BUY. May 7, China High Speed Transmission Equipment [0658.HK] Re-rating on installation acceleration; three earnings drivers; Initiate with BUY

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1 May 7, 2014 China High Speed Transmission Equipment [0658.HK] Re-rating on installation acceleration; three earnings drivers; Initiate with BUY We see more signs of accelerating wind power installation growth in China and the US this year, which we believe will translate into several earnings drivers for China High Speed Transmission Equipment (CHSTE), including sales volume growth, margin expansion and reduction of finance costs. Most importantly, we believe the market has yet to adjust to CHSTE s strong recovery. Our earnings estimates for 2014E/2015E are 30%+ above consensus. CHSTE is trading at a large discount to other wind equipment makers. We set our target price at HK$7.50 based on 17.5x 2014E PER, mid-point between mid-cycle (13x) and peak valuation (22x), to reflect the on-track earnings recovery. Initiate with BUY. China wind power installation addition projected at 20GW/22GW in 2014E/2015E from 16GW in 2013 five factors: (1) Grid curtailment continues to improve; (2) grid-connected capacity in Q1 14 increased by 18% suggesting on-track installation growth; (3) China wind turbine generator (WTG) tenders jumped 80%+ YoY in Q1 14; (4) strong project pipeline released by NEA; (5) strong government determination to improve air quality. Impressive order growth of 40% YoY from General Electric [GE] in 2014E. We believe US wind power installation will recover strongly in 2014E after the extension of the production tax credit (PTC). We estimate substantial orders from GE will help drive CHSTE s wind gear export volume to its historical high this year. Earnings drivers for CHSTE: Volume growth + margin expansion + decline in finance expenses. We expect total wind gear sales volume to reach 9.5GW/10.8GW in 2014E/2015E, up from 7.3GW in With higher utilization rate, stabilized average selling price (ASP) and less impairment, we expect margin to expand 2ppt+ to 27% in 2014E and we see further upside if the non-wind segments grow faster than our expectation. Besides, we expect the peak of the capex cycle to drive finance expenses down. Major subsidiary of CHSTE reported 166% YoY revenue growth in Q1 14; Returning to profit (PRC GAAP). Nanjing High Speed Gear Manufacturing Group is the major wind gear subsidiary of CHSTE. The strong growth reaffirmed our confidence on CHSTE s recovery story. Key risk factors: (1) Technology shift; (2) Policy risk; (3) Increase in raw material costs; (4) New business risk. Key financials (RMB m) E 2015E Revenue 7,121 6,369 6,539 7,935 8,721 Change (YoY) -3.7% -10.6% 2.7% 21.4% 9.9% EBIT 1, ,155 1,316 Change (YoY) -35.4% -28.4% -7.9% 64.8% 13.9% Core net profit Change (YoY) -42.2% -68.2% 86.3% 15.8% 29.6% ROE 10.9% 3.4% 6.0% 6.3% 7.6% Net debt/equity 55.0% 57.3% 53.6% 46.1% 36.0% PER (core earnings) (x) Dividend yield 0.0% 0.0% 0.0% 0.0% 0.0% PBR (x) EV/EBITDA (x) Sources: Company, CGIHK Research estimates Wind Power Sector Wayne Fung, CFA Analyst (852) waynefung@chinastock.com.hk John Mulcahy Head of Research (852) BUY Close: HK$5.37 (May 5, 2014) Target Price: HK$7.50 (+40%) Share Price Performance Market Cap Shares Outstanding Auditor johnmul@chinastock.com.hk US$1,133m 1,635m Deloitte Free Float 63% 52W range 3M average daily T/O Major Shareholding HK$ US$2.8m Fortune Apex (21.3%) Ji Changqun (15.7%) 1

2 Valuation We believe CHSTE s large discount to Goldwind and international wind equipment players is unjustified. We initiate coverage of CHSTE with a BUY rating. Our target price of HK$7.50 is based on 17.5x PER, mid-point between the peak level of 22x and average of 13x. We believe an above-average valuation is justified as CHSTE is entering a recovery stage with further strong earnings growth in 2015E. Cross checking, we believe Xinjiang Goldwind [2208.HK; Not rated] is the best comparable to CHSTE in the Hong Kong market. While Goldwind and CHSTE represent different technologies and are not in the same value chain, earnings of both companies are driven by the same industry factor (i.e. accelerating installation). CHSTE is now trading at 49%/38% discount to Goldwind in terms 2014E PER/PBR. Even our target price of HK$7.50 implies 29%/15% discount to the current valuation of Goldwind. By comparison with major international wind equipment players, CHSTE is trading at 41%/66% discount in terms of 2014E PER/PBR (figure 1). Figure 1: Peer comparison Ticker Company Rating Price Market cap PE (x) PB (x) EV/EBITDA (x) (local currency) (US$ m) 2013A 2014E 2015E 2013A 2014E 2015E 2013A 2014E 2015E Wind gearbox manufacturers 658 HK Equity CHSTE BUY , Chinese WTG manufacturers 2727 HK Equity SHANGHAI ELECTRIC , HK Equity DONGFANG ELECTRIC , HK Equity XINJIANG GOLDWIND , Average Chinese wind farm operators 916 HK Equity China Longyuan BUY , HK Equity Huaneng Renewables HOLD , HK Equity Datang Renewable HOLD , H Equity China Suntien BUY , HK Equity China Power New Energy HK Equity China Windpower n/a Average Overseas WTG manufacturers GE US Equity GENERAL ELECTRIC , SIE GR Equity SIEMENS AG-REG , VWS DC Equity VESTAS ,186 n/a SUEL IN Equity SUZLON ENERGY n/a n/a n/a 2.8 n/a n/a n/a GAM SM Equity GAMESA , NDX1 GR equity NORDEX AG , Average Sources: Bloomberg, Company, CGIHK Research estimates for covered stocks 2

3 Oct-09 Feb-10 May-10 Aug-10 Nov-10 Mar-11 Jun-11 Sep-11 Dec-11 Apr-12 Jul-12 Oct-12 Jan-13 May-13 Aug-13 Nov-13 Mar-14 Oct-09 Feb-10 May-10 Aug-10 Nov-10 Mar-11 Jun-11 Sep-11 Dec-11 Apr-12 Jul-12 Oct-12 Jan-13 May-13 Aug-13 Nov-13 Mar-14 Figure 2: PER band HKD x 18x 14x 10x 6x Sources: Bloomberg, Company, CGIHK Research estimates Note: The calculation of EPS excludes the exceptional items Figure 3: PBR band HKD x 2.10x 1.50x 0.90x 0.30x Sources: Bloomberg, Company, CGIHK Research estimates 3

