kg) Energy Density (Wh/kg) 2017 Subsidy Adjustments Factor Energy Density (Wh/kg) 2018 Subsidy Adjustments Factor 90-120 1 90-100 0.9 100-135 or 140 1 >120 1.1 >135 or 140 1.1

Source: NDRC, d1ev, CASH

Figure 67. NEV subsidies – requirement on energy consumption Electricity Consumption/100km optimization rate 2018 Subsidy Adjustments Factor <10% 0.9 Between 10% to 20% 1 >20% 1.1

Source: d1ev, CASH

3. CAFC and NEV credit policy China finalized the dual-credit scheme on Sep 27. All OEMs are required to meet the standards regarding CAFC (corporate average fuel consumption) target and NEV credits target. The policy reaffirms the government stance towards two topics--- Fuel economy and NEV development.

CAFC credit policy For the CAFC, OEMs need to reduce the fuel consumption to an average of 5L per 100km by 2020. OEMs that meet or exceed fuel consumption targets will generate positive CAFC credit points, or else, will incur negative credit points. Those who fail to comply with the requirement will incur financial cost to obtain credit points, or else are not allowed to sell certain models, until their credit is cleared to zero. (No product certificate will be granted to these models.)

NEV credit policy For the NEV credit program, automakers' target NEV credit points should be equivalent to 10 percent in 2019 and 12 percent in 2020 of the total vehicle production volume. OEMs can obtain credit points by producing more NEV, including BEV, PHEV and fuel cell vehicle.

China will impose the NEV credit policy in 2019 instead of the original proposal of 2018. In the final document announced on Sep27, the rules have been slightly relaxed compared to the draft. For example, OEMs can use 2020 NEV credit surplus to offset any 2019 NEV credit deficits. Also, OEMs will be allowed to carry forward 2019 NEV credit surplus to 2020. Overall, the new measures are in line with market expectations, giving OEMs more time to prepare for the new policy.

For more details, please refer to our sector report - NEV and Auto parts Sector: A New Era Has Begun, published on Nov13, 2017.

4. Continuous consumption upgrade In recent years, there is a narrowing gap between local brand and JV brand positioning. More local brands are trying to enter the mid-to-high range SUV segment (Rmb150k per unit) to find their next growth driver. Examples include Geely’s Lynk and Great Wall’s Wey brands as well as GAC’s GS8.

Figure 68. Mid-to-high range domestic car model in China

Source: xcar, CASH

Meanwhile, international brands are diversifying their product range and plan to capture more market shares in the low-to-mid range segment. For instance, international OEMs are launching more entry-level versions (Toyota CHR, VW T-Roc, Skoda Karoq, Hyundai Encino) that are priced at the same level as mass-market brands.

Figure 69. Narrowing gap between local and international brand positioning

Source: CASH

5. Electrification to be the definite trend According to IEA, China was by far the largest electric car market in 2016, accounting for more than 40% of the NEV sold globally and more than double the amount sold in the United States. According to the recent speech by Deputy Minister Xin Guobin of the MIIT, discussions are being held concerning the timeline to phase out ICEs. Electrification is a definite trend.

Figure 70. NEV sales in China

According to MIIT’s plan, China plans to produce 2m units of NEV by 2020, implying a CAGR of 40%.

Source: CAAM, CASH

Figure 71. China's NEV mix Figure 72. China's NEV mix (%)

Source: CASH

According to the Automotive Industry Medium- and- Long Term Development Plan published by MIIT, NDRC and MOST, the China PV production volume will reach 30m and 35m units respectively in 2020E and 2025E, whereas NEV production will account for 2m and 7m units.

Figure 73. MIIT’s prediction and target

Source: MIIT, CASH The above information is provided and distributed by CASH Financial Services Group Limited (“CASH”). The document is for reference only. Neither the information nor opinion expressed shall be construed, expressly or impliedly, as an advice, offer, invitation, advertisement, inducement, recommendation or representation of any kind or form whatsoever. While the information contained herein has been obtained from sources believed to be reliable, CASH or its affiliates do not represent that it is accurate or complete and it should be relied upon. CASH hereby expressly disclaims all liabilities arising out of or incidental to the accuracy and completeness of the contents and information herein contained. The contents and information in this document is subject to change without prior notice to you. As of 2 January 2018, the analyst who provides the above information has financial interests in relation to the above securities. Trade in securities covered by this report may be made only in those jurisdictions where the securities are qualified for trading. This document may not in whole or in part be reproduced or furnished to any person other than the addressee without written consent from CASH and CASH shall not be liable to any such third parties for loss arising from any unauthorized distribution. Securities dealing services are provided by Celestial Securities Limited, a corporation licensed to conduct Type 1 (dealing in securities) regulated activity under the Securities and Futures Ordinance. -62- January 2, 2018

Figure 74. Valuation and financial ratios of Automobile related stocks Stock Code Price ($LC) TP %upside 18 EPS YoY 19 EPS YoY 18PE 19PE 18ROE 19ROE 18PB 19PB GEELY AUTOMOBILE 175 HK Equity 27.10 35.00 29.2% 35.86 30.52 15.77 12.08 33.36 33.19 4.68 3.70 BRILLIANCE CHINA 1114 HK Equity 20.90 26.00 24.4% 51.10 29.12 11.52 8.93 24.11 24.96 2.52 2.03 BYD CO LTD-H 1211 HK Equity 68.10 NA NA 51.13 22.53 23.58 19.25 11.53 12.65 2.53 2.28 GUANGZHOU AUTO-H 2238 HK Equity 18.52 NA NA 20.07 12.98 8.01 7.09 21.42 20.69 1.57 1.34 GREAT WALL MOT-H 2333 HK Equity 8.95 NA NA 48.75 15.44 8.34 7.23 15.24 15.81 1.21 1.08 DONGFENG MOTOR-H 489 HK Equity 9.46 NA NA 3.93 3.11 4.81 4.66 12.07 11.38 0.55 0.51 BAIC MOTOR-H 1958 HK Equity 10.18 NA NA 60.25 21.18 9.61 7.93 14.84 15.59 1.30 1.14 SAIC MOTOR-A 600104 CH Equity 32.04 NA NA 10.77 8.84 9.47 8.70 17.56 17.47 1.59 1.45 FAW CAR CO LTD-A 000800 CH Equity 10.76 NA NA NA NA NA NA 4.11 4.43 2.11 2.02 JOHNSON ELEC H 179 HK Equity 32.75 NA NA 12.01 12.17 12.15 10.83 13.97 13.61 1.49 1.35 MINTH GROUP LTD 425 HK Equity 47.15 NA NA 22.94 21.02 16.85 13.93 19.84 21.43 3.20 2.81 NEXTEER 1316 HK Equity 18.62 22.00 18.2% 15.94 11.25 14.89 13.39 26.42 25.19 3.59 2.97 Median 22.94 15.44 11.52 8.93 16.40 16.64 1.85 1.74 Average 30.25 17.10 12.27 10.36 17.87 18.03 2.20 1.89 Source: Bloomberg , CASH

Geely Automobile (00175.HK, TP: HK$35) Automobile Sector Key Investment Themes Our top picks: The long awaited Lynk has launched last month. With its competitive price positioning and world-class tech. spec, Lynk will lead Geely into golden years from 2018E onwards. We expect 50% EPS CAGR during 2016-19F., driven by robust sales volume growth and profit margin expansion.

Satisfying results so far: 11M17 sales increased 66.3% YoY to 1094k units, achieving 99% of the 1.1m unit annual sales target. The monthly sales volume in Nov was 141k units, up 38% YoY and 13% MoM. The market share gain is evidenced by the 66% accumulated sales growth (v. China overall auto market’s muted 1.9% sales growth in 11M17.) All the four new models launched in 2016 maintained high levels of sales volumes. In particular, the sales volume of Boyue amounted to 30.9k units, being the best- selling model of the Group. While the sales of Emgrand GL/ Emgrand GS/ Vision SUV amounted to 14.2k/17.5k/13.6k units, achieving 42%/74%/25% growth.

Lynk- winner takes all: Lynk & Co brand can supplement the Group’s current market coverage. Different from Geely brand that targets at mass and Volvo brand that targets at premium, the Lynk 01 SUV have the MSRP at the range of CNY158.8-220.8k, depending on the specifications. We see the price level as a competitive one when compare to other brands, such as VW, Honda and Toyota, etc. (Fig. 76). The entry price of Lynk 01 is similar to that of Great Wall’s WEY VV7, which has the MSRP at CNY 167k- 188k. We see WEY as a proxy for Lynk sales forecast. Given VV7’s satisfactory sales figure, the market sentiment for new car models is believed to be positive (Fig 77). We are optimistic towards the sales volumes ramp of Lynk and expecting a monthly sales volume of over 10k for Lynk 01 in 2018 and 15k in 2019.

Strong new model pipeline: Apart from the Lynk & Co 01 launched last month, Lynk’s 02 (compact SUV) and 03 (sedan) are to be launched by mid-18F, and then 2 new models per year beyond 2018. The Lynk brand will mainly focus on the China market in 4Q17-2018, with expansion to Europe/US beyond 2018. We expect Lynk & Co's sales volume to account for 20-30% of Geely's total sales of 2m by 2020.

Retain Buy with TP at HKD35: We forecast Geely’s 2018 earnings growth will be around 52% based on robust sales volume growth. We reiterate buy with TP at HKD35, reflecting 15X FY19E P/E, implying an 29% upside. We believe Geely will continue to have upside earning revisions and re-rate from the current PE given its growth on new cars launch, and strengthened market position in China automobiles market.

