2 November 2017 Manufacturing Construction Machinery Deutsche Bank Markets Research Asia Industry Date China 2 November 2017 Industrials Construction Manufacturing Machinery Recommendation Change Quality growth ahead instead of quantity Fei Sun, CFA Not too late in the cycle; expect quality growth in 2018 Construction machinery sales bottomed out in 3Q16 and have been growing Research Analyst rapidly, driven mainly by demand from infrastructure projects and replacement +852-2203 6130 orders. We identify the key drivers of construction machinery demand and our Vincent Ha, CFA top-down analysis suggests the industry will deliver moderate growth next year. Research Analyst Zoomlion would have relatively greater operating leverage as the sector continues +852-2203 6247 to recover, and we believe the valuation gap between Lonking and Zoomlion will narrow. We upgrade Zoomlion to Buy, as we expect an earnings rebound in Yuki Lu FY18-19 and asset quality to improve (less bad debt provision). We maintain a Research Associate Hold on Lonking as the positives, such as the ability to gain market share and +852-2203 5925 expand margins, are already factored into its share price. Key Changes Better-than-expected demand with balanced supply Company Target Price Rating According to China Construction Machinery Association (CCMA), excavator/ 1157.HK 3.89 to 4.80 Hold to Buy wheel loader/truck crane sales volume surged 100%/45%/122% in 9M17 amid 3339.HK 2.05 to 3.60 - robust replacement and infrastructure demand. Unlike the oversupply in the Source: Deutsche Bank previous down-cycle, construction machinery supply was balanced this time. This Top picks is because, unlike in 2011, fewer individual contractors have entered the industry, Zoomlion (1157.HK),HKD3.81 Buy allowing more rational market competition. Besides this, producers' credit sales Source: Deutsche Bank terms have become much more conservative. Companies featured Zoomlion (1157.HK),HKD3.81 Buy Top-down analysis suggests stable growth ahead 2016A 2017E 2018E Our top-down analysis indicates that downstream demand is likely to remain P/E (x) – 15.5 22.8 robust in 2018E. We expect healthy infrastructure project and mining investment EV/EBITDA (x) 106.8 – 16.1 growth to continue while real estate investment growth will be stable. We forecast Price/book (x) 0.6 0.7 0.6 sales of excavators/wheel loaders/truck cranes to grow 83%/43%/117% YoY in Lonking (3339.HK),HKD3.59 Hold 2017E and 16%/12%/25% in 2018E. 2016A 2017E 2018E P/E (x) 9.9 16.8 13.5 We see a positive earnings outlook for the sector and upgrade Zoomlion to Buy EV/EBITDA (x) 2.5 7.4 5.6 We see a positive earnings outlook for the construction machinery sector in Price/book (x) 0.9 1.8 1.6 FY17-19E, and believe the industry's earnings quality has improved after sector Source: Deutsche Bank consolidation in its worst period from 2012 to 1H16. We upgrade Zoomlion to Buy and increase our target price to HKD4.8 on improving receivables quality and margins. We maintain a Hold on Lonking with a target price of HKD3.6 as its current share price has priced in the strong sales outlook. Our target prices are based on 0.8x/1.6x FY18E P/BV for Zoomlion/Lonking. Upside risks: higher infrastructure/property/mining investment, credit easing and better overseas demand. Downside risks: credit tightening and worse-than-expected demand. Deutsche Bank AG/Hong Kong Distributed on: 02/11/2017 12:12:09 GMT Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 083/04/2017. 0bed7b6cf11c 2 November 2017 Manufacturing Construction Machinery Executive summary Stable growth driven by infrastructure and replacement Figure 1: Annual sales volumes of excavator and wheel loader in China The dramatic scale and pace of the industry recovery in late 2016 kick-started 300,000 an upgrade and re-rating cycle for the sector. Earnings fundamentals rebounded 250,000 200,000 strongly, based on replacement demand, infrastructure orders and mining 150,000 demand as well as that for real estate. As a result, excavator sales doubled in 100,000 9M17 and wheel loaders increased 45%. Our full-year forecasts are 83%, 43% and 50,000 - 117% YoY growth for excavator, wheel loader and truck crane sales, respectively. 