4 E 2015E E 2015E Investment Case China wind power installation to accelerate after two-year decline China s new wind power installation reached 16.1GW in 2013 (+24% YoY), reversing a two-year decline (figure 4), according to the Chinese Wind Energy Association (CWEA). We are positive on installation growth over next two years and we forecast annual installation to increase further to 20GW and 22GW in 2014E and 2015E. The National Energy Administration (NEA), in an opinion on China s energy development issued in January 2014, said the Chinese government aims to add 18GW of grid-connected capacity in 2014 (unchanged target from 2013). While the new addition for 2013 missed the target, we believe 18GW for this year is achievable, given (1) the improvement in grid curtailment; (2) grid-connected capacity in Q1 14 increased by 18% which suggests on-track growth; (3) China wind turbine generator (WTG) tenders jumped 80%+ YoY in Q1 14; (4) strong project pipeline released by NEA; (5) strong government determination to improve air quality. Our channel checks suggest capacity growth this year could be faster than expectation. Notably, we expect the new installation will be higher than 18GW as historically the new installation (reported by CWEA) moved ahead of the grid-connected capacity (reported by China Electricity Council [CEC]) (figure 4 and 5). Figure 4: China s new wind power installation Figure 5: China s grid-connected wind power capacity (GW) (GW) % % % % 37% 24% 24% 10% -7% -26% 200% 150% 100% 50% 0% -50% China annual wind power capacity addition (GW) YoY change Sources: CWEA, CGIHK Research estimates Sources: China Electricity Council, CGIHK Research estimates 4

5 E 2015E 2020E Figure 6: China s grid-connected wind power capacity (cumulative) (GW) Grid-connected capacity is expected to double in 2020E from 2015E, according to the government target Sources: China Electricity Council, CGIHK Research estimates 1: Improvement in grid curtailment paves way for accelerated installation The mismatch between the pace of construction of wind farm and power grid infrastructure created the grid curtailment issue starting in To curb the grid curtailment issue, the National Energy Administration (NEA) in 2011 centralized the pre-approval process for all projects in China. As a result of this, during the two years before 2013, newly added wind power installation growth slowed. But the slowdown as a result of the stringent measures successfully eased the grid curtailment issue. The commencement of local grid infrastructure and the increasing willingness of grid companies to absorb wind power also helped improve wind power transmission. This is evidenced by the improvement in utilization hours (figure 7), driven by the improvement in grid curtailment and increase in wind speed. While the utilization hours in Q1 14 reduced by 55 hours YoY to 479 hours as a result of lower wind speed, according to NEA, the grid curtailment rate dropped 5.4ppt YoY to 11.7% in Q1 14. We believe this will pave the way for more installation over the coming two years. 5

6 Figure 7: Wind power utilization hours in China Chg (YoY) State Grid (average) 1,928 1,869 2, % North China Grid 1,982 2,029 2, % West Inner Mongolia 1,829 1,922 2, % South Hebei 1,908 1,883 2, % Shandong 2,028 1,986 2, % Shanxi 2,113 2,149 2, % Beijing, Tianjin, Tangshan 2,214 2,167 2, % Northeast China Grid 1,816 1,490 1, % Jilin 1,610 1,420 1, % Liaoning 1,802 1,732 1, % East Inner Mongolia 1,863 1,499 2, % Heilongjiang 2,008 1,780 1, % Central China Grid 2,085 1,844 2, % Sichuan 1,781 2,476 2, % Hubei 1,955 1,621 2, % Chongqing 2,166 1,773 2, % Henan 2,308 1,907 2, % Jiangxi 2,340 2,380 2, % Hunan - 1,814 2, % East China Grid 2,204 2,292 2, % Anhui 1,791 1,682 1, % Jiangsu 1,849 1,958 2, % Zhejiang 2,014 2,082 1, % Shanghai 2,073 2,363 2, % Fujian 3,096 2,803 2, % Northwest Grid 1,924 1,853 2, % Shaanxi 1,779 1,997 2, % Gansu 1,824 1,645 1, % Qinghai - 1,474 1, % Ningxia 1,926 1,889 2, % Xinjiang 2,317 2,450 2, % China Southern Power Grid 1,801 2,265 2, % Guangdong 1,638 1,847 1, % Guangxi 1,700 1,655 2, % Hainan 2,135 1,845 2, % Guizhou 2,230 2,069 2, % Yunnan 2,440 2,555 2, % China (average) 1,920 1,890 2, % Sources: NEA, CGIHK Research estimates 6

7 2: Grid connected capacity increased by 18% YoY in 1Q14 The grid connected capacity in Q1 14 reached 1,960MW (+18% YoY). This represents ~11% of the government target of 18GW, versus 12% in in Q1 13. We believe this suggests installation growth is on track, paving the way for additional installation. Figure 8: China wind power grid-connected capacity (monthly) (MW) 6,000 5,000 4,000 3,000 2,000 1, Sources: China Electricity Council, WIND, CGIHK Research estimates 3 China WTG public tender in Q1 14 jumped 80%+ YoY to 7GW According to the latest data released by Goldwind, wind turbine generator (WTG) public tenders in China reached 7GW, the highest level since 2Q11. This will imply strong demand for gearbox and CHSTE will be a beneficiary. Figure 9: China WTG public tender in 1Q14 Sources: Goldwind, CGIHK Research 7