Figure 75. Geely monthly sales by model

Source: Company Data, CASH

Figure 76. MSRP of comparable SUV models v.s Figure 77. Sales of GW VV7 (a proxy for Lynk 01) Lynk 01

Source: CASH

Geely Automobile 175.HK, Buy, TargetPrice: HKD35 Income Statement (RMB mn) Balance Sheet (RMB mn) Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Revenue 30,138 53,722 90,403 128,656 159,037 Cash & equivalents 9,167 15,045 23,442 32,773 42,605 Cost of goods sold (24,668) (43,880) (73,679) (104,211) (128,025) Marketable securities 0 0 0 0 0 Gross profit 5,471 9,842 16,725 24,445 31,012 Accounts receivable 14,836 29,041 43,344 59,217 70,586 SG&A (3,744) (5,063) (6,823) (8,657) (10,126) Inventories 1,226 3,066 4,405 6,231 7,654 R&D 0 0 0 0 0 Other current assets 118 97 99 101 103 Other expense 0 0 0 0 0 Total current assets 25,348 47,249 71,290 98,322 120,949 Employee share expense (62) (42) (43) (44) (45) LT investments 22 22 22 23 23 Operating profit 1,665 4,737 9,859 15,744 20,842 Fixed assets 8,034 10,650 14,437 19,875 25,663 EBITDA 2,808 6,391 11,393 17,439 22,825 Goodwill 3 7 7 7 7 Depreciation (589) (734) (734) (994) (1,369) Intangible assets 5,260 6,462 5,661 4,960 4,346 Amortisation (554) (921) (800) (701) (614) Other LT assets 3,626 3,193 3,257 3,322 3,388 EBIT 1,665 4,737 9,859 15,744 20,842 Total assets 42,292 67,583 94,674 126,509 154,376 Net interest expense (6) (30) 4 67 147 ST debt 0 174 178 181 185 Associates & JCEs 150 (9) (9) (9) (9) Accounts payable 20,114 39,779 60,558 82,798 98,211 Other income 1,066 1,506 1,536 1,567 1,598 Other current liabilities 335 677 690 704 718 Earnings before tax 2,875 6,204 11,390 17,368 22,578 Total current liabilities 20,449 40,630 61,426 83,683 99,114 Income tax (586) (1,034) (2,506) (3,821) (4,967) LT debt 1,929 2,068 2,110 2,152 2,195 Net profit After tax 2,289 5,170 8,884 13,547 17,611 Convertible debt 0 0 0 0 0 Minority interests (28) (58) (104) (159) (207) Other LT liabilities 175 198 202 206 210 Other items 0 0 0 0 0 Total liabilities 22,553 42,897 63,738 86,041 101,519 Preferred dividends 0 0 0 0 0 Minority interest 216 249 353 512 719 Normalised NPAT 2,289 4,796 8,884 13,547 17,611 Preferred interest 0 0 0 0 0 Extraordinary items 0 374 0 0 0 Common stock 161 163 163 163 163 Income attr. to shareholders 2,261 5,112 8,780 13,388 17,404 Retained earnings 19,362 24,275 30,421 39,792 51,975 Dividends (281) (960) (2,634) (4,016) (5,221) Proposed dividend 281 960 2,634 4,016 5,221 Transfer to reserves 1,980 4,152 6,146 9,372 12,183 Other equity and reserves 0 0 0 0 0 Total shareholders' equity 19,740 24,686 30,937 40,467 52,857 EPS (RMB) 0.26 0.58 1.00 1.52 1.97 Total equity & liabilities 42,292 67,583 94,674 126,509 154,376 DPS (RMB) 0.03 0.11 0.30 0.46 0.59 shares outstanding (m) 8801.66 8820.61 8820.61 8820.61 8820.61 Key Ratios FY15 FY16 FY17E FY18E FY19E Cashflow statement (RMB mn) Profitability (%) Year-end 31 Dec FY16 FY17E FY18E FY19E Gross margin 18.2% 18.3% 18.5% 19.0% 19.5% Net profit After tax 5,170 8,884 13,547 17,611 EBITDA margin 9.3% 11.9% 12.6% 13.6% 14.4% Non-cash item 1,654 1,534 1,696 1,983 EBIT margin 5.5% 8.8% 10.9% 12.2% 13.1% Change in working capital 3,984 5,148 4,554 2,632 Net Margin 7.5% 9.5% 9.7% 10.4% 10.9% Cashflow from operations 8,338 15,566 19,796 22,226 Effective tax rate 20.4% 16.7% 22.0% 22.0% 22.0% Capital expenditure (3,066) (4,520) (6,433) (7,157) Dividend payout 12.4% 18.8% 30.0% 30.0% 30.0% Free cashflow 5,272 11,046 13,364 15,069 ROE 27.2% 23.3% 31.9% 38.0% 37.8% Dec in other LT assets 433 (64) (65) (66) ROA 8.7% 9.4% 11.0% 12.2% 12.5% Inc in other LT liabilities 23 4 4 4 Adjustment (4) (0) (0) (0) Liquidity (x) CF from investing acts (2,557) (4,580) (6,494) (7,219) Current ratio 1.2 1.2 1.2 1.2 1.2 Cash dividend (302) (2,634) (4,016) (5,221) Interest coverage 16.1 41.0 83.7 127.3 175.1 Equity issue 0 0 0 0 Debt issue 326 45 46 47 Leverage Convertible debt issue 0 0 0 0 Net Debt/EBITDA (x) Net Cash Net Cash Net Cash Net Cash Others 0 0 0 0 Net Debt/Equity (%) Net Cash Net Cash Net Cash Net Cash CF from financial acts 29 (2,589) (3,971) (5,175) Net cashflow 5,810 8,396 9,331 9,832 Activity (days) Beginning cash 9,167 15,045 23,442 32,773 Days receivable 149.1 146.1 145.5 149.0 Adjustments 69 0 0 0 Days inventory 17.9 18.5 18.6 19.8 Ending cash 15,045 23,442 32,773 42,605 Days payable 249.1 248.5 251.1 258.0 Ending net debt (12,803) (21,154) (30,440) (40,225) Cash cycle (82.2) (83.9) (86.9) (89.3) Source: Company data, CASH Source: Company data, CASH

Brilliance China (01114.HK, TP: HK$26) Automobile Sector Key Investment Themes Recent share price correction provides good buying opportunity: Brilliance BMW JV’s earning amounted to EUR168m, fell by 6% YoY in 3Q17 and miss the market expectation. Meanwhile, the market had overreacted to the potential competition arouse from the cooperation between GreatWall Motor and BMW. We remain upbeat on Brilliance’s outlook as we see its fundamental remains positive. The 3Q result miss was partly explained by the initial launch cost of new 5- series and upcoming X3 SUV. The related marketing expense is merely a one-off event, and meanwhile the company is likely to record slower depreciation growth in the following years. Investors should keep an eye on the upcoming margin improvement, driven by the new 5-series sales growth and its much lower discount when compared to old models.

Strong product pipeline ahead: X3 SUV, new BMW 3 series, X2 crossover is going to be introduced in mid-2018, early 2019 and 2020 respectively. BMW Brilliance is going to benefit from the strong product cycle, and followed by the margin improvement due to the operating leverage. Increasing localization is another upside for the Company. For example, the X5 SUV localization may be possible in 2019/2020.

NEV development on the right track: The industry is now expecting a stricter NEV requirement from the PRC government with respect to the pure electricity range (R) and battery energy density of NEV models. The upcoming NEV launch from Brilliance BMW and the Jinbei- Renault partnership provides potential for the Company to be an NEV leader in the premium sector. The upcoming NEV version of 5 series, X1 and X3 can prepare Brilliance to comply with credit policies. For the Jinbei business, as mentioned in our previous sector report published on Aug 4, Renault is a market leader in the European LCV market. Management previously confirms that new car models will be produced under both the Jinbei brand and Renault brand. Given the huge potential of the China LCV market, Jinbei business is going to have unlimited potential by leveraging Renault’s technology.

Retain ‘Buy’ with TP at HK$26: We remain upbeat on Brilliance China ’s outlook based on its strong model cycle and future minibus business growth. We reiterate ‘Buy’ rating with TP at HK$26 based on 12X FY19E P/E and 2019E EPS growth of 45%, implying a 24% upside.

Brilliance China 1114.HK, Buy, TargetPrice: HKD26 Income Statement (RMB mn) Balance Sheet (RMB mn) Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Revenue 4,863 5,125 5,484 6,361 7,824 Cash & equivalents 1,071 941 4,160 9,746 17,998 Cost of goods sold (4,655) (4,954) (5,210) (5,916) (7,120) Pledged bank deposits 1,326 1,339 1,366 1,393 1,421 Gross profit 208 172 274 445 704 Accounts receivable 1,445 1,584 2,629 2,928 3,473 SG&A (941) (995) (1,725) (1,126) (1,293) Inventories 1,211 1,104 1,258 1,429 1,720 Other Income 81 82 82 82 82 Other current assets 2,123 2,041 2,082 2,124 2,166 Employee share expense 0 0 0 0 0 Total current assets 7,175 7,009 11,496 17,619 26,778 Operating profit (652) (741) (1,369) (599) (507) LT investments 0 0 0 0 0 EBITDA (470) (472) (1,138) (362) (273) Fixed assets 2,042 2,250 2,379 2,345 2,299 Depreciation (136) (132) (145) (153) (151) Goodwill 0 0 0 0 0 Amortisation (45) (138) (86) (84) (83) Intangible assets 1,423 1,339 1,307 1,287 1,282 EBIT (652) (741) (1,369) (599) (507) Other LT assets 16,432 20,445 20,854 21,271 21,697 Net interest expense (66) (80) (43) 47 184 Total assets 27,072 31,043 36,036 42,522 52,056 Associates & JCEs 4,043 4,246 5,865 7,389 10,255 ST debt 1,585 1,325 1,352 1,379 1,406 Other income 0 0 0 0 0 Accounts payable 3,038 3,324 4,282 4,700 5,462 Earnings before tax 3,325 3,425 4,453 6,837 9,932 Other current liabilities 3,249 3,674 3,747 3,822 3,898 Income tax (45) (36) (45) (68) (99) Total current liabilities 7,872 8,323 9,380 9,901 10,767 Net profit After tax 3,280 3,389 4,408 6,769 9,833 LT debt 0 0 0 0 0 Minority interests (214) (293) (331) (508) (737) Convertible debt 0 0 0 0 0 Other items 0 0 0 0 0 Other LT liabilities 137 122 124 127 129 Preferred dividends 0 0 0 0 0 Total liabilities 8,009 8,444 9,505 10,028 10,896 Normalised NPAT 3,280 3,389 4,408 6,769 9,833 Minority interest (832) (1,125) (795) (287) 450 Extraordinary items 0 0 0 0 0 Preferred interest 0 0 0 0 0 Income attr. to shareholders 3,495 3,682 4,078 6,261 9,095 Common stock 396 397 397 397 397 Dividends (453) (475) (530) (814) (1,182) Retained earnings 19,500 23,327 26,875 32,322 40,234 Transfer to reserves 3,042 3,207 3,548 5,447 7,913 Proposed dividend 0 0 530 814 1,182 Other equity and reserves 0 0 55 63 77 EPS (RMB) 0.69 0.73 0.81 1.24 1.80 Total shareholders' equity 19,064 22,599 26,532 32,494 41,159 DPS (RMB) 0.09 0.09 0.11 0.16 0.23 Total equity & liabilities 27,072 31,043 36,036 42,522 52,055 shares outstanding (m) 5045.99 5044.83 5045.27 5045.27 5045.27

