November 21, 2016 Initiation of Coverage ZTO Express (ZTO, BUY, TP: $21.00) BUY HOLD SELL ZTO: Logistics Leader Stands Out from the Crowd; Initiate Buy with $21 Target Target Price: $21.00 Current Price: $16.30 52-Week High (MM) $18.45 We are initiating coverage of ZTO Express with a Buy rating and $21 price target, 52-Week Low (MM) $14.15 representing 30% upside. We are attracted to ZTO as one of the best managed express EV (MM) $10,342 delivery companies, whose sound growth strategy for sustainable share gain should Market Cap (MM) $12,098 Shares Outstanding (MM) 742 propel it to the forefront of a growing industry. The company owns and manages a high Average Daily Trading Volume (M) 7.3 % of core assets which has helped it earn the highest net profit per parcel among its Source: Factset Tongda peers. We think that these factors together with RMB 11bn net cash balance should help the company compete successfully in the ever-growing express delivery industry. Meanwhile, we think its investment in automated sorting lines and trucks Price Performance should help drive continuous cost structure improvement. Our $21 target is based on 18 32x our 2017 non-GAAP EPS estimate of $0.64, or 0.7x PEG. 17 Ready for Express 2.0. We think China's express delivery industry has entered 16 ▪ 2.0 after the initial explosive growth stage. The market likely remains highly 14 competitive, however, strategy, operations, execution, and precise management 13 of network partners should play a more essential role. We expect that the main Oct-16 Nov-16 players' market share will diverge more prominently in the next few years and ZTO eventually, large-scale M&A will consolidate the market. We expect ZTO to emerge as one of the winners. ▪ Greater Share of a Growing Market. We think ZTO's top-line growth will be primarily driven by parcel volume, i.e., ~30% industry growth coupled with gradual market share gain. This should be partially offset by continuous price declines, however, we anticipate the price decline trajectory will become flatter than in previous years. ▪ Strong Margins Despite Pricing Pressure. While we anticipate some mild price decline in the coming years, we believe ZTO can still realize margin improvement due to cost leverage, use of automated sorting lines, and more large-load trucks. ▪ Financial Estimates. We expect ZTO's top-line to grow at 37% 2015-2018 CAGR, while bottom-line non-GAAP net profit grows at over 55% 2015-2018 CAGR. We assume 53%, 46%, and 35% parcel volume growth in 2016, 2017, and 2018, respectively. We forecast that the adjusted net margin will reach 21.7%, 24.5% and 25.7%, respectively, over the next three years. Our adjusted diluted EPS is $0.41, $0.64, and $0.86 for 2016-2018, respectively. ▪ Risks include Cainiao's potential introduction of charges for its waybill services or direct involvement in order dispatch or delivery price-setting in the long term. Price competition is another concern. Per our sensitivity analysis, another RMB 5 cent (-3%) and 10 cent (-5%) decline in price would lead to 10% and 15% discounts in 2017 net profit, respectively, assuming all cost items remain unchanged. Summary financial data Research Team Ella Ji, CFA Highlights 2015A 2016E 2017E 2018E Head of TMT Research Revenue (MM) ($) 916 1,419 1,987 2,644 +1 212-554-2966 Operating Income (MM) ($) 230 391 613 866 [email protected] EPS ($) 0.29 0.41 0.64 0.86 Nicky Ge P/E 56.2x 39.8x 25.5x 19.0x Senior Associate, China Renaissance Securities (HK) Limited +852 2287 1661 EPS:Non-GAAP EPS excluding SBC [email protected] Source: China Renaissance Securities (US) Inc. ("CRSUS"), Company reports. China Renaissance Securities (US) Inc. 1 See Appendix A for Analyst Certification and Important Disclosures November 21, 2016 Initiation of Coverage KEY INVESTMENT THESIS 3 PEER VALUATION COMP TABLE 9 THE WORLD’S LARGEST EXPRESS MARKET, DRIVEN BY E-COMMERCE PROSPERITY 10 ENTERING THE 2.0 ERA WITH SOLID GROWTH 10 BEYOND ECOMMERCE: THE FASTER AND HIGHER MARGIN WORLD OF BUSINESS SOLUTIONS 12 LIMITED ROOM FOR FURTHER PRICE DECLINE 14 NETWORK PARTNER MODEL VS DIRECT OWNERSHIP: IN OUR VIEW, TONGDA OPERATORS CAPTURE THE BEST PROFITABILITY IN THE WHOLE CHAIN 16 REALITY CHECK ON NETWORK STATIONS AND TAOBAO MERCHANTS 18 ZTO, OUTPERFORMING THROUGH ITS STRONG NETWORK AND CONSISTENT QUALITY 21 EXPECTING ZTO TO STAND OUT FROM ITS TONGDA PEERS 21 KEY OPERATING ASSET OWNERSHIP IS VITAL FOR EFFICIENCY IMPROVEMENT 21 ZTO OUTPERFORMS IN PER PARCEL PROFIT 23 EXPRESS DELIVERY COMPANIES DUPONT ANALYSIS 25 STRONG BONDS WITH NETWORK PARTNERS 26 FINANCIAL ANALYSIS AND VALUATION 27 REVENUE AND COST OF REVENUE FORECAST 27 SENSITIVITY ANALYSIS (PRICE WAR, CAINIAO CHARGES, AND FUEL COST) 30 RISK 1: PRICE WAR 30 RISK 2: CAINIAO CHARGES 31 RISK 3: DIESEL PRICE HIKE 31 STRONG CASH FLOW GENERATION 32 VALUATION 32 FINANCIAL MODEL 33-35 2 China Renaissance Securities (US) Inc. 2 November 21, 2016 Initiation of Coverage Key Investment Thesis ZTO Is Well Poised for Sustainable Market Share Gain in the 2.0 Era We think