8 4: Strong project pipeline released by NEA In February this year, NEA released the fourth batch of approved wind power projects, with a total capacity of 27.6GW. The geographical breakdown (figure 10) continues to indicate a strong growth in the non-curtailment regions (i.e. other than the northern and northeast regions). We see significant increase in projects in provinces like Xinjiang, Ningxia, Hunan, Hainan, Guangxi etc. Further regional diversification will continue to reduce the overall risk of grid constraint, which we believe will help ensure the upcoming installation, offering opportunities to equipment manufacturers. Figure 10: Wind power projects approved by NEA Sources: NEA,, CGIHK Research estimates 1st batch 2nd batch 3rd batch 4th batch Province MW % MW % MW % MW % Innner Mongolia 5, % Hebei 3, % 1, % 1, % 1, % Xinjiang 2, % 2, % 1, % 3, % Heilongjiang 2, % Jilin 2, % Shandong 1, % 2, % 1, % 1, % Shanxi 1, % 2, % 2, % 2, % Liaoning % 1, % % % Guangdong % 1, % 1, % 1, % Yunnan % 2, % 3, % - - Jiangsu % % 1, % 1, % Ningxia % - - 1, % 1, % Fujian % 1, % 1, % 1, % Gansu % - - 2, % 1, % Guizhou % 1, % 1, % 1, % Hunan % % % 2, % Shaanxi % % 1, % 1, % Henan % 1, % % 1, % Qinghai % % % % Zhejiang % 1, % % % Anhui % 1, % % % Sichuan % % % % Jiangxi % % % % Guangxi % % % 1, % Hubei % % % % Chongqing % % % % Shanghai % % % % Tianjin % % % % Hainan % 0 0.0% Beijing % % - - Tibet % % - - Others 3, % 1, % 1, % - - Total 28, % 25, % 28, % 27, % 8

9 5: Strong support from government to improve air quality Decentralization of project approval to drive installation growth In mid-2013 the NEA decentralized project approval rights back to local government, to simplify procedures to boost the installation of renewable energy. We believe this is an important move given that local governments will have higher autonomy on wind power development, which will help drive faster installation. Premier declaring war against pollution suggest strong commitment to boost renewable energy In the NPC and CPPCC annual session in March, Premier Li Keqiang s statement to declare war against pollution suggested a strong signal by the government that it will continue to crack down on the sources of pollution and boost the use of renewable energy. In the meeting of the State Energy Commission held in April, Li said China would continue to boost the installation of renewable energy, including wind power. CHSTE is a major beneficiary of accelerating wind installation As the largest wind turbine gearbox manufacturer in China with an average market share of ~55% over the past few years, CHSTE has established a dominant position in the domestic market. While CHSTE had suffered from the installation slowdown over the past two years, we believe the worst is over and we expect new installation growth cycle starting 2014E will drive CHSTE sales volume. We forecast demand for geared WTG to reach 14GW in China this year. This is after excluding 30% of direct drive WTG out of the total demand of 20GW. We are using this 14GW to derive the gearbox demand. We expect CHSTE to maintain 50% market share, which suggests 7GW sales volume (figure 11) 9

10 Figure 11: Production volume of wind turbine generator (WTG) and implied gearbox demand E 2015E WTG production volume (MW) Sinovel ,403 3,495 4,386 2,939 1, Goldwind ,132 2,722 3,735 3,600 2,522 3, Dongfang Electric ,053 2,036 2, Mingyang ,050 1,178 1,134 1, XEMC , Guodian United Power ,643 2,847 2,029 1, Vestas Shanghai Electric , Gamesa China Creative Wind Energy CSIC (Chongqing) Haizhuang Windpower Equipme CSR Envision Energy , GE Suzlon Huayi Wind Energy Development Yinxing Energy China Windey Sany Changxing Wind Power Beizhong CASC-Acciona New Unite REpower Nordex Others , Total 1,337 3,304 6,247 13,803 18,928 17,631 12,960 16,089 20,000 22,000 Geared WTG 892 2,466 4,995 10,627 14,686 13,318 9,546 11,286 14,000 15,400 Direct drive WTG ,252 3,176 4,242 4,313 3,415 4,802 6,000 6,600 Percentage of geared WTG 66.7% 74.6% 80.0% 77.0% 77.6% 75.5% 73.7% 70.2% 70.0% 70.0% CHSTE gearbox sales volume (domestic) 502 1,314 2,729 5,850 8,713 6,978 4,673 5,632 7,093 8,326 Market share of CHSTE 56.3% 53.3% 54.6% 55.0% 59.3% 52.4% 49.0% 49.9% 50.7% 54.1% Market share of WTG makers Sinovel 5.6% 20.6% 22.5% 25.3% 23.2% 16.7% 9.3% 5.6% - - Goldwind 33.3% 25.1% 18.1% 19.7% 19.7% 20.4% 19.5% 23.3% - - Dongfang Electric 0.7% 6.7% 16.9% 14.7% 13.9% 5.4% 3.6% 3.6% - - Mingyang 0.0% 0.0% 2.8% 5.4% 5.5% 6.7% 8.7% 8.0% - - XEMC 0.0% 0.2% 1.9% 3.3% 2.7% 4.0% 6.9% 6.5% - - United Power 0.0% 0.0% 0.0% 5.6% 8.7% 16.1% 15.7% 9.2% - - Vestas 23.6% 11.2% 9.6% 4.4% 4.7% 3.8% 3.2% 3.2% - - Shanghai Electric 0.0% 0.7% 2.9% 2.0% 3.2% 4.0% 6.3% 6.3% - - Gamesa 15.9% 17.0% 8.1% 2.0% 3.1% 2.1% 3.8% 1.6% - - China Creative Wind Energy 0.0% 0.1% 0.0% 1.2% 2.6% 3.5% 2.0% 2.9% - - CSIC (Chongqing) Haizhuang Windpower Equipme 0.0% 0.1% 0.0% 0.6% 2.0% 2.2% 3.1% 4.9% - - CSR 0.0% 0.0% 0.0% 0.9% 1.8% 2.6% 3.0% 2.1% - - Envision Energy 0.0% 0.0% 0.0% 1.0% 1.3% 2.0% 4.2% 7.0% - - GE 12.7% 6.4% 2.3% 2.3% 1.1% 2.3% 0.5% 1.1% - - Suzlon 0.9% 6.2% 2.1% 2.1% 1.1% 0.5% 0.0% 0.0% - - Huayi Wind Energy Development 0.0% 0.0% 0.0% 0.9% 0.9% 0.9% 0.9% 2.0% - - Yinxing Energy 0.0% 0.0% 0.0% 0.0% 0.8% 1.3% 0.0% 0.0% - - China Windey 0.0% 2.0% 3.7% 1.9% 0.7% 2.1% 2.8% 3.3% - - Sany 0.0% 0.0% 0.0% 0.3% 0.6% 1.0% 2.1% 1.4% - - Changxing Wind Power 0.0% 0.0% 0.0% 0.4% 0.5% 0.0% 0.0% 0.0% - - Beizhong 0.0% 0.0% 1.0% 1.0% 0.0% 0.0% 0.0% 0.0% - - CASC-Acciona 3.7% 1.5% 2.4% 0.0% 0.0% 0.0% 0.0% 0.0% - - New Unite 0.0% 0.3% 1.2% 0.4% 0.2% 0.0% 0.0% 0.0% - - REpower 0.0% 0.1% 0.0% 1.4% 0.0% 0.0% 0.0% 0.0% - - Nordex 2.0% 1.7% 2.3% 0.8% 0.5% 0.3% 0.0% 0.0% - - Others 1.6% 0.0% 2.3% 2.3% 1.4% 2.1% 4.5% 8.0% - - Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% - - Sources: CWEA, company, CGIHK Research estimates Note 1: The direct drive WTG makers include Goldwind and XEMC. Note 2: Some of the historical sales figures of CHSTE are based on estimates. 10