Key Ratios Cashflow statement (RMB mn) FY15 FY16 FY17E FY18E FY19E Year-end 31 Dec FY16 FY17E FY18E FY19E Profitability (%) Net profit After tax 3,389 4,408 6,769 9,833 Gross margin 4.3% 3.3% 5.0% 7.0% 9.0% Non-cash item 270 231 237 234 EBITDA margin -9.7% -9.2% -20.7% -5.7% -3.5% Change in working capital (413) (236) (45) (68) EBIT margin -13.4% -14.5% -25.0% -9.4% -6.5% Cashflow from operations (932) 4,349 6,898 9,922 Net Margin 71.9% 71.8% 74.4% 98.4% 116.2% Capital expenditure (455) (274) (119) (106) Effective tax rate 1.3% 1.0% 1.0% 1.0% 1.0% Free cashflow (1,387) 4,074 6,779 9,816 Dividend payout 13.0% 12.9% 13.0% 13.0% 13.0% Dec in other LT assets (3,929) (409) (417) (425) ROE 27.2% 16.9% 16.0% 20.8% 24.8% Inc in other LT liabilities (15) 2 2 3 ROA 8.7% 11.7% 13.1% 17.2% 20.8% CF from investing acts 1,114 (681) (534) (528) Cash dividend (475) (530) (814) (1,182) Liquidity (x) Equity issue 5 0 0 0 Current ratio 0.9 0.8 1.2 1.8 2.5 Debt issue 170 27 27 28 Interest coverage (4.4) (5.6) (12.7) (5.4) (3.8) Convertible debt issue 0 0 0 0 Others 0 55 8 14 Leverage CF from financial acts (312) (449) (779) (1,141) Net Debt/EBITDA (x) Net Cash 2.47 23.13 60.73 Net cashflow (130) 3,219 5,586 8,253 Net Debt/Equity (%) 2% Net Cash Net Cash Net Cash Beginning cash 1,071 941 4,160 9,746 Adjustments 0 0 0 0 Activity (days) Ending cash 941 4,160 9,746 17,998 Days receivable 107.8 140.2 159.4 149.3 Ending net debt 384 (2,809) (8,367) (16,592) Days inventory 85.3 82.8 82.9 80.7 Source: Company data, CASH Days payable 234.4 266.4 277.1 260.5 Cash cycle (41.3) (43.5) (34.8) (30.5) Source: Company data, CASH

Nexteer (01316.HK, TP: HK$22) Automobile Sector Key Investment Themes Perfect player for the future trend: With its world class EPS (Electric Power Steering system), Nexteer is well positioned for EV development. Ever since 1906, Nexteer started to accumulate experience and had a close bond with GM. Until now, GM remains its most important customer, accounting for 42% of sales. The Company’s technology is well recognized. The coming decades of electrification will certainly be the big year for Nexteer.

Solid order backlog: The order backlog of Nexteer amounted to USD23.7b in 3Q17, largely flat with 2Q17. EPS (electronic power steering) accounted for 70% of the total backlog, followed by DL (driveline, 15%), CIS (column and intermediate shafts, 11%) and HPS (hydraulic power steering, 4%). The solid EPS backlog (6x its 2016 revenue) offers high visibility of its future earnings growth.

Implication of US tax reform: US federal corporate tax would fall from 35 per cent to 21 per cent upon the tax reform. Nexteer currently generates cc.66% of its revenue from the NA region, in which over two-third is from USA, implying that tax reform will provide approx. 5-6% upside to the future earnings.

Reap the harvest of ADAS in the near future: By introducing in house- developed ADAS technology, such as Steering on Demand and Quiet Wheel Steering, and cooperating with leading global companies in the autonomous driving field, Nexteer will reap the harvest of ADAS in the near future. This will translate into Nexteer’s backlog in FY17-19E and further enhance its long-term earnings growth.

We like Nexteer: We are positive on Nexteer for three reasons: 1) the conversion from conventional HPS (hydraulic power steering) to high margin EPS (electric power steering) will raise ASP and profit margin; 2) JV with Changan Motors and Dongfeng Motors will increase its market share in China. The company growth will also be driven by increasing EPS penetration in China, estimated to reach 60-70% in 2020; and 3) its EPS is a key enabler of ADAS (advanced driver assistance services) and autonomous driving. By forming partnership with international players, such as Continental AG, GM – CRUISE, and WABCO, Nexteer is well positioned for the EV revolutionary tide.

TP at HKD22; retain “Buy” rating: Our TP of HKD22 is based on 2019 P/E of 14x and 2019E EPS growth of 28%, implying a 18% upside.

Nexteer 1316.HK, Buy, TargetPrice: HKD22 Income Statement (USD mn) Balance Sheet (USD mn) Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Year-end 31 Dec FY15 FY16 FY17E FY18E FY19E Revenue 3,361 3,842 4,309 4,841 5,450 Cash & equivalents 417 484 627 829 1,102 Cost of goods sold (2,816) (3,181) (3,555) (3,970) (4,442) Marketable securities 0 0 0 0 0 Gross profit 545 662 754 871 1,008 Accounts receivable 570 590 696 782 880 SG&A (117) (130) (133) (135) (138) Inventories 254 262 307 342 383 R&D (97) (123) (164) (184) (207) Other current assets 95 92 94 95 97 Other expense (17) 7 7 7 7 Total current assets 1,336 1,428 1,723 2,048 2,463 Employee share expense 0 0 0 0 0 LT investments 0 0 0 0 0 Operating profit 313 415 465 560 671 Fixed assets 685 779 888 1,009 1,144 EBITDA 455 578 628 737 856 Goodwill 0 0 0 0 0 Depreciation (89) (94) (107) (121) (137) Intangible assets 408 450 394 338 290 Amortisation (53) (69) (56) (56) (48) Other LT assets 28 37 38 38 39 EBIT 313 415 465 560 671 Total assets 2,457 2,693 3,043 3,433 3,936 Net interest expense (31) (30) (31) (27) (24) ST debt 81 75 77 79 80 Associates & JCEs 1 1 1 2 2 Accounts payable 559 604 690 771 863 Other income 0 0 0 0 0 Other current liabilities 167 180 184 188 191 Earnings before tax 283 386 436 534 648 Total current liabilities 807 860 951 1,037 1,134 Income tax (73) (84) (96) (117) (117) LT debt 561 489 468 433 405 Net profit After tax 210 302 340 417 532 Convertible debt 0 0 0 0 0 Minority interests (5) (7) (8) (10) (12) Other LT liabilities 235 253 258 264 269 Other items 0 0 0 0 0 Total liabilities 1,602 1,602 1,678 1,734 1,808 Preferred dividends 0 0 0 0 0 Minority interest 27 32 40 49 62 Normalised NPAT 210 302 340 417 532 Preferred interest 0 0 0 0 0 Extraordinary items 0 0 0 0 0 Common stock 32 32 32 32 32 Income attr. to shareholders 205 295 332 407 519 Retained earnings 540 834 1,100 1,426 1,841 Dividends (41) (59) (66) (81) (104) Proposed dividend 41 59 66 81 104 Transfer to reserves 164 236 266 326 416 Other equity and reserves 256 192 192 192 192 Total shareholders' equity 854 1,091 1,364 1,700 2,127 EPS (USD) 0.08 0.12 0.13 0.16 0.21 Total equity & liabilities 2,457 2,693 3,043 3,433 3,936 DPS (USD) 0.02 0.02 0.03 0.03 0.04 shares outstanding (m) 2503.82 2503.82 2503.82 2503.82 2503.82 Key Ratios FY15 FY16 FY17E FY18E FY19E Cashflow statement (USD mn) Profitability (%) Year-end 31 Dec FY16 FY17E FY18E FY19E Gross margin 16.2% 17.2% 17.5% 18.0% 18.5% Net profit After tax 302 340 417 532 EBITDA margin 13.6% 15.0% 14.6% 15.2% 15.7% Non-cash item 163 163 177 185 EBIT margin 9.3% 10.8% 10.8% 11.6% 12.3% Change in working capital 35 (63) (39) (46) Net Margin 6.1% 7.7% 7.7% 8.4% 9.5% Cashflow from operations 509 439 554 672 Effective tax rate 25.8% 21.8% 22.0% 22.0% 18.0% Capital expenditure (283) (215) (242) (273) Dividend payout 20.0% 20.0% 20.0% 20.0% 20.0% Free cashflow 227 224 312 399 ROE 27.2% 31.2% 27.9% 27.4% 28.0% Dec in other LT assets (9) (1) (1) (1) ROA 8.7% 11.7% 11.8% 12.9% 14.4% Inc in other LT liabilities 19 5 5 5 Adjustment 0 0 0 0 Liquidity (x) CF from investing acts (283) (211) (238) (268) Current ratio 1.7 1.7 1.8 2.0 2.2 Cash dividend (40) (66) (81) (104) Interest coverage 9.4 13.2 15.2 20.7 27.7 Equity issue 0 0 0 0 Debt issue (78) (19) (34) (26) Leverage Convertible debt issue 0 0 0 0 Net Debt/EBITDA (x) 0.14 Net Cash Net Cash Net Cash Others (63) 0 0 0 Net Debt/Equity (%) 7% Net Cash Net Cash Net Cash CF from financial acts (155) (85) (116) (130) Net cashflow 71 143 201 274 Activity (days) Beginning cash 417 484 627 829 Days receivable 55.1 54.5 55.7 55.7 Adjustments (3) 0 0 0 Days inventory 29.6 29.2 29.8 29.8 Ending cash 484 627 829 1,102 Days payable 66.7 66.5 67.2 67.1 Ending net debt 80 (82) (317) (617) Cash cycle 17.9 17.1 18.4 18.3 Source: Company data, CASH Source: Company data, CASH

China Export Sector

Export growth is regaining momentum: Although the growth of China exports was softened since April 2017, we observed that the figure recorded positive growth in the past 9 consecutive months and strengthened again in November 2017. Besides, November exports growth data has broken through the 6-month downtrend, signalling an even stronger growth in coming few months. Looking forward, we believe that the growth would likely remain robust given that 1) US rate hike cycle is expected to be faster than that of China and 2) Trump’s tax cut plan is likely to start since 1 Jan 2018.