China’s express delivery industry has entered the 2.0 era after its initial explosive growth stage, fueled by demand for door-to-door pick-up and delivery of e-commerce purchases. Growth strategy, operations and execution, and finer management of network partners will play a more essential role going forward. We also think service quality will become more important to senders as opposed to price, since the market price is already at quite a low level, and we observe more willingness from end customers to pay for quality services. We like ZTO and view it as one of the best managed companies in the industry with a sound growth strategy for sustainable share gain opportunities. Industry Outlook: Organic Development First, Consolidation Later The industry has become more fragmented in the past few years. We think this is because robust market growth created plenty of business opportunities, and capital was abundant for new ventures. We think competition will likely remain the main theme in the industry in the next few years, as companies compete in execution, efficiency, and operations. A majority of the express delivery market is occupied by four companies—ZTO, YTO, STO, and Yunda—which all specialize in the intermediate segment of the parcel delivery chain and hire local “network partners” for last-mile services (see Exhibit 17). Currently, the major players each occupy 10%-15% market share, and they were all successfully funded via recent public listings. Thus, large scale M&A activities between them are not likely, in our view, although tuck-in acquisitions are possible. However, we think leading players, such as ZTO, will be able to gain more market share via better services and higher efficiency in the coming years. As the larger companies grow even bigger, their cost advantage over the smaller players will likely become even more obvious. Then, it is likely that the industry will experience some consolidation and that there will be some large- scale M&A between the major players. We do not believe the Chinese express market will consolidate to the extent of markets like the US duopoly. ZTO’s Growth Outlook: A Bigger Slice of a Bigger Pie We think ZTO’s topline growth will be primarily driven by parcel volume, i.e., ~30% industry growth in 2015-2018 coupled with gradual market share gains fueled by ZTO’s industry-leading cost structure, capacity, and relationships with network partners. With a high net cash balance of more than RMB 11 billion post its recent IPO and with committed investment in core assets, we think ZTO is well positioned to take more market share in the coming years. Exhibit 1 3 China Renaissance Securities (US) Inc. 3 November 21, 2016 Initiation of Coverage below illustrates our forecast of market share change in the following years, assuming no M&A activities. Volume growth will be partially offset by mid-single digit price declines in the next few years. We anticipate the price decline trajectory will become much flatter than in previous years, per our analysis in the following sections. Exhibit 1. Express Delivery Market Share Forecast Source: CRSUS, Company reports We identify ZTO’s key advantages as: 1) high direct ownership of key operating assets which should lead to attractive efficiency improvements; 2) flat, stable and balanced network partner structure, which should enable highly effective central management. As the following table illustrates, ZTO has some of the best cost management in the industry and a high net profit per parcel. Its strength in those metrics does not stop here: we estimate its net profit per parcel will further improve to RMB 0.44 with its net margin at 20.5% in 2016. This should provide the company with a deeper pocket to withstand any potential price competition. 4 China Renaissance Securities (US) Inc. 4 November 21, 2016 Initiation of Coverage Exhibit 2. ZTO Earned High Profits per Parcel among Network Partner Express Companies 2015 SF YTO STO Yunda ZTO Revenue per parcel 24.43 3.99 3.00 2.37 2.38 (Revenue net of last-mile delivery fee) 24.43 2.60 1.52 2.37 2.38 Unit waybill fees per parcel 0.91 0.72 0.93 1.08 Unit network transit fee per parcel 1.46 0.72 1.36 1.30 Unit last-mile delivery fee per parcel 1.39 1.48 0.00 0.00 COGS per parcel 19.60 3.44 2.50 1.63 1.60 (Cost net of last-mile delivery) 2.05 0.97 1.63 1.60 Gross profit per parcel 4.83 0.55 0.51 0.74 0.78 GM 20% 21% 33% 31% 33% We estimate ZTO net Operating profit per parcel 0.71 0.33 0.39 0.38 0.54 margin will OM 3% 13% 25% 16% 23% exceed 20% in 2016 Net profit per parcel 0.59 0.24 0.30 0.25 0.39 NM 2% 9% 20% 11% 16% Note:Note: we used 2015 pro pro forma forma data data for for ZTO ZTO Source:Source: CRSUSCRSUS and and SF, SF, YTO, YTO, STO, STO, ZTO, ZTO, and and Yunda Yunda company company reports reports Profitability Outlook: Margin Gains Followed by Potential Long-Term Mix Shift We think ZTO will be able to continue improving its margins in the next few years as express delivery companies have strong leverage in their cost structure.