11 Overseas: CHSTE to benefit from the recovery of wind installation in the US helped by the removal of policy risk General Electric [GE] is CHSTE s largest customer. After close to 10 years of cooperation, CHSTE has become one of GE s major suppliers, exporting wind gearboxes to the US. In 2013 the US wind power industry reported a 92% decline in new installation from 13GW in 2012 to 1.1GW. This was due to the last-minute extension (for one year) of the federal production tax credit (PTC) on Jan 2, 2013 (Note: The federal renewable electricity PTC is a per-kilowatt-hour tax credit for electricity generated by qualified energy resources and sold by the taxpayer to an unrelated person during the taxable year). As a result of this, the supply chain slowed during the months preceding the potential tax credit expiration. In April this year, a two-year extension of the US production tax credit (PTC) for wind power installation was confirmed. The extension implies that wind farm developers will continue to enjoy US$2.3 cents/kwh rebate for the first ten years of operation. We believe the removal of policy uncertainty will boost wind power installation in the US. According to the American Wind Energy Association (AWEA), by end there were 100 projects, totaling 12GW, under construction. We believe this suggests more opportunities for CHSTE over the coming two years. Figure 12: Wind power installation in the US 9, % 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1, % -6% 19% -20% 0% -42% -58% 107% 79% 48% 4% -82% 143% 52% 52% 15% -88% -100% -96% -100% 150% 100% 50% 0% -50% -100% -150% US Quarterly Wind Capacity Addition (MW) Change (YoY) Sources: AWEA, CGIHK Research 11

12 CHSTE earnings to be driven by volume growth; margin recovery; and finance expense reduction We project recurring earnings for CHSTE at RMB553m/RMB717m in 2014E/2015E, 30%+ above Bloomberg consensus. We believe the market has underestimated volume and margin recovery. We estimate wind gearbox sales volume to increase to 9.5/10.8GW (+30%/ +14% YoY) in 2014E/2015E from 7.3GW in Strong recovery in 2H13 results. According to data provided by CHSTE, we estimate total wind gearbox sales volume in 2013 to have reached 7.3GW (+10% YoY). This implies sales volume of 4.2GW in 2H13, up 45% YoY, suggesting strong recovery in 2H13. We expect CHSTE s domestic sales to rebound to 7GW/8.3GW in 2014E/2015E from 5.6GW (estimate) in We are applying a top-down approach to achieve our estimates: For 2014E, assuming 20GW of new installation in China, excluding ~30% of direct driver volume and assuming 50% market share for CHSTE, we estimate sales volume to reach 7GW. Strong GE orders; +40% YoY to reach historical high. Orders from GE have been picking up, with volume increasing by 40% YoY this year, and becoming the key growth driver. We forecast sales volume (in terms of MW) to account for 25% of total wind gearbox shipments this year. We expect strong sales growth to be maintained, driven by strong demand in the US market and potential orders for new model (GE announced its 2.75MW WTG model in March this year). Started supplying its 2.75MW model to Alstom SA in While we estimate this will contribute only ~RMB100m in 2014E, we see further upside potential for CHSTE s export market over the coming years. We expect wind power revenue (including wind gearbox, pitch, yaw motor and drive) to grow 24%/11% in 2014/2015E, largely driven by sales volume growth. We expect ASP to remain stable, given that the pricing of wind turbines has already bottomed out, easing pricing on gearboxes. For the marine segment, CHSTE reported RMB341m revenue in 2013 (+36% YoY), the highest level since With 50% order growth according to management, we expect the marine segment to see further growth in 2014E/2015E. We see LED business as a potential new growth driver over the coming few years. CHSTE s LED sapphire capacity (4-inch panel) is the largest in China. Order backlog for 2014E has been fully filled, according to management. The monthly production capacity is currently 500,000 pieces, and is expected to reach 800,000 pieces by June We have not yet modeled this in our earnings estimates but expect potential upside if the business materializes. 12