The cycle is far from an end: China exports have been largely determined by exports to North America and Europe. We observed that there is a Lead-lag effect between currency exchange and export data. Therefore, we believe that the cycle of China exports is not over yet and we are in the mid-cycle only. The subsequent growth will be mainly fuelled by China exports to the US in 2018.

China’s rate hike cycle will be relatively slow: Due to the high debt-to-GDP ratio, China will not be able to push interest rate upward at a very fast pace in shorter term. Instead, we expect that China will focus on its deleveraging effort and will only be able to widen interest rate gap again after successful deleveraging. Therefore, we expected a narrowing interest rate gap between China and other regions, supporting CNY to depreciate and thus the export data.

Trump’s tax cut plan will likely boost China exports further: US president Donald Trump proposed to lower the corporate tax rate from 35% to 21% permanently in the Tax Cuts and Jobs Act. The market expects that the final version will be passed by the end of 2017. In our view, the Act will help shift China export companies’ future investment to the US market and thus will stimulate China exports towards the US.

Reiterate “Buy” to Techtronic Industries (0669.HK) with Dec-18 TP of HK$65: EPS is expected to climb to US$0.34/0.41 in FY18E/FY19E. We reiterate “BUY” rating for TTI and raise our Dec-18 TP to HK$65 (Previous: HK$45), reflecting 20X FY19E P/E. Major downside risks include: 1) increase in market competition from peers, and 2) aggressive appreciation of RMB against USD.

China Export growth Export growth is regaining momentum Although the growth of China exports was softened since April 2017, we observed that the figure recorded positive growth in the past 9 consecutive months and strengthened again in November 2017, supporting our views that the export sector is rebounding and the rebound is not over yet.

November China Total exports amounted to US$217.38 billion, increased by 12.31%YoY (Previous month: 6.76%YoY). As seen from the graph below, November exports growth data has broken through the 6-month downtrend. It is believed that this can be treated as a reference of turnaround signal.

Figure 78. China Total Exports 250000 60.00% Break through the downtrend again! 50.00%

200000 40.00%

30.00%

150000 20.00%

10.00%

100000 0.00%

-10.00%

50000 -20.00%

-30.00%

0 -40.00%

Jul-12 Jul-17

Jan-10 Jan-15

Jun-10 Jun-15

Oct-08 Oct-13

Apr-11 Feb-12 Apr-16 Feb-17

Sep-11 Sep-16

Dec-07 Dec-12

Aug-09 Aug-14

Nov-10 Nov-15

Mar-09 Mar-14

May-08 May-13 China Total Exports China Total Exports YoY (%)

Source: General Administration of Customs PRC, CASH

Looking forward, we believe that the growth would likely remain robust given that 1) US rate hike cycle is expected to be faster than that of China and 2) Trump’s tax cut plan is likely to start since 1 Jan 2018.

The cycle is far from an end China exports have been largely determined by exports to North America and Europe. According to data shown by Bloomberg, November China exports to the US were up 15.21%YoY to US$42.10 billion, setting a consecutive 9-month positive growth. On the other hand, October China exports to Europe were up 11.71%YoY to 32.26 billion, setting a consecutive 8-month positive growth.

We observed that there is a Lead-lag effect between currency exchange and export data. The currency rates have been leading the China exports to Europe/the US by 0.5/2 years.

Figure 79. Yearly change in China exports to Europe v. CNY/EUR 80.00% 12.0

60.00% 11.0

40.00% 10.0

20.00% 9.0

0.00% 8.0

-20.00% 7.0

Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Jun-17

Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 -40.00% 6.0 China Exports to Euro YoY (%) CNY/EUR

Source: Bloomberg, General Administration of Customs PRC, CASH

Figure 80. Yearly change in China exports to US v. CNY/USD 60.00% 7.4 50.00% 7.2 40.00% 7 30.00% 20.00% 6.8 10.00% 6.6 0.00% 6.4 -10.00%

-20.00% 6.2

Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Jun-17

Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 -30.00% 6 China Exports to US YoY (%) CNY/USD

Source: Bloomberg, General Administration of Customs PRC, CASH

Therefore, we believe that the cycle of China exports is not over yet and we are in the mid-cycle only. The subsequent growth will be mainly fueled by China exports to the US in 2018. Companies who are exporting their products to the US will likely be the beneficiaries in the coming year.

China’s rate hike cycle will be relatively slow According to Bloomberg Economics economists Fielding Chen and Tom Orlik estimation, China’s 2016 debt-to-GDP ratio was at 256%. The figure is projected to further surge to 327% in 2022, making China the most indebted countries in the world.

China Central bank Governor Zhou Xiaochuan, who has hinted he’ll soon retire, recently also warned of the risks in company and household debt, saying that corporate borrowing was "very high" and that the nation needs to be on guard against excessive optimism that could spark a sudden drop in asset prices.

Due to the high debt-to-GDP ratio, China will not be able to push interest rate upward at a very fast pace in shorter term. Instead, we expect that China will focus on its deleveraging effort. Only if the deleveraging effort significantly reduce debt-to-GDP ratio will China be able to widen the interest rate gap again in the longer term.

Therefore, it is expected that the interest rate gap between China and other regions will likely decline in the foreseeable future, supporting CNY/EUR and CNY/USD to go up. The depreciation in CNY will then support the export data to climb further at a faster pace.

Figure 81. China-Europe rate gap v. CNY/EUR 4.00% 12.0 3.00% 11.0 2.00% 10.0 1.00% 9.0 0.00% 8.0

-1.00% 7.0

Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Jun-17

Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 -2.00% Dec-07 6.0 China Europe interest rate gap (%) CNY/EUR

Source: Bloomberg, General Administration of Customs PRC, CASH

Figure 82. China-US rate gap v. CNY/US 2.50% 7.4 2.00% 7.2 1.50% 7 1.00% 6.8 0.50% 6.6 0.00% -0.50% 6.4

6.2

Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Jun-17

-1.00% Jun-08

Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-07 Dec-13 Dec-14 Dec-15 Dec-16 -1.50% 6 China US interest rate gap (%) CNY/USD

Source: Bloomberg, General Administration of Customs PRC, CASH Trump’s tax cut plan The Tax Cuts and Jobs Act was introduced in the United States House of Representatives on 2 November 2017, by Congressman Kevin Brady, Republican representative from Texas. The bill was then passed by the House and the Senate in mid-November and early-December.

Differences between the House and Senate bills were reconciled in a conference committee that signed the final version on December 15, 2017. The final bill has been passed already by both the House and Senate and will be enacted after President signs it.

Donald Trump proposed to lower the corporate tax rate from 35% to 21% permanently and drop the top individual rate for the richest Americans to 37% temporarily. The market expects that the final version will be passed in early January 2018.

Most of the companies that are generating profits in the US will be benefitted by the Act. They can either lower the price of their products and thus boost the product demand or just retain the product price and distribute the tax saving to shareholders. In our view, the Act will help shift the aforesaid companies’ focus to the US market and thus can stimulate China exports towards the US.

Figure 83. Valuation and financial ratios of exports related stocks Stock Code Price ($LC) TP %upside 18 EPS YoY 19 EPS YoY 18PE 19PE 18ROE 19ROE 18PB 19PB TECHTRONIC IND 669 HK Equity 50.95 65.00 27.6% 18.60 17.32 21.31 18.16 18.86 19.11 3.77 3.29 VTECH HLDGS LTD 303 HK Equity 102.40 130.00 27.0% 7.42 5.44 13.71 13.00 38.06 38.65 5.31 5.03 REGINA MIRACLE I 2199 HK Equity 7.70 NA NA 88.10 35.44 16.24 11.99 18.78 21.76 2.89 2.48 PAX GLOBAL TECHN 327 HK Equity 3.50 NA NA 23.92 10.68 7.19 6.49 13.30 12.58 0.91 0.83 SHENZHOU INTL GP 2313 HK Equity 74.40 NA NA 19.21 18.16 20.77 17.58 22.52 23.30 4.21 3.69 LI & FUNG LTD 494 HK Equity 4.29 NA NA 107.14 27.59 18.93 14.84 9.16 11.71 1.66 1.63 MAN WAH HOLDINGS 1999 HK Equity 7.43 NA NA 18.87 12.04 13.56 12.10 33.00 32.14 4.18 3.74 Median 19.21 17.32 16.24 13.00 18.86 21.76 3.77 3.29 Average 40.47 18.10 15.96 13.45 21.96 22.75 3.28 2.96 Source: Bloomberg , CASH

Techtronic Ind. (0669.HK, TP: HK$65) China Export Sector Key Investment Themes US new home sales and house price is increasing at a higher pace: We observe that both new home sales and home price in the US are increasing, with a higher yearly growth rate. In 3Q2017, US new home sales were up 13.16% to 645K. The market expects a 25%YoY growth in 4Q2017, amounted to 685K. On the other hand, US national home price index was up 1.81%YoY to 194, making it the 23rd consecutive months recording positive growth.

TTI’s revenue shows a high correlation with these 2 factors, especially US home price index. Therefore, we believe that the strong new home market will persist and will be a positive to TTI’s revenue in FY2018.

Figure 84. US new home sales 800 40.00% 700 30.00% 600 20.00% 500 10.00% 400 0.00% 300 -10.00% 200 -20.00% 100 -30.00%

0 -40.00%

Sep-12 Sep-08 Sep-09 Sep-10 Sep-11 Sep-13 Sep-14 Sep-15 Sep-16 Sep-17

Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 New Home Sales (Thousands) YoY (%)

Source: Bloomberg, CASH

Figure 85. US home price index 250 4.00% 3.00% 200 2.00% 1.00% 150 0.00% 100 -1.00% -2.00% 50 -3.00% -4.00%

0 -5.00%

Sep-09 Sep-10 Sep-08 Sep-11 Sep-12 Sep-13 Sep-14 Sep-15 Sep-16 Sep-17

Mar-10 Mar-08 Mar-09 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 US National Home Price Index (Seasonally Adjusted) QoQ (%)

Source: Bloomberg, CASH

Home improvement spending on an uptrend: The US home improvement spending has been on an uptrend in the past 2 years. October US home improvement spending was up 8.66%YoY to US$189.6 billion. We believe that the growth will stay at around 10% in 2018 due to the strong demand after both Hurricanes Harvey and Irma.

Figure 86. US home improvement spending 250000 25.00% 200000 20.00% 150000 15.00% 100000 10.00% 50000 5.00% 0 0.00%

U.S. Home Improvement Spending (million) YoY (%)

Source: Bloomberg, CASH

Home Depot 3Q2017 results delightful: Home Depot (HD), TTI’s largest clients, reported delightful 3Q2017 results. HD’s 3Q2017 sales were up 8.1%YoY to US$25 billion, with +7.7% comps for US stores. HD estimated that hurricane-related sales positively impacted comparable store sales growth by approximately $282 million in 3Q2017.