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2019E 2018E 2017E This magnitude will not be repeated and we expect volume demand will moderate Excavator Wheel loader next year to the mid-teens, to be clearly lower but still in positive territory. In order Source: CCMA, Deutsche Bank estimates to estimate the normalized demand level for the industry, we track the fleet sizes of excavators and wheel loaders along with total Fixed Capital Formation (FCF) data. Figure 3 shows that the spike in fleet size or industry capacity in 2009-11, Figure 2: Number of PPP projects in driven by RMB4tr infra investment, was not sustainable. The ratio has declined PPP bank sharply since then and will trend lower, but it provides a basis for estimating future 16,000 40% 14,000 sustainable demand levels. Using this model, we forecast that sales of excavators/ 35% 12,000 wheel loaders/truck cranes will grow 16%/12%/25% in 2018E and in 8%/7%/15% 10,000 30% 8,000 in 2019E. 6,000 25% 4,000 20% 2,000 Leading indicators that support these projections are based on: 0 15% Jul-16 Jul-17 Oct-16 Apr-16 Apr-17 Jun-16 Jan-16 Jun-17 Jan-17 Mar-16 Mar-17 Feb-16 Feb-17 Dec-16 Nov-16 Sep-16 Aug-16 Aug-17 May-16 May-17 Number of PPP projects in PPP bank PPP landing rate n Infrastructure FAI: Infrastructure projects have been a major driver of construction machinery sales. Supporting evidence includes a high Source: Wind correlation between excavator sales and the total value of PPP projects among different provinces. We expect infra investment will continue Figure 3: Excavator/wheel loader to support construction machinery demand, especially earth-moving fleet sizes over fixed capital construction machinery like excavators (sales +83% in 2017E, +16% in formation 2018E and +8% in 2019E) and wheel loaders (sales +43% in 2017E, +12% 14 in 2018E and +7% in 2019E). 13 12 n FAI for mining: The YTD FAI growth rate for coal mining dressing reached 11 its lowest point of -35% in July 2016 and has been recovering since. 10 The YTD FAI growth rate turned positive in July 2017 for the first time 9 in two years. We attribute the recovery of mining FAI to the rebound in 8 2016 2015 2014 2013 2012 2011 2010 2009 2008 2019E 2018E commodity prices, but note that investment has been constrained by the 2017E environment controls and mine closures imposed on low-quality miners. Source: Wind, Deutsche Bank estimates Our metals mining analyst, James Kan, estimates that the full-year YoY change in FAI in the coal mining dressing sector will reach 10% in 2017, 2018 and 2019, which would be an important driver of construction Figure 4: Monthly operating machinery sales. hours for Komatsu construction equipment in China n GFA starts: YTD GFA starts declined YoY in 2014 and 2015, and have been (hrs/month) 250 40% recovering since. Our property analyst, Jeffery Gao, expects property 30% 200 supply to fall in 2017 and 2018, as developers have recently begun to cut 20% 150 10% capex. Real estate investment growth would likely stay at a high single- 0% digit level with new starts at ~5%. We expect weak real estate demand 100 -10% -20% 50 to provide limited support for construction machinery demand. -30% 0 -40% n Replacement demand: we estimate that the life span of excavators Jan-17 Jan-16 Jan-15 Jan-14 Jan-13 Jan-12 Jan-11 Sep-17 Sep-16 Sep-15 Sep-14 Sep-13 Sep-12 Sep-11 Sep-10 May-17 May-16 May-15 May-14 May-13 May-12 and wheel loaders ranges 5-10 years (with 15,000-20,000 hours of use May-11 on average). Machines purchased during the peak years of 2010-2011 Source: Komatsu Page 2 Deutsche Bank AG/Hong Kong 2 November 2017 Manufacturing Construction Machinery are starting to be replaced, providing solid demand for construction machinery. Strong earnings rebound with limited bad debt risk Figure 5: Zoomlion - ROE vs. P/BV Driven by strong construction machinery sales, revenue and margins of major 1.6 25% 1.4 construction machinery producers improved significantly in 1H17. We estimate 20% 1.2 15% 1.0 Zoomlion to record FY17-19 revenue growth of 6.8-13.9% YoY. We expect the Average 0.8 10% company to book RMB1.2-1.6bn net profit in FY17-19 vs. net loss in FY16. 0.6 5% 0.4 For Lonking, we forecast FY17-19 revenue to increase by 9.6-51.9% YoY on 0% 0.2 10.0-38.4% YoY sales volume growth. Together with a stable and improving 0.0 -5% Jul-16 Jul-15 Jul-14 Jul-13 Jul-12 Jul-17 Jul-18 Oct-16 Oct-17 Oct-18 Apr-16 Oct-15 Apr-15 Oct-14 Apr-14 Oct-13 Apr-13 Oct-12 Apr-12 Apr-17 Apr-18 Jan-16 Jan-15 Jan-14 Jan-13 Jan-17 Jan-18 margin trend, we estimate net profit to surge 68.0% in FY17 and to expand by Jan-12 16.2-24.3% YoY in FY18-19.