13 We expect gross margin improvement from reduced write-offs; higher utilization; stabilized ASP. Average gross margin improved to 24.9% in 2013 from 24.4% in Wind gear gross margin expanded 2.6ppt YoY to 29.4%, the highest since 2010, helped by higher utilization rate and low raw material cost. Notably, CHSTE wrote off RMB223m of inventory in Adding back this one-off item to gross profit, gross margin for the full year would be ~28%, much higher than the reported figure. We understand that the write off in 2013 was due to the delivery deferral of some finished products (1.5MW model) originally scheduled for Sinovel. However, we believe these products could be delivered to other customers in future. As such, we do not expect CHSTE to report such a huge write off in 2014E. It is also possible that the some or all of the inventory write-off in 2013 could be recovered. We expect the overall utilization rate to increase to 79%/90% in 2014E/2015E from 61% in Also, we expect the gearbox ASP to stabilize while raw materials and component costs should remain stable. We expect average gross margin to expand more than 2ppt to ~27% in 2014E, driven by wind power margin expansion. Figure 13: Key operating assumptions E 2015E Capacity (MW) Wind gear transmission equipment 1,300 3,500 6,300 9,000 12,000 12,000 12,000 12,000 12,000 Sales (MW) Wind gear transmission equipment 1,314 3,211 6,300 9,539 8,628 6,678 7,332 9,502 10,801 3MW ,050 2MW, 2.5MW gearbox ,174 1,038 1, ,982 5,000 6, , 1.3, 1.5 MW gearbox 677 2,187 4,628 8,385 7,343 5,687 4,899 3,750 3, kW gearbox Utilization rate 101.1% 91.7% 100.0% 106.0% 71.9% 55.7% 61.1% 79.2% 90.0% Sales volume (set) Wind gear transmission equipment 1,291 2,666 4,422 6,255 5,515 4,269 4,411 5,252 5,851 3MW MW, 2.5MW gearbox ,500 3, , 1.3, 1.5 MW gearbox 451 1,458 3,171 5,590 4,895 3,791 3,266 2,500 2, kW gearbox 834 1, Yaw Motor and Drive 4,545 9,678 7,822 11,646 14,349 15,181 16,289 16,500 17,000 Pitch 3,985 5,573 5,820 8,963 11,888 11,129 11,771 12,000 12,500 ASP (w ind) Wind gearbox average (RMB/MW) 458, , , , , , , , ,078 Change YoY -7.5% 5.5% 16.1% -6.8% -7.0% 2.7% -2.8% -0.8% -1.1% 3MW , , , , , ,000 2MW, 2.5MW 583, , , , , , , , , , 1.3, 1.5 MW 427, , , , , , , , , kW gearbox 490, , , , , ,662 1,104, , ,000 Yaw motor and drive (Rmb/unit) 18,922 20,975 25,569 31,599 30,913 32,280 28,214 27,000 26,500 Pitch (Rmb/unit) 7,277 7,716 10,997 10,376 10,431 11,008 9,849 10,000 10,000 Sources: Company, CGIHK Research estimates 13

14 Figure 14: Segment financials breakdown E 2015E Revenue (RMB m) Wind gear transmission equipment 717 1,801 3,805 5,458 4,770 3,952 4,140 5,147 5,728 3MW MW, 2.5MW gearbox ,425 2, , 1.3, 1.5 MW gearbox 289 1,031 2,557 4,372 3,563 2,853 2,422 1,819 1, kW gearbox Yaw Motor and Drive Pitch Marine gear transmission equipment Transmission equipment for high speed locomotives Gear transmission equipment for construction materials Gear transmission equipment for bar rolling, w ire rolling & plate-rolling mills General purpose gear transmission equipment High-speed heavy-load gear transmission equipment Computer numerical controlled (CNC) equipment Diesel engine products Others Total 1,905 3,439 5,647 7,393 7,121 6,369 6,539 7,935 8,721 Revenue growth 60.8% 80.6% 64.2% 30.9% -3.7% -10.6% 2.7% 21.4% 9.9% Gross profit (RMB m) Wind gear transmission equipment ,214 1,703 1,297 1,059 1,217 1,621 1,822 Marine gear transmission equipment Transmission equipment for high speed locomotives Gear transmission equipment for construction materials Gear transmission equipment for bar rolling, w ire rolling & plate-rolling mills General purpose gear transmission equipment High-speed heavy-load gear transmission equipment Computer numerical controlled (CNC) equipment Diesel engine products Others Total ,860 2,298 1,820 1,555 1,630 2,153 2,432 Gross profit growth 62.3% 79.4% 87.5% 23.5% -20.8% -14.6% 4.8% 32.1% 12.9% Gross margin Wind gear transmission equipment 27.5% 27.7% 31.9% 31.2% 27.2% 26.8% 29.4% 31.5% 31.8% Marine gear transmission equipment 22.1% 22.7% 29.7% 23.6% 23.8% 11.1% 10.7% 15.0% 16.0% Transmission equipment for high speed locomotives 0.0% 0.0% 38.9% 28.6% 29.4% 40.1% 33.2% 35.0% 35.0% Gear transmission equipment for construction materials 29.8% 30.7% 34.4% 33.5% 32.6% 33.0% 19.1% 19.0% 19.0% Gear transmission equipment for bar rolling, wire rolling & plate-rolling mills 34.4% 34.7% 33.5% 25.8% 5.3% 8.9% 8.6% 9.5% 9.5% General purpose gear transmission equipment 35.8% 36.7% 38.2% 42.7% 38.8% 37.3% 9.3% 11.0% 11.0% High-speed heavy-load gear transmission equipment 52.8% 52.9% 72.8% 65.4% 40.4% 37.8% 20.4% 22.0% 22.0% Computer numerical controlled (CNC) equipment 0.0% 0.0% 0.0% 23.0% 17.9% 22.2% 20.7% 21.0% 21.0% Diesel engine products 0.0% 0.0% 0.0% 0.0% 17.3% 15.1% 13.1% 15.0% 15.0% Others 22.4% 27.4% 39.4% 32.5% 17.2% 20.8% 23.6% 25.0% 28.0% Average 29.0% 28.8% 32.9% 31.1% 25.5% 24.4% 24.9% 27.1% 27.9% Sources: Company, CGIHK Research estimates 14

15 Figure 15: Gross profit breakdown (RMB m) 3,000 2,500 2,000 1,500 1, E 2015E Others Diesel engine products Computer numerical controlled (CNC) equipment High-speed heavy-load gear transmission equipment General purpose gear transmission equipment Gear transmission equipment for bar rolling, wire rolling & plate-rolling mills Gear transmission equipment for construction materials Transmission equipment for high speed locomotives Marine gear transmission equipment Wind gear transmission equipment Sources: Company, CGIHK Research estimates Reducing net debt to equity to drive down finance expense In Dec 2013 CHSTE completed the issuance of new shares (272.5m), raising net proceeds of RMB856m. This helped reduce net debt/equity to 54% by end from 57% in We expect the gearing ratio to further reduce to ~46% by end-2014 and ~36% by end-2015e, as management has indicated that the investment cycle peaked last year, with capex this year of only RMB500m (down from ~RMB890m in 2013). We project this will help reduce finance expenses starting this year, after reaching historical high in 2013 (RMB564m). Figure 16: CHSTE s bond issuance history. The interest rate dropped for the first time in April. Date Priincipal amt Interest rate Maturity Entity Type (RMB m) (%) Mar Mar-13 Nanjing High Speed Gear Manufacturing Unsecured commercial paper Feb Feb-14 Nanjing High Speed Gear Manufacturing Unsecured commercial paper May May-18 Nanjing High Accurate Drive Unsecured medium term note Sep Sep-15 Nanjing High Accurate Drive Unsecured bond Jan Jan-15 Nanjing High Speed Gear Manufacturing Unsecured commercial paper Apr Apr-19 Nanjing High Accurate Drive Unsecured medium term note Sources: Company, CGIHK Research 15