Management guidance on FY2017 sales was raised from 5.3% in 2Q2017 to 6.3% in 3Q2017 with expected comps raised from +5.5% in 2Q2017 to +6.5% in 3Q2017, mainly driven by the demand raised from hurricane-related sales. In our view, the hurricane-related sales could last to 2018 and will help boost TTI’s top line in both FY2017 and FY2018.

Figure 87. HD revenue growth v. TTI revenue growth 10.00% 14.00% 12.00% 8.00% 10.00% 6.00% 8.00% 4.00% 6.00% 4.00% 2.00% 2.00% 0.00% 0.00%

HD Revenue YoY (%) (LHS) TTI Revenue YoY (%) (RHS)

Source: Bloomberg, CASH

Figure 88. HD Revenue Figure 89. TTI Depot Revenue 60000 10.00% 3500 14.00% 9.00% 50000 3000 12.00% 8.00% 7.00% 2500 10.00% 40000 6.00% 2000 8.00% 30000 5.00% 4.00% 1500 6.00% 20000 3.00% 1000 4.00% 2.00% 10000 1.00% 500 2.00%

0 0.00% 0 0.00%

HD Revenue (million) YoY (%) TTI Revenue YoY (%) Source: Bloomberg, CASH

Cordless products innovation remains the top line catalyst: TTI continuously launches new cordless products in order to differentiate its products from that of competitors. In our view, some new cordless products’ market penetration remains low at this moment (such as cordless lighting tools and cordless hydraulic cutting tools) and thus are of great potential. Such kind of new tools will help TTI to seize the professional market and drive TTI’s top line growth.

Reiterate “Buy” with Dec-18 TP of HK$65: EPS is expected to climb to US$0.34/0.41 in FY18E/FY19E. We reiterate “BUY” rating for TTI and raise our Dec-18 TP to HK$65 (Previous: HK$45), reflecting 20X FY19E P/E and a 27.6% upside. Major downside risks include: 1) increase in market competition from peers, and 2) aggressive appreciation of RMB against USD.

Techtronic Industries 0669.HK, BUY, TargetPrice: HK$65 Income Statement (Million US$) Balance Sheet (Million US$) Year end Dec 31 FY15A FY16A FY17F FY18F FY19F Year end Dec 31 FY15A FY16A FY17F FY18F FY19F Revenue 5,038 5,480 5,908 6,382 6,925 Cash & equivalents 771 803 1,039 1,319 1,700 Cost of goods sold (3,240) (3,495) (3,722) (3,977) (4,270) Marketable securities 27 22 22 23 23 Gross profit 1,798 1,985 2,187 2,405 2,655 Accounts receivable 849 951 1,068 1,131 1,239 SG&A (1,275) (1,393) (1,485) (1,557) (1,655) Inventories 1,190 1,296 1,325 1,446 1,536 R&D (128) (147) (165) (175) (192) Other current assets 155 125 128 130 133 Other expense 0 0 0 0 0 Total current assets 2,993 3,197 3,582 4,048 4,632 Employee share expense 0 0 0 0 0 LT investments 11 11 11 11 11 Operating profit 395 445 537 672 808 Fixed assets 538 601 666 744 821 EBITDA 567 637 742 898 1,053 Goodwill 554 553 553 553 553 Depreciation (91) (101) (112) (125) (138) Other intangible assets 521 547 579 614 654 Amortisation (82) (91) (93) (100) (106) Other LT assets 185 211 216 220 224 EBIT 395 445 537 672 808 Total assets 4,803 5,120 5,607 6,190 6,896 Net interest expense (13) (10) (10) (11) (10) ST debt 672 502 512 523 533 Associates & JCEs 0 0 0 0 0 Accounts payable 1,160 1,331 1,427 1,520 1,635 Other income 5 5 5 5 5 Other current liabilities 237 237 241 246 251 Earnings before tax 387 440 532 667 803 Total current liabilities 2,069 2,070 2,181 2,289 2,419 Income tax (33) (31) (41) (40) (47) LT debt 467 501 501 501 501 Net profit After tax 354 409 490 627 757 Convertible debt 0 0 0 0 0 Minority interests (0) (0) (0) (0) (0) Other LT liabilities 111 151 154 157 160 Other items 0 0 0 0 0 Total liabilities 2,647 2,721 2,836 2,946 3,080 Preferred dividends 0 0 0 0 0 Minority interest (0) (1) (0) (0) 0 Normalised NPAT 354 409 490 627 757 Preferred interest 0 0 0 0 0 Extraordinary items 0 0 0 0 0 Common stock 647 649 649 649 649 Income attr. to shareholders 354 409 490 627 756 Retained earnings 1,604 1,905 2,277 2,750 3,322 Dividends (83) (102) (118) (154) (184) Proposed dividend 83 102 118 154 184 Transfer to reserves 271 306 372 473 572 Other equity and reserves (95) (155) (155) (155) (155) Total shareholders' equity 2,156 2,399 2,771 3,244 3,816 EPS (In US$) 0.19 0.22 0.27 0.34 0.41 Total equity & liabilities 4,803 5,120 5,607 6,190 6,896 DPS (In US$) 0.05 0.06 0.06 0.08 0.10 Key Ratios FY15A FY16A FY17F FY18F FY19F Growth (%) Cashflow statement (Million US$) Revenue N/A 8.8% 7.8% 8.0% 8.5% Year end Dec 31 FY15A FY16A FY17F FY18F FY19F Gross profit N/A 10.4% 10.2% 10.0% 10.4% Income attr. to shareholders 354 409 490 627 757 Operating profit N/A 12.8% 20.5% 25.3% 20.2% Depreciation & Amortization 173 192 206 226 245 Income attr. to shareholders N/A 15.5% 19.9% 27.9% 20.7% Change in working capital 271 124 (48) (88) (83) Cashflow from operationgs 335 584 648 765 919 Profitability (%) Capital expenditure (154) (186) (177) (204) (214) Gross margin 35.7% 36.2% 37.0% 37.7% 38.3% Free cashflow 182 398 471 561 704 Operating margin 7.8% 8.1% 9.1% 10.5% 11.7% CF from investing acts (321) (286) (304) (341) (363) Net Margin 7.0% 7.5% 8.3% 9.8% 10.9% Cash dividend (83) (102) (118) (154) (184) Dividend payout 23.3% 25.0% 24.2% 24.6% 24.4% Equity issue 3 (4) 0 0 0 ROAE N/A 17.9% 19.0% 20.8% 21.4% Debt issue 173 (137) 10 10 10 ROAA N/A 8.2% 9.1% 10.6% 11.6% Convertible debt issue 0 0 0 0 0 Others (95) (60) 0 0 0 Liquidity (x) CF from financial acts 93 (243) (108) (144) (174) Current ratio 1.4 1.5 1.6 1.8 1.9 Net cashflow 107 54 235 280 382 Interest coverage 30.7 43.9 53.7 63.0 78.1 Beginning cash 688 771 803 1,039 1,319 Adjustments (24) (22) 0 0 0 Leverage Ending cash 771 803 1,039 1,319 1,700 Net Debt/EBITDA (x) 0.6 0.3 (0.0) (0.3) (0.6) Ending net debt 368 200 (25) (295) (666) Net Debt/Equity (%) 17% 8% -1% -9% -17% Source: Company data, CASH Source: Company data, CASH

HK Retail Sector

Strong evidence shows that Hong Kong retail sector has been turning around since early 2017. According to HK Census and Statistics Department, September retail sales value index was up 5.6%YoY, setting a 7-month consecutive positive growth; retail sales volume index was also up 5.5%YoY, setting a 5-month consecutive positive growth. Visitor arrivals were boosted 2.2%YoY for the first 9 months in 2017.

We believe that the trend will persist given that 1) China economy is regaining momentum, and 2) slow depreciation in RMB against HKD, and 3) income level in China is rising persistently. Besides, we have seen a decline in rentals and believe that this will be a positive catalyst for the whole retail sector.

The tourism sector is turning around: Visitor arrivals increased 2.2%YoY to 42.6 million for the first 9 months in 2017. The rise was mainly contributed by a boost in visitor arrivals from China, driven by 1) the recovering China economy 2) slow depreciation in RMB against HKD and 3) increasing income level in China. This supports our belief that tourism sector is turning around.

Jewellery and cosmetics retail sales still strong: Total retail sales value increased 0.9%YoY for the first 9 months in 2017, amounted to HK$325,012 million. For the first 9 months in 2017, Jewellery sales value rose 4.31%YoY to HK$53,575 million; Cosmetics sales value rose 3.59%YoY to HK$32,466 million. We believe that the trend will continue owing to the strong demand from China tourists.

Rental expense is dropping: Rental value for high street shops has been down significantly since 3Q2015. As most of the terms of leasing contracts for retailers last for 3 years, we expect the terms renegotiation would help them reduce the rental cost by ~20% in 2018.

We prefer Luk Fook (0590.HK, Dec18 TP: HK$37) and Sa Sa (0178.HK, Dec18 TP: HK$3.5): We see robust FY18 SSSG for both Luk Fook’s Hong Kong and Macau market and China market and believe that the trend will persist due to the introduction of more varieties of stylish and value-for-money products. Besides, although we can’t see a delightful SSSG in FY18 for Sa Sa, we believe that it’s a good time to accumulate Sa Sa’s shares in FY18 as we believe that the decline in SSSG was mainly caused by one-off shops and inventory relocation, which will negatively impact Sa Sa’s short-term profitability but will benefit Sa Sa’s long-term profitability. We believe that this will makes Sa Sa’s shares undervalued.

Statistics at a glance Visitor arrivals According to Hong Kong Tourism Board statistics, visitor arrivals increased 2.2%YoY to 42.6 million for the first 9 months in 2017 compared with the same period in 2016. Among the 9 months, 6 of them recorded positive year on year growth. This supports our belief that tourism sector is turning around. Besides, we see uptrends in both of the growth of total visitor arrivals and growth of the number of visitor arrivals from China.

The rise was mainly contributed by a boost in visitor arrivals from China, driven by 1) the recovering China economy 2) slow depreciation in RMB against HKD and 3) increasing income level in China. According to Tourism Board statistics, visitor arrivals from China increased 2.46%YoY to 32.5 million for the first 9 months in 2017 compared with the same period in 2016.

