July 23, 2014 China Logistics OVERWEIGHT (New) Analysts On a structural uptrend Osbert TK Tang, CFA . High cost of logistics in China will create demand for (86) 21-5096 8370 China [email protected] sophisticated value-added logistics services, providing numerous opportunities to industry players. Tracy Liu (86) 21 5096 8367 . Structural, rather than cyclical, drivers support the uptrend [email protected] in China’s logistics sector over the long term. Top pick still Sinotrans; China Merchants (CM) is an alternative play. Kerry Logistics Network’s (KLN) growth is slow and valuations stretched, initiate at HOLD. Numerous opportunities for logistics players China’s logistics costs reached 17.9% of GDP in FY13, 9.5ppt higher than the average for developed countries such as the US, Japan SECTOR RESEARCH | RESEARCH SECTOR and Germany. We expect a continued drive to lower logistics costs, advancement of technology and the improvement of infrastructure networks to further stimulate demand for sophisticated logistics services, translating into numerous business opportunities for experienced logistics providers with solid service know-how. Seven drivers positive for sector outlook We see seven key drivers underpinning solid logistics demand in China: 1) growth in e-commerce volume, driven by online shopping and “Haitao” demand; 2) manufacturers relocating production, stimulating supply chain services; 3) increase in enterprise outsourcing accelerating third-party logistics (3PL); 4) rise in demand for value-added services translating into more profit opportunities; 5) upgrading of logistics facilities enhancing unit revenue; 6) expansion of Chinese enterprises overseas generating cross-border logistics demand; and 7) more favourable government policies creating a more positive operating environment. BUY Sinotrans and CM, HOLD KLN Reiterate BUY on Sinotrans and CM, as both fit well into the trend of accelerated logistics demand. We expect Sinotrans to continue to generate solid growth from 3PL and warehouse upgrades, and it will see further parent-asset injections. CM has a growing logistics business, though its contribution is only 7.2% for FY15F. For KLN, while it has good exposure to the China and Asia logistics markets, growth will be weighed down by its Hong Kong warehouses. It will also take time for the M&A to reflect significantly on its earnings; ROE will remain low for the next two years. Initiate at HOLD and believe its current valuation is fair. Stock Mkt cap Rating Price TP Upside P/E (x) P/B (x) Dividend yld (%) (USD'm) (LC) (LC) (%) 14E 15E 14E 15E 14E 15E China Merchants 8,311.7 Buy 25.50 29.80 17 14.9 14.0 1.3 1.2 3.2 3.5 Sinotrans 2,912.0 Buy 4.90 6.20 27 15.2 11.3 1.4 1.2 1.7 2.2 Kerry Logistics 2,778.7 Hold 12.74 12.80 0 21.9 19.9 1.5 1.4 1.0 1.1 SEE PAGE 54 FOR IMPORTANT DISCLOSURES AND ANALYST CERTIFICATIONS China Logistics Three key charts Figure 1: Emerging Markets logistics potential quadrant China is an attractive market for logistics investment. Source: Agility Figure 2: Internal and external management of logistics processes Outsourcing of logistics management Internal to external companies remains low. External,Chinese logistics companies External, non-Chinese logistics companies Unknown, n/a, does not apply to our company *12% *24% *36% *7% Supply chain monitoring 63% 8% 13% 16% Warehousing 44% 20% 9% 27% Customs clearance 28% 36% 27% 9% Transport management 23% 35% 36% 6% 0% 20% 40% 60% 80% 100% Source: PWC Logistics in China Figure 3: Greater China 3PL market share breakdown 3PL market in China is highly DHL Supply fragmented with Sinotrans being the Sinotrans Chain & Global largest, followed by DHL and KLN 6.0% Forwarding Kerry Logistics 1.9% 1.3% CEVA Logistics 1.0% Expeditors International of Washington 1.0% Others 88.8% Source: Armstrong July 23, 2014 2 China Logistics Drivers for China’s logistics industry Weak infrastructure and a less efficient network mean logistics costs in Continuous drive to lower logistics China are higher than in most other countries. In 2013, China’s social cost will further stimulate the demand logistics revenue reached CNY1,978b, achieving a 10-year CAGR of 14.6%. for sophisticated logistics services. Based on data from the China Federation of Logistics & Purchasing, China’s logistics costs reached 17.9% of GDP in FY13. This is 9.5ppt higher than the average for developed countries like the US, Japan and Germany. We expect the continuous drive to lower logistics costs, advancement of logistics technology and the improvement in infrastructure network to further stimulate the demand for sophisticated logistics services. This should translate into numerous business opportunities for experienced logistics providers with solid service know-how. Figure 4: China’s total social logistics cost CNYt China social logistics cost % Change (RHS) 12 20% 18% 10 16% 14% 8 12% 6 10% 8% 4 6% 4% 2 2% 0 0% 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: iFind Figure 5: China’s total social logistics cost breakdown Management expense 12.7% Transportation expense 52.9% Storage cost 35.3% Source: iFind Traditionally, Chinese companies tend to manage their product distribution in-house, mostly due to the high volumes (which made it cost-efficient), the lack of quality logistics service providers and the under-development of logistics information systems. However, over the past five years, manufacturers and retailers have become increasingly aware of the importance of an efficient logistics network. The increase in market competition, driven by e-commerce growth and the rise in demand for timely deliveries, has also driven the demand for more efficient logistics arrangements. The emergence of bigger and more professional 3PL companies that offer more comprehensive services have made it even July 23, 2014 3 China Logistics more efficient and cost-effective for enterprises to outsource their logistics requirements rather than handling them in-house. In China, most of the logistics service providers are small companies The logistics market in China is highly involved in just one or two segments of the overall supply chain. There are fragmented, with more knowledgeable just a handful of companies capable of providing customers with overseas companies like UPS, FedEx comprehensive supply chain management services. The logistics market in and DHL dominating the cross-border arena. China is highly fragmented, with more knowledgeable overseas companies like UPS, FedEx and DHL dominating the cross-border arena. Domestically, state-owned and Hong Kong-based players like Sinotrans and KLN have been aggressively building up their presences. Additionally, domestic express operators like SF Express and Shentong have started to construct a nation-wide logistics network, while the Cainiao Network, a logistics infrastructure initiated by Alibaba Executive Chairman Jack Ma, has caught significant market attention. Based on Armstrong & Associates, logistics spending in China amounted to USD1.5t in 2012, making it, as a single country, the highest in the world. We expect China’s logistics spending to experience a CAGR of 10-12% between FY13 and FY17. However, the growth in demand for more value- added services and increase in outsourcing by corporates mean the 3PL market will grow much faster than the growth in logistics spending in the next five years. Figure 6: 3PL revenue growth by region 2007-2012 2012-2015E 20% 18.8% 15% 13.3% 9.5% 10% 8.0% 6.3% 4.8% 4.0% 4.2% 5% 3.6% 1.5% 1.0% 0% -1.7% -5% Greater Asia Pacific South North Japan Europe China (ex. Greater America America China and Japan) Source: Armstrong We continue to be positive on the China logistics sector over the next five years and envisage the key demand drivers to be: 1) growth in e-commerce volume; 2) manufacturing relocations; 3) increase in enterprise outsourcing; 4) rise in demand for value-added services; 5) upgrade in facility quality; 6) expansion of Chinese enterprises overseas; and 7) more favourable government policies. According to Agility, China is classified as a country with high market potential but few barriers to entry, effectively meaning it is one of the biggest targets for logistics investments as well as the easiest markets in which to operate. July 23, 2014 4 China Logistics Figure 7: Emerging Market logistics potential quadrant Source: Agility 1) Growth in retail e-commerce volume The rise in domestic consumption is expected to be an important driver for Continued urbanization is one of the logistics demand in China. Over the past seven years, China’s retail sales key impetuses to support growth in have increased at a CAGR of 17.4%. Although growth slowed to 11.9% in retail sales and e-commerce. 1Q14, the pace remains decent. Continued urbanization is one of the key impetuses to support growth in retail sales. Under the 12th Five-Year Plan and Premier Li, urbanization is an important focus of China’s development in the next five years. Based on data from the National Bureau of Statistics of China (NBS), China’s urbanization rate rose from 47.0% in 2008 to 53.7% in 2013, primarily driven by the government’s policy of actively relocating rural residents to urban areas. According to the NBS, urbanization will continue to increase as rural residents migrate to cities to provide labour for the processing and service industries. As a result, China’s urbanization rate is expected to reach 58.9% by 2017 and 70% by 2030. Urban disposable income has been growing at a 10-year CAGR of 11.1%, and rising urbanization rate will keep this on the growth track. The Boao Review forecasts the middle class in China will grow from over 100m currently to more than 400m (accounting for 30-40% of China’s total population) in the next 10 years, and the resultant spending power is extremely significant.