16 Earnings in 2013 distorted by exceptional loss While CHSTE s 2013 reported net profit declined 53% to RMB65m, net profit in 2H13 actually jumped 268% YoY to RMB354m, driven by 18% YoY increase in revenue (including 44% YoY surge in wind gear equipment revenue), 2.2ppt YoY expansion in gross margin to 28.2%, as well as 3x increase in other income (largely government grants). CHSTE incurred a few impairment items in 2013, including a charge of RMB140m in 2013 on receivables due to delayed payment by customers, a charge of RMB53m on a JV company, Jiangsu Hongsheng Heavy Industries (a forged steel manufacturer), write-off of RMB223m on inventories (as discussed earlier) and a charge of RMB36m on intangibles. The charge on receivables was largely due to SInovel. We understand that the outstanding balance due from Sinovel was ~RMB400m, accounting for ~6% of total receivables as of end While CHSTE has consistently reported impairment over the past few years and the total impairment loss amount was huge in 2013 (total: RMB452m), we expect this item to decline starting 2014E when the business operation improves. Figure 17: Exceptional items breakdown 2008A 2009A 2010A 2011A 2012A 2013A Exceptional gains/(losses) 242 (168) 76 (250) (118) (413) Impairment loss on goodw ill/intangible assets 0 (1) (3) (10) (3) (36) Impairment loss on trade and other receivables (2) (15) (23) (113) (86) (141) Impairment loss on JV (53) Gain on disposal of available-for-sale investments (0) 0 39 Write dow n on inventories (0) (20) (10) (38) (29) (223) Fair value change on CB 631 (438) 149 (34) 0 0 Fair value change on derivatives (386) 299 (38) (54) 0 0 Sources: Company, CGIHK Research estimates Receivables risk under control. While trade receivables increased by 34% YoY in 2013 (versus 3% YoY increase in revenue), management said cash collection was making good progress in Q1 14, with cash collected faster than revenue generated. 16

17 Nanjing High Accurate s strong Q1 14 confirms the recovery story Nanjing High Accurate Drive Equipment Manufacturing Group, CHSTE s key operating subsidiary, reported impressive revenue growth of 40% YoY to RMB1.4bn in Q1 14 (PRC GAAP). The net loss in Q1 14 sharply narrowed by 58% YoY to RMB53m (Note: Q1 is a traditional low season). Figure 18: Quarterly results of Nanjing High Accurate (PRC GAAP) Key financials (PRC GAAP) Q12 2Q12 3Q12 4Q Q13 2Q13 3Q13 4Q Q14 Chg YoY (RMB m) Revenue 8,514 1,535 2,182 1,974 1,238 6,929 1,033 2,184 1,868 2,155 7,240 1,446 40% COGS (6,261) (1,147) (1,637) (1,496) (933) (5,215) (862) (1,676) (1,403) (1,411) (5,352) (1,171) 36% Gross profit 2, , , % Operating expenses (1,100) (259) (197) (361) (112) (928) (224) (288) (316) (337) (1,165) (245) 9% EBIT 1, (54) n/a Finance expenses (293) (140) (102) (98) (83) (422) (142) (124) (72) (166) (504) (105) -27% Pretax profit/(loss) 860 (12) (196) (75) -62% Income tax (163) (13) (61) (17) 6 (85) 20 (13) 50 (172) (115) (4) n/a After tax profit/(loss) 697 (24) (176) (79) -55% MI (59) 14 (20) 29 (3) % Net profit/(loss) 638 (11) (127) (53) -58% Margin chg ppt Gross margin 26.5% 25.2% 25.0% 24.2% 24.6% 24.7% 16.5% 23.3% 24.9% 34.5% 26.1% 19.0% 2.5 EBIT margin 13.5% 8.4% 16.0% 5.9% 15.6% 11.3% -5.2% 10.1% 8.0% 18.9% 10.0% 2.0% 7.3 Pretax profit margin 10.1% -0.8% 11.3% 0.9% 8.9% 5.2% -19.0% 4.5% 4.1% 11.2% 3.0% -5.2% 13.8 After tax profit margin 8.2% -1.6% 8.5% 0.1% 9.4% 4.0% -17.1% 3.9% 6.8% 3.2% 1.4% -5.5% 11.6 Net margin 7.5% -0.7% 7.6% 1.5% 9.2% 4.3% -12.3% 5.3% 7.6% 3.3% 2.8% -3.7% 8.6 Sources: Company, CGIHK Research Wind gear segment strongly recovered in Q1 14 Wind gear segment revenue surged 166% YoY in Q1 14, according to Nanjing High Speed Gear Manufacturing (subsidiary of Nanjing High Accurate). Reported net profit improved to RMB65m, versus a loss of RMB62m in Q1 13. This further confirms CHSTE s turnaround story. Figure 19: Quarterly results of Nanjing High Speed Gear Manufacturing (PRC GAAP) Key financials (PRC GAAP) Q12 2Q12 3Q12 4Q Q13 2Q13 3Q13 4Q Q14 Chg YoY (RMB m) Revenue 4, ,456 1, , ,613 1,132 1,144 4,272 1, % COGS (3,394) (647) (999) (889) (344) (2,879) (293) (1,148) (798) (576) (2,815) (796) 171% Gross profit 1, , , % Operating expenses (966) (106) (99) (150) 10 (346) (58) (113) (142) (193) (506) (101) 76% EBIT % Finance expenses 226 (112) (68) (67) (78) (325) (94) (78) (47) (88) (307) (50) -47% Pretax profit/(loss) (62) n/a Income tax (136) (12) (49) (19) 6 (75) 0 (47) 24 (92) (115) (7) n/a After tax profit/(loss) (62) n/a MI n/a Net profit/(loss) (62) n/a Margin chg ppt Gross margin 31.7% 30.5% 31.4% 29.9% 29.4% 30.5% 23.3% 28.9% 29.5% 49.6% 34.1% 21.9% (1.4) EBIT margin 12.3% 19.1% 24.6% 18.0% 31.4% 22.1% 8.3% 21.9% 16.9% 32.8% 22.3% 12.0% 3.7 Pretax profit margin 16.8% 7.1% 19.9% 12.7% 15.3% 14.3% -16.3% 17.1% 12.8% 25.1% 15.1% 7.1% 23.4 After tax profit margin 14.1% 5.8% 16.5% 11.2% 16.5% 12.5% -16.3% 14.2% 15.0% 17.0% 12.4% 6.4% 22.7 Net margin 14.1% 5.8% 16.5% 11.2% 16.5% 12.5% -16.3% 14.2% 15.0% 17.0% 12.4% 6.4% 22.7 Sources: Company, CGIHK Research 17