Further investigating the structure of visitor arrivals from China, we find that for the first 9 months in 2017, PRC overnight visitor arrivals were up 5.34%YoY to 13.5 million. During the same period, PRC same-day visitor arrivals were down 1.47%YoY to 18.9 million. Such a healthy change in PRC visitor arrivals structure could result in growth in overall capital spending.

Figure 90. Total visitor arrivals 6 000 000 25.0% 20.0% 5 000 000 15.0% 4 000 000 10.0% 5.0% 3 000 000 0.0% -5.0% 2 000 000 -10.0% 1 000 000 -15.0% -20.0% 0 -25.0% Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Total Visitor arrivals y/y (%)

Source: Hong Kong Tourism Board, CASH

Figure 91. Visitor arrivals from China 5 000 000 40.0% 4 500 000 30.0% 4 000 000 3 500 000 20.0% 3 000 000 10.0% 2 500 000 2 000 000 0.0% 1 500 000 -10.0% 1 000 000 -20.0% 500 000 0 -30.0% Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Vistor arrivals from China y/y (%)

Source: Hong Kong Tourism Board, CASH

Figure 92. Structure of visitor arrivals from China 20.00%

15.00%

10.00%

5.00%

0.00% Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 -5.00%

-10.00%

-15.00%

-20.00% PRC overnight visitor arrivals y/y (%) PRC sameday visitor arrivals y/y (%) Overall y/y (%)

Source: Hong Kong Tourism Board, CASH

Hong Kong Retail sector According to Census and Statistics, total retail sales value increased 0.9%YoY for the first 9 months in 2017, amounted to HK$325,012 million. Among all types of retail outlet, 1) Fuels, 2) Motor vehicles and parts, 3) Jewellery, watches and clocks, and valuable gifts, 4) Chinese drugs and herbs, and 5) Medicines and cosmetics recorded at least 6 months positive growth and meanwhile recorded not less than 3% on year growth on average in the past 9 months. These statistics help us filter out types of retail outlet that are still in a trouble and safeguard our investment.

Among the 5 types of retail outlet, we have initiated coverage in listed companies in 2 of them, namely 1) Jewellery, watches and clocks, and valuable gifts and 2) Medicines and cosmetics.

For the first 9 months in 2017, Jewellery, watches and clocks, and valuable gifts sales value rose 4.31%YoY to HK$53,575 million; Medicines and cosmetics rose 3.59%YoY to HK$32,466 million. For Jewellery, watches and clocks, and valuable gifts/ Medicines and cosmetics, 7/8 out of the first 9 months in 2017 recorded positive year on year growth with an average year on year monthly growth rate of 4.7%/3.8%. Besides, we see uptrends in both the value growth and volume growth for total retail sales, jewellery, watches and clocks, and valuable gifts sales and medicines and cosmetics sales.

In our view, we believe that the trend will continue due to the strong demand from China tourists. We expect a 4-8%YoY growth in total retail sales value, an 8-13%YoY growth in Jewellery, watches and clocks, and valuable gifts sales value and a 5-8%YoY growth in Medicines and cosmetics sales value in 2018.

Figure 93. Total Sales value index Figure 94. Total Sales volume index 140.0 20.00% 140.0 20.00% 15.00% 15.00% 120.0 120.0 10.00% 10.00% 100.0 100.0 5.00% 5.00% 80.0 0.00% 80.0 0.00%

60.0 -5.00% 60.0 -5.00% -10.00% -10.00% 40.0 40.0 -15.00% -15.00% 20.0 20.0 -20.00% -20.00% 0.0 -25.00% 0.0 -25.00%

Total retail sales value index y/y (%) Total retail sales volume index y/y (%) Source: Census and Statistics Department, CASH

Figure 95. Jewellery, watches and clocks, and Figure 96. Jewellery, watches and clocks, and valuable gifts sales value index valuable gifts sales volume index 140.0 20.00% 140.0 20.00%

120.0 10.00% 120.0 10.00%

100.0 100.0 0.00% 0.00% 80.0 80.0 -10.00% -10.00% 60.0 60.0 -20.00% -20.00% 40.0 40.0

20.0 -30.00% 20.0 -30.00%

0.0 -40.00% 0.0 -40.00%

Jewellery, watches and clocks, and valuable gifts sales value index y/y (%) Jewellery, watches and clocks, and valuable gifts sales volume index y/y (%) Source: Census and Statistics Department, CASH

Figure 97. Medicines and cosmetics sales value Figure 98. Medicines and cosmetics sales volume index index 140.0 25.00% 140.0 20.00%

120.0 20.00% 120.0 15.00% 15.00% 100.0 100.0 10.00% 10.00% 80.0 80.0 5.00% 5.00% 60.0 60.0 0.00% 0.00% 40.0 40.0 -5.00% -5.00%

20.0 -10.00% 20.0 -10.00%

0.0 -15.00% 0.0 -15.00%

Medicines and cosmetics sales value index y/y (%) Medicines and cosmetics sales volume index y/y (%) Source: Census and Statistics Department, CASH

Rental in Hong Kong According to JLL Datatouch, while rental value index for prime shopping centre was flat last in the past 2 years, rental value for high street shops has been down significantly since 2Q2015. The figure has declined by more than 40% in the past 2 years and is anticipated to further go down in future.

Looking forward, as most of the terms of leasing contracts for retail companies last for 3 years, we expect the terms renegotiation would help these companies reduce their rental cost further for ~20% in 2018.

Figure 99. Hong Kong Rental value index

Source: JLL Datatouch

Same-store sales growth (SSSG) Luk Fook (0590.HK): For 2QFY18, LF’s overall same-store sales growth was at 17% (previous quarter: 5%), with SSSG of 11% (previous quarter: 23%) in China market and SSSG of 18% (previous quarter: 3%) in Hong Kong & Macau market.

Both gold and gem-set in Hong Kong & Macau market recorded double-digit SSSG, at 21% (previous quarter: 0%) and 18% (previous quarter: 9%) respectively. Besides, LF’s China Market was mainly supported by gold SSSG, at 19% (previous quarter: 32%), but was offset by -2% gem-set SSSG (previous quarter: 10%).

Looking forward, we believe that the group’s overall SSSG will remain robust given the strong Hong Kong & Macau demand in gem-set driven by the introduction of more varieties of stylish and good-value-for-money products, but will be partially impacted by the appreciation of HKD against RMB.

Chow Sang Sang (0116.HK): For 1HFY17, CSS’s Hong Kong and Macau market SSSG was at -3% (previous half year: -24%). Gem-set was still under pressure and was still in a downtrend. China market SSSG was at 8% (previous half year: -3%). Gold SSSG was stronger than gem-set SSSG due to the low base effect.

Looking forward, we believe that sales of gem-set in mainland China market will still lead the overall group’s SSSG in FY2018.

Chow Tai Fook (1929.HK): For 2QFY17, CTF’s Hong Kong and Macau market SSSG was at 13% (previous quarter: 5%), with gold SSSG at 21% (previous quarter: 9%) and gem-set SSSG at 7% (previous quarter: -4%). For CTF’s China market, SSSG was at 9% (previous quarter: 11%), with gold SSSG at 15% (previous quarter: 16%) and gem-set SSSG at -1% (previous quarter: 3%).

Looking forward, we believe that the group’s overall SSSG in FY18 will remain flat, supported by strong local consumer sentiment.

Sa Sa (0178.HK): Sa Sa’s 2QFY18 Hong Kong and Macau SSSG was at-1.8% (previous quarter: -2.5%). On the other hand, we see that the average sales per transaction were up 4%YoY (previous quarter: +2.8%YoY) to HK$336, moving in the opposite direction of SSSG. This supports our belief that the declining SSSG was caused by one-off shops and inventory relocation only and will be recovered very soon.

Figure 100. Luk Fook’s HK & Macau SSSG (%) Figure 101. Luk Fook’s China SSSG (%) 30% 40%

20% 30% 10% 20% 0% 10%

-10%

Jul-15 Jul-16 Jan-17

Jan-16 0%

Sep-15 Sep-16

Nov-15 Nov-16

Mar-15 Mar-16 Mar-17

May-15 May-17 -20% May-16

-10% Jul-16

-30% Jul-15

Jan-16 Jan-17

Sep-16 Sep-15

Nov-15 Nov-16

Mar-16 Mar-17 Mar-15

May-15 May-16 May-17 -40% -20% -50% -30%

-60% -40% HK & Macau - Gold HK & Macau - Gem-set China - Gold China - Gem-set

Source: Company Data, CASH

Figure 102. Chow Sang Sang’s HK & Macau SSSG Figure 103. Chow Sang Sang’s China SSSG (%) (%) 60% 40% 50% 30% 40% 30% 20%

20% 10% 10% 0% 0%

-10% -10%

Jun-17 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16

Oct-14 Oct-12 Oct-13 Oct-15 Oct-16

Feb-13 Feb-14 Feb-15 Feb-16 Feb-17

Jun-15 Jun-16 Jun-17 Jun-12 Jun-13 Jun-14

Oct-12 Oct-13 Oct-14 Oct-15 Oct-16

Feb-14 Feb-15 Feb-16 Feb-17 -20% Feb-13 -20% -30% -40% -30% SSSG - HK & Macau SSSG - China

Source: Company Data, CASH Figure 104. Chow Tai Fook’s HK & Macau SSSG (%) Figure 105. Chow Tai Fook’s China SSSG (%) 30% 30%

20% 20%

10% 10%

0% 0%

-10% -10%

Jul-16 Jul-15 Jul-17

Jul-17 Jul-15 Jul-16

Jan-16 Jan-17

Sep-15 Sep-16 Sep-17

Sep-16 Sep-15 Sep-17

Nov-15 Nov-16

Mar-15 Mar-16 Mar-17

May-15 May-16 May-17

May-15 May-16 May-17 -20% -20%

-30% -30%

-40% -40% HK & Macau - Gold HK & Macau - Gem-set China - Gold China - Gem-set

Source: Company Data, CASH

Figure 106. Sa Sa’s HK & Macau SSSG (%) 5.0%

0.0%

-5.0%

-10.0%

-15.0%

-20.0% HK & Macau

Source: Company Data, CASH

Infrastructure projects in Hong Kong HK-Zhuhai-Macao Bridge (HZMB) The HZMB is a transport infrastructure project that connects Hong Kong Special Administrative Region, the Macau Special Administrative Region, and Zhuhai City of Guangdong province.

Hong Kong, Macau and the Mainland are now managing to achieve the target of completing the major construction works of the main bridge and the ports by the end of 2017. Commissioning date then will be announced once confirmed by the Central Task Force.

The China and Hong Kong government are now planning to issue a quota of 10,000/300 permits for Hong Kong/Mainland cross-boundary private cars before the commissioning of the bridge. More permits are expected to be issued afterwards. We believed that the commissioning date of HZMB will be in 1H2018. The project will help boost the number of same-day and overnight tourists visiting Hong Kong and will benefit the whole retail sector dramatically.

Figure 107. HK-Zhuhai-Macao Bridge

Source: Highways Department, CASH

Guangzhou-Shenzhen-HK Rail Link The Hong Kong section of the Guangzhou-Shenzhen-Hong Kong Express Rail Link (Express Rail Link) was first envisaged in the Railway Development Strategy 2000 proposed by the HKSAR government. In April 2008, the HKSAR Government asked the MTR Corporation to carry out further planning and design of the Express Rail Link.

On 20 October 2009, the Chief Executive in Council authorized the Scheme and the Amendments of the Scheme of the Express Rail Link. On 16 January 2010, the Finance Committee of the Legislative Council approved the funding application for the construction of the Express Rail Link. The construction commenced in late January 2010 with a target of completion by 3Q2018.

The 26-km Express Rail Link will link Hong Kong with major Mainland cities with significantly reduced travelling times. It is believed that the Express Rail Link will boost the number of same-day tourists from China cities that are far from Hong Kong.

Figure 108. China High-speed Railway Network

Source: Sohu, CASH

The “One station, two systems” co-location Arrangement has been a controversial issue in Hong Kong for several months. It is the one of the main bottleneck for Express Rail Link to be operational in Hong Kong. On one hand, the arrangement is supported by the pro-Beijing party for minimizing travel time of visitors and maximizing the efficacy of Express Rail Link. On the other hand, pro-democracy party blamed the arrangement for allowing Chinese police to enforce the PRC law in Hong Kong and eroding the “One country, two systems” and the spirit of the rule of law.

Recently, the Legislative Council (LegCo) passed a non-binding motion supporting the co-location arrangement, which reflects that the arrangement was supported by a great public opinion.

Besides, on 18 November 2017, the Chief Executive, Mrs Carrie Lam signed the Co-operation Arrangement with the People's Government of Guangdong Province, signifying the formal commencement of the "Three-Step Process". The remaining 2 steps include: 1) seeking approval and endorsement of the arrangement from the Standing Committee of the National People's Congress, and 2) commence the local legislative process. In our view, HKSAR government will face opposition from the pro-democracy party and may lead to a delay in the Express Rail Link opening. We expect the delay would not be too long and the Express Rail Link will be operational in 1H2019.

Figure 109. Valuation and financial ratios of retail related stocks Stock Code Price ($LC) TP %upside 18 EPS YoY 19 EPS YoY 18PE 19PE 18ROE 19ROE 18PB 19PB CHOW SANG SANG 116 HK Equity 18.88 NA NA 15.31 16.58 12.72 10.91 9.88 10.78 1.24 1.15 LUK FOOK HLDGS 590 HK Equity 33.55 37.00 10.3% 13.03 8.61 14.82 13.64 13.63 13.99 1.96 1.83 CHOW TAI FOOK 1929 HK Equity 8.20 NA NA 14.86 10.31 17.98 16.30 13.70 14.56 2.43 2.31 SA SA INTL HLDGS 178 HK Equity 3.01 3.50 16.3% 22.86 15.12 17.50 15.20 23.34 27.43 4.05 3.99 L'OCCITANE INTL 973 HK Equity 14.32 NA NA 8.64 10.23 17.40 15.79 12.52 12.72 2.06 1.88 BONJOUR HLDGS 653 HK Equity 0.27 NA NA NA NA NA NA NA NA NA NA SINCERE CO LTD 244 HK Equity 0.33 NA NA NA NA NA NA NA NA NA NA WING ON CO 289 HK Equity 27.70 NA NA NA NA NA NA NA NA NA NA LIFESTYLE INTL 1212 HK Equity 10.38 NA NA -22.85 6.09 9.73 9.17 48.23 40.36 4.00 3.42 CROCODILE GARMEN 122 HK Equity 0.84 NA NA NA NA NA NA NA NA NA NA ESPRIT HLDGS 330 HK Equity 4.18 NA NA 119.15 44.17 20.29 14.07 3.44 4.64 0.67 0.64 GIORDANO INTL 709 HK Equity 4.16 NA NA 9.52 5.80 12.06 11.40 20.00 21.30 2.40 2.39 I.T LTD 999 HK Equity 3.33 NA NA 17.63 19.44 7.80 6.53 14.90 16.33 1.11 1.01 ORIENTAL WATCH 398 HK Equity 1.78 NA NA NA NA NA NA NA NA NA NA TSE SUI LUEN 417 HK Equity 2.35 NA NA NA NA NA NA NA NA NA NA Median 14.86 10.31 14.82 13.64 13.70 14.56 2.06 1.88 Average 22.02 15.15 14.48 12.56 17.74 18.01 2.21 2.07 Source: Bloomberg , CASH

Luk Fook (0590.HK, TP: HK$37) Retail Sector Key Investment Themes Positive FY18E/19E SSSG: Luk Fook’s overall SSSG was 17% in FY2Q18 (vs 5% in FY1Q17). SSSG for Gold was 21% (vs 5% in FY1Q17) and SSSG for gem-set jewellery was 16% (vs 9% in FY1Q17), much higher than the market expectation, thanks to Hong Kong and Macau region. Management expects a better 2nd half result due to the low base effect.

In our view, although the base for FY18/19 top line will be higher, we still expect an overall SSSG of 10%/12% for FY18E/19E, driven by shifting customer preference from gold products towards gem-set products and by the improving visitor arrivals due to the opening of HZMB in 1H2018 and Express Rail Link in 1H2019.

Expansion in China will support a higher top line: Management adjusted their target number of new shops in China in FY18 from 50 shops to 100 shops (consecutive estimate by the management), which includes more licensed shops than self-operated shops, due to the improving market condition. The management also expects a double-digit SSSG in Mainland China Region in FY18.

We believe that in FY19, Luk Fook’s management will continue the China expansion plan by opening more licensed shops, which is less risky to Luk Fook as compared self-operated shops. Such expansion plan will have a positive impact on Luk Fook’s top line.

Rental cost likely to be cut further: The management guidance for rental cost reduction for street-level stores in FY18 will be at 30%-50%, which will help reduce the operating cost. We believe such rental cost cut will continue in FY19 with a smaller magnitude (~20% cut) due to the recovery of the retail sector.

Reiterate “Buy” with Dec-18 TP of HK$37: EPS is expected to climb to HK$2.04/2.38 in FY18E/FY19E. We reiterate “BUY” rating for Luk Fook and raise our Dec-18 TP to HK$37 (Previous: HK$35.1), reflecting 15.6X FY19E P/E and a 10.3% upside. Major downside risks include: 1) aggressive depreciation of RMB against HKD, 2)delay of the opening of HZMB and Express Rail Link, 3) unexpected deterioration of China/HK economic condition.

Luk Fook Holdings 590.HK, Buy, TargetPrice: 37 Income Statement (Million HKD) Balance Sheet (Million HKD) Year-end 31 March FY16 FY17 FY18E FY19E FY20E Year-end 31 March FY16 FY17 FY18E FY19E FY20E Revenue 14,031 12,807 14,190 16,035 17,158 Cash & equivalents 2,362 1,529 1,708 1,350 1,447 Cost of goods sold (10,777) (9,530) (10,799) (12,150) (12,942) Marketable securities 71 333 339 346 353 Gross profit 3,254 3,277 3,392 3,885 4,216 Accounts receivable 215 217 241 277 282 SG&A (2,131) (2,150) (2,060) (2,310) (2,447) Inventories 6,345 6,973 7,129 8,022 8,544 R&D 0 0 0 0 0 Other current assets 338 380 387 395 403 Other expense 89 162 165 168 172 Total current assets 9,330 9,431 9,805 10,389 11,029 Employee share expense 0 0 0 0 0 LT investments 234 177 180 184 188 Operating profit 1,212 1,289 1,497 1,743 1,941 Fixed assets 604 564 551 552 559 EBITDA 1,347 1,420 1,625 1,873 2,074 Goodwill 0 0 0 0 0 Depreciation (128) (122) (118) (118) (120) Other intangible assets 215 248 295 348 404 Amortisation (8) (8) (10) (12) (14) Other LT assets 247 259 264 270 275 EBIT 1,212 1,289 1,497 1,743 1,941 Total assets 10,629 10,679 11,096 11,743 12,455 Net interest expense 28 15 23 19 20 ST debt 711 437 365 334 439 Associates & JCEs (79) (54) (55) (56) (58) Accounts payable 892 1,005 1,065 1,232 1,276 Other income 0 0 0 0 0 Other current liabilities 154 152 155 158 161 Earnings before tax 1,161 1,250 1,464 1,706 1,903 Total current liabilities 1,757 1,594 1,585 1,724 1,877 Income tax (200) (223) (257) (299) (333) LT debt 0 0 0 0 0 Net profit After tax 961 1,027 1,208 1,407 1,570 Convertible debt 0 0 0 0 0 Minority interests (3) (10) (10) (11) (11) Other LT liabilities 104 105 108 110 112 Other items 0 0 0 0 0 Total liabilities 1,861 1,699 1,693 1,833 1,989 Preferred dividends 0 0 0 0 0 Minority interest 95 107 117 127 138 Normalised NPAT 961 1,027 1,208 1,407 1,570 Preferred interest 0 0 0 0 0 Extraordinary items 0 0 0 0 0 Common stock 59 59 59 59 59 Income attr. to shareholders 959 1,017 1,198 1,396 1,559 Retained earnings 6,121 6,321 6,734 7,229 7,775 Dividends (647) (646) (784) (901) (1,013) Proposed dividend 647 646 784 901 1,013 Transfer to reserves 312 371 413 496 546 Other equity and reserves 2,494 2,494 2,494 2,494 2,494 Total shareholders' equity 8,769 8,980 9,403 9,910 10,466 EPS 1.63 1.73 2.04 2.38 2.66 Total equity & liabilities 10,629 10,679 11,096 11,743 12,455 DPS 1.10 1.10 1.34 1.53 1.73