18 Earnings Projection Income Statement (Year end 31 Dec) (RMB m, except for per share data) 2008A 2009A 2010A 2011A 2012A 2013A 2014E 2015E Revenue 3,439 5,647 7,393 7,121 6,369 6,539 7,935 8,721 COGS (2,447) (3,786) (5,180) (5,302) (4,815) (4,908) (5,782) (6,289) Gross profit 992 1,861 2,213 1,819 1,553 1,631 2,153 2,432 Other income/(expenses) Distribution and selling exp (107) (139) (200) (254) (279) (281) (349) (384) Administrative exp (284) (318) (460) (527) (502) (613) (635) (680) Research and development cost (55) (70) (50) (83) (138) (139) (159) (174) EBIT 572 1,390 1,645 1, ,155 1,316 D&A EBITDA 732 1,606 2,014 1,618 1,335 1,332 1,831 2,018 Other non recurring gain/(loss) 212 (140) 111 (70) (2) Shares of results of Associates/JCE (27) (62) Finance costs (29) (100) (147) (323) (524) (564) (550) (480) Pretax profit 764 1,166 1, Taxation (72) (200) (257) (147) (79) (57) (62) (127) After tax profit , Minority interests (0) 1 (10) (4) (5) Net profit , EPS (RMB/shr) Recurring net profit 450 1,134 1, Recurring EPS (RMB) Dividend DPS (RMB) Growth rates 2008A 2009A 2010A 2011A 2012A 2013A 2014E 2015E Revenue 80.6% 64.2% 30.9% -3.7% -10.6% 2.7% 21.4% 9.9% Gross profit 79.4% 87.6% 18.9% -17.8% -14.6% 5.0% 32.0% 12.9% EBITDA 121.5% 119.3% 25.4% -19.7% -17.5% -0.2% 37.5% 10.2% EBIT 140.8% 143.2% 18.3% -35.4% -28.4% -7.9% 64.8% 13.9% Net profit 125.8% 39.6% 43.3% -59.8% -75.1% -53.4% 756.4% 29.6% Recurring net profit 43.2% 152.0% 15.4% -38.3% -68.2% 86.3% 15.8% 29.6% EPS 93.3% 39.6% 39.2% -62.3% -75.1% -53.7% 618.8% 29.6% Recurring EPS 22.6% 152.0% 12.1% -42.2% -68.1% 85.0% -2.8% 29.6% M argins 2008A 2009A 2010A 2011A 2012A 2013A 2014E 2015E Gross margin 28.8% 33.0% 29.9% 25.5% 24.4% 24.9% 27.1% 27.9% EBITDA margin 21.3% 28.4% 27.2% 22.7% 21.0% 20.4% 23.1% 23.1% EBIT margin 16.6% 24.6% 22.2% 14.9% 12.0% 10.7% 14.6% 15.1% Net margin 20.1% 17.1% 18.7% 7.8% 2.2% 1.0% 7.0% 8.2% Recurring net margin 13.1% 20.1% 17.7% 11.3% 4.0% 7.3% 7.0% 8.2% Sources: Company, CGIHK Research estimates 18

19 Balance Sheet (As of Dec) (RMB m, except for per share data) 2008A 2009A 2010A 2011A 2012A 2013A 2014E 2015E Non current assets PP&E 2,362 3,845 4,870 5,589 6,238 6,633 6,533 6,206 Interest in associates/jv Others ,239 1,721 2,035 2,059 1,984 1,909 3,617 5,198 6,789 8,148 9,069 9,337 9,175 8,787 Current assets Inventories 1,336 1,313 1,258 1,799 1,781 2,390 2,521 2,821 Trade and other receivables 1,294 2,613 3,811 4,938 4,668 6,238 6,372 7,248 Pledged disposal & restricted cash 1, ,253 1,898 2,515 2,515 2,515 Cash ,124 2,175 2,405 2,235 1,138 1,019 Others ,861 5,037 8,142 10,253 10,813 13,633 12,801 13,858 Total assets 8,478 10,235 14,932 18,401 19,882 22,971 21,976 22,645 Current liabilities Trade and other payables 2,049 1,566 2,613 2,826 2,945 3,986 3,934 4,681 Bank borrow ings 1,292 1,556 1,209 4,991 7,449 7,109 5,659 4,909 Others , ,395 3,288 5,226 7,998 10,645 11,509 10,007 10,004 Non current liabilities Bank borrow ings 68 1,012 2,043 2,627 1,288 2,338 2,288 2,238 CB 932 1, Deferred income Others ,348 2,496 2,191 2,781 1,493 2,700 2,650 2,600 Equity Share capital Reserves 3,636 4,326 7,289 7,370 7,437 8,395 8,948 9,665 3,731 4,421 7,393 7,473 7,539 8,514 9,067 9,784 Minority interests ,735 4,450 7,514 7,622 7,745 8,762 9,319 10,041 Total equity and liabilities 8,478 10,235 14,932 18,401 19,882 22,971 21,976 22,645 BVPS (RMB/shr) Sources: Company, CGIHK Research estimates 19