Key Ratios FY16 FY17 FY18E FY19E FY20E Cashflow statement (Million HKD) Profitability (%) Year-end 31 March FY17 FY18E FY19E FY20E Gross margin 23.2% 25.6% 23.9% 24.2% 24.6% Income attr. to shareholders 1,027 1,208 1,407 1,570 EBITDA margin 9.6% 11.1% 11.4% 11.7% 12.1% Non-cash item 131 128 130 133 EBIT margin 8.6% 10.1% 10.5% 10.9% 11.3% Change in working capital (823) (131) (773) (495) Net Margin 6.8% 7.9% 8.4% 8.7% 9.1% Cashflow from operationgs 720 1,205 764 1,208 Effective tax rate 17.2% 17.8% 17.5% 17.5% 17.5% Capital expenditure (95) (105) (119) (127) Dividend payout 67.5% 63.5% 65.5% 64.5% 65.0% Free cashflow 626 1,100 645 1,081 ROE 11.1% 11.5% 12.9% 14.3% 15.1% Dec in other LT assets (12) (5) (5) (5) ROA 9.0% 9.6% 10.9% 12.0% 12.6% Inc in other LT liabilities 2 2 2 2 Adjustment 6 (61) (68) (73) Liquidity (x) CF from investing acts (408) (169) (190) (203) Current ratio 5.3 5.9 6.2 6.0 5.9 Cash dividend (646) (784) (901) (1,013) Interest coverage 88.5 143.1 195.3 227.1 176.9 Equity issue 0 0 0 0 Debt issue (274) (72) (31) 105 Leverage Convertible debt issue 0 0 0 0 Net Debt/EBITDA (x) Net Cash Net Cash Net Cash Net Cash Others 0 0 0 0 Net Debt/Equity (%) Net Cash Net Cash Net Cash Net Cash CF from financial acts (1,131) (857) (932) (908) Net cashflow (819) 179 (358) 97 Activity (days) Beginning cash 2,362 1,529 1,708 1,350 Days receivable 5.6 6.2 6.2 6.3 6.0 Adjustments (13) 0 0 0 Days inventory 214.9 267.1 241.0 241.0 241.0 Ending cash 1,529 1,708 1,350 1,447 Days payable (30.2) (38.5) (36.0) (37.0) (36.0) Ending net debt (1,092) (1,343) (1,016) (1,008) Cash cycle 190.2 234.8 211.2 210.3 211.0 Source: Company data, CASH Source: Company data, CASH

Sa Sa Int’l (0178.HK, TP: HK$3.5) Retail Sector Key Investment Themes HK & Macau market is further improving: The group’s retail sales in HK and Macau increased 2.2% in 1HFY18. However, SSSG was at -2.1% in the same period due to the duplication of stores in major tourists areas and conservative inventory management policy during the relocation of warehouse in 1HFY18, which prevent Sa Sa from capturing the full potential of the market recovery.

As these events will not persist, and because of the opening of HZMB in 1H2018 and Express Rail Link in 1H2019, we are confident that sales growth will be strong in the coming future given the increasing number of tourists brought by the 2 infrastructure projects and the improving local customers’ sentiment.

The impact from duplicated stores will likely disappear in FY19: In 1HFY18, the company opened new stores at premium locations in traditional tourist areas. The move duplicated 7 stores that had previously been relocated to second-line locations due to high rent. Such duplication had led to a 30% sales decline in these stores and impacted both the group’s HK & Macau market SSSG and rental cost. Excluding the effect, HK & Macau SSSG in 1HFY18 have been positive. The management indicated that most of the duplicated stores will be closed by the end of FY18.

In our view, such duplication would influence the group’s short-term profitability but will improve its long-term profitability. Thus, it will lead to an abnormal FY18 result and make Sa Sa’s stocks mispriced.

The rental reduction will be reflected since FY19: Due to the duplication of several stores in traditional tourist areas, we cannot see a significant reduction in rental cost in 1HFY18. Management expects that the duplication of stores will generate the extra rental cost of HK$16/26/4.6 million in 1HFY18/2HFY18/1HFY19. Therefore, we believe that the effect of rental reduction will be reflected on income statement since 1HFY19.

E-commerce and China market should improve: Sa Sa has launched its Tmall shops since September 2017. We believe that the move was great as Tmall is the largest business-to-consumer (B2C) retail platform in Asia. Although management does not expect a break-even in FY18 and FY19, we believe the losses from e-commerce segment will be significantly narrowed.

For China business, management believes that it will break even in FY19 given the SSSG improvement.

One-off expenses will chop FY18 earnings, but not longer-term profitability: In our view, security price should only be determined by company’s long-term profitability. As there are many one-off expense items in FY18 and FY19 including HK$42 million (1HFY18: HK$16 million; 2HFY18: HK$26 million)/4.6 million rental cost for duplicated stores in FY18/FY19 and HK$39 million (1HFY18: HK$24 million; 2HFY18: HK$15 million) warehouse relocation cost in FY18, we believe that the market has not adjusted for it and therefore the stock has been mispriced at this moment.

Reiterate “Buy” with Dec-18 TP of HK$3.5: EPS is expected to climb to HK$0.14/0.19 in FY18E/FY19E. We reiterate “BUY” rating for Sa Sa and raise our Dec-18 TP to HK$3.5 (Previous: HK$3.4), reflecting 18.4X FY19E P/E and a 16.3% upside. Major downside risks include: 1) aggressive depreciation of RMB against HKD, 2)delay of the opening of HZMB and Express Rail Link, 3) unexpected deterioration of China/HK economic condition.

Sa Sa Int'l 178.HK, BUY, TargetPrice: 3.5 Income Statement (million HK$) Balance Sheet (million HK$) Year-end Mar 31 FY16 FY17 FY18E FY19E FY20E Year-end Mar 31 FY16 FY17 FY18E FY19E FY20E Revenue 7,791 7,746 7,888 8,460 8,962 Cash & equivalents 686 456 366 323 273 Cost of goods sold (4,418) (4,517) (4,531) (4,824) (5,071) Marketable securities 393 513 523 534 544 Gross profit 3,373 3,229 3,357 3,637 3,891 Accounts receivable 79 67 76 81 86 SG&A (3,033) (2,940) (2,966) (3,063) (3,205) Inventories 1,102 1,222 1,204 1,255 1,320 R&D 0 0 0 0 0 Other current assets 207 223 227 232 237 Other expense 117 108 110 112 114 Total current assets 2,468 2,481 2,397 2,425 2,459 Employee share expense 0 0 0 0 0 LT investments 0 0 0 0 0 Operating profit 458 397 501 686 801 Fixed assets 321 284 353 366 365 EBITDA 581 500 630 821 936 Goodwill 0 0 0 0 0 Depreciation (123) (103) (129) (135) (135) Other intangible assets 0 0 0 0 0 Amortisation 0 0 0 0 0 Other LT assets 183 164 168 171 174 EBIT 458 397 501 686 801 Total assets 2,972 2,929 2,917 2,961 2,999 Net interest expense 9 10 11 11 12 ST debt 0 0 0 0 0 Associates & JCEs 0 0 0 0 0 Accounts payable 261 314 285 311 327 Other income 3 (1) 0 0 0 Other current liabilities 372 337 343 350 357 Earnings before tax 470 405 512 697 813 Total current liabilities 633 651 629 661 684 Income tax (87) (79) (97) (132) (154) LT debt 0 0 0 0 0 Net profit After tax 383 327 415 565 659 Convertible debt 0 0 0 0 0 Minority interests 0 0 0 0 0 Other LT liabilities 50 59 61 62 63 Other items 0 0 0 0 0 Total liabilities 683 710 689 723 747 Preferred dividends 0 0 0 0 0 Minority interest 0 0 0 0 0 Normalised NPAT 383 327 415 565 659 Preferred interest 0 0 0 0 0 Extraordinary items 0 0 0 0 0 Common stock 289 299 299 299 299 Income attr. to shareholders 383 327 415 565 659 Retained earnings 1,186 831 839 851 864 Dividends (675) (506) (406) (554) (646) Proposed dividend 675 506 406 554 646 Transfer to reserves (292) (179) 8 11 13 Other equity and reserves 813 1,089 1,089 1,089 1,089 Total shareholders' equity 2,288 2,219 2,227 2,239 2,252 EPS 0.13 0.11 0.14 0.19 0.22 Total equity & liabilities 2,972 2,929 2,917 2,961 2,999 DPS 0.24 0.17 0.13 0.18 0.21

Key Ratios FY16 FY17 FY18E FY19E FY20E Cashflow statement (million HK$) Profitability (%) Year-end Mar 31 FY17 FY18E FY19E FY20E Gross margin 43.3% 41.7% 42.6% 43.0% 43.4% Income attr. to shareholders 327 415 565 659 EBITDA margin 7.5% 6.4% 8.0% 9.7% 10.4% Non-cash item 103 129 135 135 EBIT margin 5.9% 5.1% 6.4% 8.1% 8.9% Change in working capital (226) (27) (40) (62) Net Margin 4.9% 4.2% 5.3% 6.7% 7.4% Cashflow from operationgs 357 516 660 732 Effective tax rate 18.5% 19.4% 19.0% 19.0% 19.0% Capital expenditure (82) (197) (148) (134) Dividend payout 176.1% 154.9% 98.0% 98.0% 98.0% Free cashflow 275 319 512 598 ROE 16.8% 14.7% 18.6% 25.2% 29.3% Dec in other LT assets 19 (3) (3) (3) ROA 12.9% 11.2% 14.2% 19.1% 22.0% Inc in other LT liabilities 9 1 1 1 Adjustment (141) 0 0 0 Liquidity (x) CF from investing acts (194) (199) (150) (137) Current ratio 3.9 3.8 3.8 3.7 3.6 Cash dividend (381) (406) (554) (646) Interest coverage N/A N/A N/A N/A N/A Equity issue (5) 0 0 0 Debt issue 0 0 0 0 Leverage Convertible debt issue 0 0 0 0 Net Debt/EBITDA (x) Net Cash Net Cash Net Cash Net Cash Others 0 0 0 0 Net Debt/Equity (%) Net Cash Net Cash Net Cash Net Cash CF from financial acts (386) (406) (554) (646) Net cashflow (224) (89) (44) (50) Activity (days) Beginning cash 686 456 366 323 Days receivable 3.7 3.2 3.5 3.5 3.5 Adjustments (6) 0 0 0 Days inventory 91.1 98.7 97.0 95.0 95.0 Ending cash 456 366 323 273 Days payable (21.6) (25.4) (23.0) (23.5) (23.5) Ending net debt (456) (366) (323) (273) Cash cycle 73.2 76.5 77.5 75.0 75.0 Source: Company data, CASH Source: Company data, CASH