20 Cash Flow Statement (Year end 31 Dec) (RMB m, except for per share data) 2008A 2009A 2010A 2011A 2012A 2013A 2014E 2015E Pretax profit 764 1,166 1, D&A Tax (20) (107) (200) (287) (153) (91) (62) (127) Interest expenses/(income) (15) Shares of results of JV/associates (10) (16) (41) (26) (13) (13) Change in w orking capital (556) (1,784) (185) (1,588) 319 (1,509) (317) (429) Other non cash item (176) 169 (76) Operating cash flow 149 (282) 1,634 (118) 1,542 (7) 1,408 1,438 PP&E (944) (1,499) (1,082) (1,002) (1,037) (883) (500) (300) Investment/(disposal) in JV/Associate (561) 0 (44) (157) (9) Interest received Others (1,708) 698 (937) (1,086) (963) (840) 0 0 Investing cash flow (3,169) (775) (2,031) (2,174) (1,923) (1,602) (455) (277) Issue/(repurchase) of CB 1, (1,254) Issue/(repurchase) of shares 0 0 1, Net borrow ing 867 1, ,342 1, (1,500) (800) Dividend paid (88) (274) (327) (375) Interest paid (29) (100) (147) (389) (568) (611) (550) (480) Others (35) Financing cash flow 2, ,050 2, ,439 (2,050) (1,280) Net change in cash (835) (210) 1, (169) (1,097) (119) Ratios Valuation PER (recurring earnings) Dividend yield 4.6% 5.6% 6.4% 0.0% 0.0% 0.0% 0.0% 0.0% PBR EV/EBITDA Operational Recurring net margin 13.1% 20.1% 17.7% 11.3% 4.0% 7.3% 7.0% 8.2% Asset Turnover Asset / Equity Adjusted ROAE 13.2% 27.8% 22.2% 10.9% 3.4% 6.0% 6.3% 7.6% Adjusted ROAA 6.8% 12.1% 10.4% 4.8% 1.3% 2.2% 2.5% 3.2% Sources: Adjusted Company, ROIC CGIHK Research estimates 9.4% 15.8% 13.8% 6.3% 1.6% 2.8% 3.2% 4.2% Interest coverage Net debt / Equity 3.4% 64.3% 2.9% 55.0% 57.3% 53.6% 46.1% 36.0% Current ratio Quick ratio Days receivables Days payables Days inventories Sources: Company, CGIHK Research estimates 20

21 Appendix Major risk factors: Technology shift. CHSTE's outlook could be negatively affected by technological breakthroughs in other types of substitutable systems. For instance, the increasing cost efficiency and reliability of direct drive systems may create uncertainty in the demand for gearboxes. Policy risk. We expect the Chinese government to continue the favorable policies to encourage the sector growth. However, any change in policy could affect the demand for gearboxes. Increase in raw materials costs. While CHSTE has been quite successful in passing through the raw material costs to customers, an unexpected intensification of competition may result in the failure of its cost-plus pricing model. New business risk. CHSTE has no track record on the development of coal mining equipment and LED business. Potential failure of these new businesses will erode the overall earnings. Company background Founded in 1969, China High Speed Transmission Equipment Group (CHSTE) is the largest wind gearbox manufacturer in China (2013 capacity: 12GW). It also engages in the manufacture of other traditional mechanical transmission equipment. HU Yueming (Chairman) and other management team members currently own 21.29% of the company. Figure 20: Shareholding structure Fortune Apex 21% Others 55% Ji Changqun 16% Capital Group 8% Sources: HKEx 21

22 Selected management team members HU Yueming, 64, the chairman, chief executive officer and executive director. HU is a university graduate and was graduated from Fudan University majoring in laser technology in HU is a senior engineer, with more than 30 years of experience in the management of machinery and industrial enterprises and has served as the head of various state-owned enterprises such as Nanjing Engineering Equipment Factory and general manager of various foreign invested enterprises including Nanjing Atlas Copco Construction Machinery Ltd. In 1998, HU became the general manager of Nanjing High Speed Gear Factory. He has been the chairman and the general manager of Nanjing High Accurate Drive Equipment Manufacturing Group Co., Ltd. (NGC), the subsidiary of CHSTE, since March CHEN Yongdao, 51, executive director. CHEN obtained a bachelor s degree from Jiangsu Institute of Technology majoring in metal material and heat treatment in 1983 and a master s degree from Nanjing University of Science and Technology majoring in engineering in CHEN is a senior engineer. He served as the deputy head of the inspection and gauging section, head of the production allocation section of the factory and deputy general manager of Nanjing High Speed Gear Factory. He has been a director and deputy general manager of NGC since March LU Xun, 59, executive director. LU graduated from Nanjing Aeronautical Institute majoring in managerial engineering in He also attended and finished postgraduate courses. LU is a senior engineer. He worked as the deputy head of the quality assurance section, deputy head of the technology section, head of the operational planning section, deputy Chief Economist, head of the operational planning division and deputy general manager of Nanjing High Speed Gear Factory. He has been a director and deputy general manager of NGC since March

23 Gearbox is the "Heart" of Wind Turbines A gearbox is subjected to a wide range of conditions in which factors such as lubrication, loads, stresses, vibrations and temperatures continuously vary. The multiple wheels and bearings in a wind turbine gearbox suffer tremendous stress because of wind turbulence, and a small defect in any one component can bring the turbine to a halt. This makes the gearbox the most high-maintenance part of a turbine. We understand that the malfunction of the gearbox is one of the major reasons for the breakdowns in turbines. Replacing the gearbox is a timeconsuming and costly procedure (sometimes as high as 20% of the total value of the equipment). As a result, most WTG manufacturers would rather procure gearboxes from quality suppliers. WTG manufacturers would even take years to observe the suppliers' performance before making a formal purchase from them. This effectively creates a higher entry barrier to newcomers, making the gearbox sector a less competitive market compared with other equipment. Figure 21: Component breakdown of a wind turbine Sources: World Wind Energy Association 23

24 Figure 22: CHSTE customer portfolio Sources: Company, CGIHK Research Figure 23: Production cost breakdown Direct labour cost 6% Power fee 2% Cast iron and forged steel 18% Manufacturing fee 19% Subcontracting & processing 10% Other raw materials (including bearing and steel plates) 45% Sources: Company, CGIHK Research 24

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Explanation on Equity Ratings BUY SELL HOLD : : share price will increase by >20% within 12 months in absolute terms share price will decrease by >20% within 12 months in absolute terms : no clear catalyst, and downgraded from BUY pending clearer signal to reinstate BUY or further downgrade to outright SELL Copyright Reserved No part of this material may be reproduced or redistributed without the prior written consent of China Galaxy International Securities (Hong Kong) Co., Limited. China Galaxy International Securities (Hong Kong) Co. Limited, CE No.AXM459 Room , 35/F, Cosco Tower, Grand Millennium Plaza, 183 Queen s Road Central, Sheung Wan, Hong Kong. General line: