A Unique Oversea Platform of China Aerospace & Defense Sector, Initiate with Accumulate

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1 : AviChina (02357 HK) Angus Chan 陈庆 公司报告 : 中航科工 (02357 HK) angus.chan@gtjas.com.hk A Unique Oversea latform of China Aerospace & Defense Sector, Initiate with Accumulate 中国航空航天和国防领域的独特海外平台, 首次给予 收集 评级 We initiate AviChina with an Accumulate rating. AviChina is the largest producer of helicopter and trainer and a leading general aircraft producer in China, backed by its parent, AVIC, which has dominant position in China Aviation industry (both civil aircraft and military aircraft); almost all types of aircrafts made in China are made by AVIC. Rating: 评级 : Accumulate Initial 收集 ( 首次研究 ) 6-18m T 目标价 : HK$13.50 GTJA Research 国泰君安研究 We expect the Company to record a CAGR of 21.5% revenue growth in FY14-17F period and we believe the revenue growth in helicopter and aero systems & equipments will be the key growth driver. We forecast net profit to record a CAGR of 22.6% in FY14-17F. AviChina s share price is largely discounted to A-Share market value of its four subsidiaries. Our target price of HK$13.50 translates into an implied FY15F ER of 59.6x. AviChina s share price is trading at 46.1% discount to our SOT valuation. Moreover, AviChina s FY15F ER is trading at 74.0% discount to A-share peers and 166.6% premium to global peers. We believe the premium is mainly due to 1) rich cash position;2) potential assets injections;3) faster growth of aircraft market in China and 4) mutual market access between Hong Kong and A-Share market. Share price 股价 : Stock performance 股价表现 % of return HK$ 我们首次覆盖中航科工并给予 收集 的投资评级 中航科工是中国直升机和教练机的最大的生产商和领先的通用飞机制造商, 其母公司, 中航工业集团在中国航空无论是在民用飞机和军用飞机制造工业都具有主导地位 ; 几乎所有类型在中国制造的飞机都是由中国航空工业集团公司生产 在 FY14-17F 期间, 我们预计公司收入将录得 21.5% 的复合年增长率, 我们相信在直升机和航空系统及设备的收入增长将成为主要增长动力的收入增长将成为主要增长动力 我们预测 FY14-17F 净利润复合年增长率为 22.6% 中航科工的股价大幅折让折让于其四家子公司的 A 股市场价值市场价值 我们的目标价 港元对应 59.6 倍 FY15F 市盈率 目前中航科工的股价 46.1% 折让于我们的分类加总估值法的估值 此外, 中航科工的 FY15F 市盈率目前较 A 股同业有 74.0% 的折让, 而较全球同业有 166.6% 的溢价 我们相信, 溢价主要是由于 1) 丰富的现金状况 ;2) 潜在资产注入 ;3) 中国较快增长飞机市场和 4) 香港和 A 股市场之间的互通 (20.0) May-13 Aug-13 Nov-13 Feb-14 May-14 Change in Share rice 股价变动 HSI AviChina 1 M 1 个月 3 M 3 个月 1 Y 1 年 Abs. % 绝对变动 % Rel. % to HS index 相对恒指变动 % Avg. share price(hk$) 平均股价 ( 港元 ) Source: Bloomberg, Guotai Junan International. Year End 年结 Turnover 收入 Net rofit 股东净利 ES 每股净利 ES 每股净利变动 ER 市盈率 BS 每股净资产 BR 市净率 DS 每股股息 Yield 股息率 ROE 净资产收益率 12/31 (RMB m) (RMB m) (RMB) ( %) (x) (RMB) (x) (RMB) (%) (%) FY13A 22, FY14A 25, FY15F 31, FY16F 38,026 1, FY17F 46,131 1, Shares in issue (m) 总股数 (m) 5,574.4 Major shareholder 大股东 AVIC 54.6% Market cap. (HK$ m) 市值 (HK$ m) 55,620.2 Free float (%) 自由流通比率 (%) month average vol. 3 个月平均成交股数 ( 000) 29,630.6 FY15 Net gearing (%) 15 年净负债 / 股东资金 (%) Net cash 52 Weeks high/low (HK$) 52 周高 / 低 / SOT (HK$) 分类加总估值法 (HK$) 18.9 Source: the Company, Guotai Junan International. See the last page for disclaimer age 1 of 21

2 Table of Content Company Background... 3 Opening Low-altitude Airspace... 4 Civil Market Opportunity for Commercial Aircraft... 7 China Defense Spending Uptrend Boost Aero Systems & Equipments Demand otential Assets Injections from AVIC Financial Analysis & Earnings Forecasts Valuation Investment Risks See the last page for disclaimer age 2 of 21

3 Company Background An overseas platform of China s State-owned aerospace & defense company. AviChina was founded in China in 2003 and listed in Hong Kong in the same year. Its parent company used to be AVIC-II, owned by SASAC. In 2008, AVIC-I and AVIC II merged into AVIC (Aviation Industry Corporation of China). Currently, AviChina s largest shareholder is AVIC, with a stake of 54.6%. European Aeronautic Defence and Space Company (EADS), the parent of Airbus and Eurocotper, is a strategic shareholder with a 5.1% stake. Before mid-2008, AviChina mainly operated auto business while the Company has gradually restructured into an aviation product maker since AviChina has become the largest producer of helicopter and trainer and a leading general aircraft producer China, backed by its parent, AVIC which has dominant position in China aviation industry both in civil aircraft and military aircraft; almost all types of aircrafts made in China are made by AVIC. Through different assets injection and restructuring, AviChina has controlling holdings in four A-share listed aviation related companies, namely AVIC Helicopter (35.10% stake, CH), Hongdu Aviation (43.63%, CH), AVIC Avionics (43.22% stake, CH) and Jonhon Optronic (41.57%, CH). AviChina is also engaged in development and manufacture of aviation parts and components, avionics and electric connectors. Moreover, AviChina is also the only overseas listed company of AVIC which is operating aircraft related business. Figure-1: AviChina Organization Chart European Aeronautic Defenceand Space Company EADS N.V. AviChina Others 5.02% 54.61% 40.37% AviChinaIndustry & Technology Company Limited 41.57% 43.22% 43.63% 100% 100% 53.63% JONHON Optronic (SZ002179) AVIC Avionics (SH600372) Hongdu Aviation (SH600316) Harbin Aviation Group Tianjin Aviation CAMC Shenyang Xinghua 62.87% 100% 100% 100% 86.74% 100% 100% Xi an Forstar Qianshan Avionics Shaanxi Baocheng 58.18% 80% 100% Shaanxi Huayan Taiyuan Instrument Shanghai Aviation Electric 100% Lanzhou Aviation Electric AVIC Kaitian AVIC Lanfei Oriental Instrument 100% Keeven Instrument Changfeng Avionics 100% 6.45% 13.51% Airbus Composite Materials AVIC Helicopter (SH600038) 10% 28.65% Changfei arts and Components 100% 100% Jingdezhen Helicopter 100% 100% Helicopter Tianjin 24.50% 24.50% Changhe Aviation AVIC Huiyang Harbin Embraer 60% Changhe Agusta Source: the Company. See the last page for disclaimer age 3 of 21

4 Figure-2: AviChina Milestone Initial public offering in HK Exchange, issued 1,600mn shares at HK$1.21 per share, China Aviation Industry Corporation II (61.06%) 2003 Source: the Company. The central government merged China's two large aerospace entities, CVIC I and CVIC II, creating one business unit with ten aerospace subsidiary companies. The new company, which took the name AVIC and became the controlling shareholder of AviChina The company had mn H Shares placement at the lacing rice of HK$3.40 per H Share and raised bn the Company acquired from AVIC 86.74% equity interest in AVIC Kaitianfor RMB 581 mn and 100% equity interest in AVIC LANFEI RMB 327 mn HongduAviation had new A share placement amounting to RMB2,536 mn 2010 The Company disposed of 100% equity interest in Harbin Automobile Group to AVIC Automobile at the price of RMB 1 mn Completed the acquisition of aviation assets by Changhe Auto from AVIC and the disposal of automobile assets.issued Consideration Shares to AVIC The Company entered a joint venture with Harbin Aircraft Group, Airbus China, Hafei Aviation and Harbin Heliin producing component s for Airbus and contributed USD 15 mn. (10% of registered capital) 2011 Disposed all the equity interest (54.51% ) in DonganMotor to AVIC and acquired 43.34% JonhonOptronicfrom AVIC Subsidiary, HafeiAviation placed new A shares to AVIC Helicopter, AVIC Hafei, and raised RMB1,106 mn The company subscribed 44.6 mn A shares of ZEMIC for RMB mn, equal to 2.28% equity interest The company subscribed 18.6 mn shares of JonhonOptronic s new share placement. JO raised a total RMB807 mn Feb.2012,HK share placement: 342 mnh Shares at the lacing rice of HK$3.55 per lacing Share, raised bn The company issued 183 mnnew Domestic Shares to AMES for the acquisition of Tianjin Aviation for RMB768 mil. The company entered a joint venture with AVIC, AVIC Tongfeiand HebeiAviation Investment and formed HuabeiAircraft Capital Injection: the Company, AVIC Economy and Technology Institute and China Aviation News injected RMB 33 mninto CAMC JONHON OTRONIC injected capital into Shenyang Xinghuain an aggregate amount of RMB 235 mn AVIC Avionic, acquired 100% equity interest of Oriental Instrument for RMB176 mnfrom HanzhongAviation AVIC Avionics acquired 100% equity interest of KeevenInstrument and ChangfengAvionics for RMB 1.4 bnfrom AVIC AvonicsSystems Asset transfer to Hafei Aviation: 100% equity interest of Chang fei, Chang he, Huiyangand Tianjincorporations. AVIC Avionics accept the entrustment from AVIC on managing its equity interest in AVIC Avionics Systems, AviChina entitled for the full decision right on the manufacture and operation of AVIC Avionics Systems Figure-3: AviChina Revenue Breakdown in FY14 Aero systems & equipments 56.1% Helicopter 38.6% Source: the Company. Other entire aircraft 5.3% Opening Low-altitude Airspace Opening low-altitude airspace will boost general aircraft (GA) demand. In China, low-altitude airspace is mainly controlled by the military. China s Airspace Control Commission (CACC) issued Low-altitude Airspace Management Reform Guidance in 2010, the reform guides to progressively open low-altitude airspace of below 4,000m to the country s major aviation control areas by Currently, the experiment areas have been carried out in part of the flight control zone, including Shenyang, Guangzhou, Hainan, Changchun, Tangshan, Xian, Qingdao, Hangzhou, Ningbo, Kunming and Chongqing. Most of GA activities are taking place in below 4,000m, including oil services, forest protection, helicopter business flights, emergency rescue, fire fighting, sports, entertainment and seeding etc. We believe the full opening of low-altitude airspace will boost the demand of GA, especially helicopters and fixed-wing aircraft which are mostly use in low-altitude airspace. See the last page for disclaimer age 4 of 21

5 Given very low level of general aircraft ownership level in China, we expect substantial demand upside in coming years. In China, there were around 1,654 units of GA by 2013, much lower than other developed countries. In USA, there were around 220,000 units of GA in 2013, and the country s population was around 0.3 billion. China was lagging behind in terms of GA on a per-capita basis. In countries like USA, the developed GA sector has significantly contributed to its national GD and aviation-related employment opportunities. A healthy GA sector should offer important intangible benefits to the society, for example, enhanced transportation capabilities, improved rescue and emergency medical care missions, better agricultural, and better infrastructure development missions etc. At this moment, we see several factors constraining the GA growth in China, 1) regulatory restrictions; 2) restrictive air space and 3) poor infrastructure. We see opening up of low-altitude airspace to be the major catalyst to boost GA demand in coming years. Based on our forecast, the opening up of low-altitude airspace and loosening of controls on air routes could lift up ownership of GA to reach around 5,000 units by 2020, representing a CAGR of 17.7% in Moreover, the opening up of low-altitude airspace will also reduce the approval lead time of GA flights from seven working days to less than three days, and no prior approval is needed if flight plans are submitted earlier. Figure-4: Map on Opening Up of Low Altitude 500 km 300 mi Source: the Company. Guotai Junan International. See the last page for disclaimer age 5 of 21

6 Figure-5: Most General Aviation are Taken lace in the Low Altitude 3000 m Commercial airlines, business flights & aero-photography 1000 m Oil services, forest protection, helicopter business flights 500 m Emergency rescue, fire fighting, sports, entertainment, seeding Source: the Company. Guotai Junan International. Figure-6: Ownership Units of General Aircraft in China Unit 6,000 25% 5,000 20% 4,000 15% 3,000 10% 2,000 5% 1,000 Figure-7: Sales of New General Aircraft in China Unit % 120% 100% 80% 60% 40% 20% 0% -20% -40% F 0% F -60% Source: Development Report on China General Aviation 2013, Guotai Junan International. Source: Development Report on China General Aviation 2013, Guotai Junan International. See the last page for disclaimer age 6 of 21

7 Table-1: The Gap Between China's and Overseas General Aviation Sector China USA Canada Australia Brazil Area (thousand square kilometers) , opulation (Billion) Number of GA aircraft 1, ,000 31,018 11,117 10,310 GA aircraft in flight hours (Yearly) 600,000 26,000,000 4,500,000 1,695,000 1,500,000 Transport aviation aircraft and aircraft navigation proportion 1:0.67 1:32 1:61 1:34 1:24 Number of general aviation airports 70(Temporary landing point 329) 19,983 1, ,498 ilot 2, ,000 FBO Fixed Base Operator 4 3,500 Source: General Aviation Development Report AviChina is expected to benefit the most from growing GA demand. AviChina s parent, AVIC, is the largest aviation industry group in China. AVIC made almost all types of domestic-made aircraft both civil and military. Through different assets injections, AviChina is the major contractor in the GA sector. AviChina s helicopter business, which is accounting for around 40% of FY14F revenue, is expected to see notable growth after the opening up of low-altitude airspace. Its helicopter business will be benefit the most given their vertical takeoff and landing ability. Currently, over 90% of AviChina s helicopter orders come from government, and the gross margin is very low (below 10%). We think there is upside for its helicopter margin given that opening up of low-altitude airspace could boost demand from private sector, and the margin is higher for private sector. Compared with foreign leading GA producers, AviChina s GA offers similar quality and lower prices. Moreover, on the back of AVIC, AviChina can offer better maintenance services and strong support. Civil Market Opportunity for Commercial Aircraft Commercial aircraft market has huge upside in the long run. AviChina s aero systems and equipment business is likely to benefit from growing commercial aircraft market. The RC Government decided to enter the commercial aircraft market in 2008, and Commercial Aircraft Corporation of China (COMAC) was formed for this purpose. COMAC will build C919 commercial aircraft which is an around 170 seat narrow-body airliner and it will be the largest commercial airliner designed and built in China. The C919 commercial aircraft is China s long term goal to compete with Airbus and Boeing s duopoly, and the aircraft is intended to compete against narrow-body airliners like Airbus A320 and Boeing 737. As for long term plan, twin-engine C929 and C939 are proposed, offering seats. At the end of 2014, there were 430 outstanding C919 orders, mostly from the RC airlines and aircraft-leasing companies. The C919 s first flight is expected to take place in 2015, and first deliveries are scheduled for late AviChina is one of the major suppliers of C919 and we see growth of commercial aircraft is likely to continue over the next years. AVIC is the major shareholder of COMAC, therefore AVIC is a guaranteed supplier of C919. As one of the major subsidiaries of AVIC, AviChina will supply back sections, doors, lighting systems, cockpits, and E-E cabin equipment racks and etc to C919. The orders of C919 are believed to be high enough to ensure stable order growth for AviChina aero systems and equipment business. Moreover, AviChina could also benefit from solid growth of commercial aircraft in China. Boeing has projected that China will be the major growth driver of commercial aircraft given that passenger traffic is expected to increase 6.9% and air cargo traffic is expected to increase 6.7% annually over the next 20 years. The majority of the growth, around 65%, will be within China. About 16% of the growth will be international traffic to destinations with the Asia acific region. The remaining 19% will be long-haul international. Boeing estimates that China will need 6,020 new airplanes valued at USD870 billion. In our view, the growing demand of commercial aircrafts should offer huge opportunities for subcontracting activity for Chinese aircraft manufacturers from both Boeing and Airbus. China is one of the major subcontractors of aircraft parts (cabin door, tailpieces, wing ribs, access doors, flaps etc), we see AviChina is one of the major beneficiaries of growing demand of commercial aircraft given that its parent AVIC is the biggest Chinese state-owned aerospace and defense company. See the last page for disclaimer age 7 of 21

8 Figure-8: C919 roject A. AVIC Avionics: Air data and inertial reference B. Hongdu: Fwd fuselage, Mid-aft fuselage E. Jonhon. Optical and electrical connectors F. Hafei. Fuselage-to-wing fairing; Vertical stabilizer; Nose & Main landing gear door C. Changhe: Leading and trailing flap edge D. Tianjin. Fire detection system Source: the Company. Guotai Junan International. Table-2: C919 Orders C919 Order Order Number CDB Leasing 10 ICBC Leasing 45 Bank of Communications Financial Leasing 30 BOC Aviation 20 ABC Financial Leasing 45 China Aircraft Leasing 20 CCB Leasing 50 Industrial Bank Financial Leasing 20 CMB Financial Leasing 30 China Eastern Airlines 20 China Southern Airlines 20 Air China 20 Hainan Airlines 20 Hebei Airlines 20 Joy Air 20 GECAS (General Electric Capital Aviation Services) 20 Sichuan Airlines 20 Total 430 Source: AVIC. See the last page for disclaimer age 8 of 21

9 Table-3: Major Civil Aircraft in China Type Model Main Contractor Notes D/T/ Operate in rugged conditions Commercial MA60/MA600 Xi'an Aircraft Industrial Corporation with limited ground support and has short take-off and landing capability. Conventional configuration, with MA700 Xi'an Aircraft Industrial Corporation a non-swept tapered wing mounted high on the midfuselage D ARJ21 AVIC I Commercial Aircraft Company (ACAC) and Antonov Twin-engine regional jet T C919 Commercial Aircraft Corporation of China Narrow-body jet airliner, the largest commercial airliner designed and built in China D Helicopter AC310 AVIC Helicopter Company Civilian helicopter, an updated design based on the earlier Harbin Z-8 AC301 AVIC Helicopter Company Civilian helicopter, an updated design based on the earlier Z- 11 AC311 AVIC Helicopter Company Civilian helicopter, an updated design based on the earlier Z- 11 AC312 Harbin Aircraft Manufacturing Corporation Civilian helicopter, an updated design based on the earlier Z-9 Z-9/H425 HC120 Harbin Aircraft Manufacturing Corporation Harbin Aircraft Industry Corporation and Europe Helicopter Corporation Multirole, based on Z-9, currently most advanced civilian helicopter Same with Eurocopter EU120, 5 seat light helicopter Z-11 Changhe Aircraft Industries Corporation and China Helicopter Design and Research Institute Multirole helicopter based on French AS350 AC352 AVIC Helicopter Company Medium sized, currently most safe, comfortable, easy-driving premium civilian helicopter. T AC313 AVIC Helicopter Company Updated design based on Harbin Z-8 Source: AVIC, Guotai Junan International. Note: D=Development stage, T=Testing stage and =roduction stage. See the last page for disclaimer age 9 of 21

10 China Defense Spending Uptrend Boost Aero Systems & Equipments Demand China s defense spending has large room to grow, and defense spending as a percentage of GD is still lagging behind in terms of world average. China s official defense spending accounted for only around 1.3% of GD in 2014 (around 2.0% SII estimate), much lower than developed counties. USA s was around 3.9% and Russia s was around 3.5%, while the world average was around 2.9% in China announced a defense budget of USD141 million for 2015, an increase of 10.1% YoY. We believe the defense spending is likely to post double-digit increase in the next ten years given that the sovereignty disputes in the near seas which are the Yellow, East China and South China Seas. We see tensions between China and Japan in Diaoyu Island and East China Sea matters remain the major factor for China defense spending to continue to grow, with potential upside in the next ten years. Moreover, the maritime disputes with the hilippines and Vietnam concerns are growing. Against such backdrop, China is eager to flex its military muscle. It is true that AviChina does not produce military aircraft, but some of its aero systems & equipments products are ultimately supplied to military aircraft manufacturing. Tensions between Russia and other western countries could raise China s A&D related products export. We think the EU and USA clash with Russia regarding the Ukraine issue could ultimately benefit China. Russia ranked the third in terms of defense spending in the world, and a lot of parts and components are imported from other western countries. The tensions between Russia and other western countries could shift the purchase to China. Assuming that Russia is to look for alternative complex technological equipment and China is definitely its top choice. Figure-9: China Defense Spending & CAGR Growth RMB mn 3,500,000 3,000,000 Defense Spending % % 10-15F10.7% 15F-20F 15.2% 20F-25F 12.4% 2,500,000 2,000,000 1,500,000 1,000, , F 2018F 2020F 2022F 2024F Source: National Bureau of Statistics of China, Guotai Junan International. Figure-10: China Defense Spending, % of GD GD Defense Spending to GD Ratio SIRI Estimated Ratio RMB bn 70, % 60, % 8.0% 50, % 40, % 5.0% 30, % 20, % 2.0% 10, % 0 0.0% Source: National Bureau of Statistics of China, SIRI, Guotai Junan International. See the last page for disclaimer age 10 of 21

11 Figure-11: World Top 15 Defense Spending, % of GD Figure-12: World Top 15 Defense Spending 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% Average 2.9% U SD bn % 0 Saudi Arabia UAE USA Russia India Source: SIRI, Guotai Junan International. Note: China defense spending is based on SIRI estimation. Turkey France South Korea UK China Italy Australia Brazil Germany Japan USA China Russia Saudi Arabia France Source: SIRI, Guotai Junan International. Note: China defense spending is based on SIRI estimation. UK Germany Japan India South Korea Italy Brazil Australia Turkey UAE otential Assets Injections from AVIC Assets injections and restructuring is likely to continue in China s defense industry. China defense industry has been viewed as important opportunities for investment. The market believes asset injections and restructuring is likely to continue in the China s defense industry. China s top ten defense companies total assets were around RMB2,700 billion, and securitization rate was around 30% in AVIC ranked the first in terms of total assets of around RMB600 billion, with securitization rate of over 50% in AviChina s parent, AVIC, is the sole largest defense-aerospace group. The Group manufactures China s major fighters. Its major subsidiaries, namely Shenyang Aircraft (J-8, J-11, J15 and J-31 fighters), Changhe/AVIC Helicopter (Z-8, Z-9, Z-11 helicopters), Chengdu Aircraft Industry (J-10, J-20 fighters), Hongdu Aviation Industry (K-8, L-15 trainers and Xi an Aircraft (H-6, JH-7 bombers) are important assets in China s airspace and defense industry. We see opportunity that AVIC is to speed up asset injections and restructuring given that the recent events in China s defense industry. China s marine military has started to inject defense assets into listed company, which should speed up the process of other military manufacturers to inject defense assets into listed company. In early 2014, China Shipbuilding Industry Corporation (CSIC) ( CH) acquired four shipbuilding companies through private placement, at a consideration of RMB17.46 billion. After the asset injection, CSIC become the first A-Share listed company with marine warship equipment manufacturing. Moreover, Guangzhou Shipyard International (GSI) (00317 HK, CH) acquired its parent China Shipbuilding Corporation (CSSC) s Huangpu Wenchong Shipbuilding Company, and related shipbuilding assets held by Yangzhou Kejin. GSI is the only overseas capital operation platform of CSSC. After the acquisition, GSI become the first military industry-related company with dual-listing status in Hong Kong and Shanghai. As to improve overall profitability and industry efficiency, the government started asset injection plans in its defense industry. AviChina is the major overseas capital platform of AVIC, we think there are great potential that its parent could inject military/ aero-space related assets into AviChina. The termination of the proposed Chengfei Integration ( CH) injection could open for other options of assets injection/restructuring in the future. In May 2014, AviChina s parent, AVIC, announced an RMB 16 billion asset restructuring plan which involved injection of China s major fighter jet assets into A-Share listed Chengfei Integration. In this deal, AviChina and its subs AVIC Avionics ( CH) was involved. Upon completion of this deal, AviChina will be the only overseas listed company involving in military asset injection. However, the proposal was terminated, as the proposal did not receive approval from the State Security Regulator, State Administration for Science, Technology and Industry for National Defense (SASTOMD), due to monopoly concerns. In our view, we see the termination of the proposal does not have significant impact on AviChina s fundamentals, but we see opportunity for other AVIC-listed companies to involve in assets injection/restructuring in the future. We believe AviChina is likely to engage in AVIC s alternative proposals in the future given that the Company is the only overseas capital platform of aerospace related company. Moreover, AviChina entrusts AVIC Avionics to manage its equity interests in AVIC Avionics Systems. Currently, AviChina has the right to manage the manufacture and operation of the entrusted AVIC Avionic Systems which include the five profitable research institutes. We see potential assets injection of Avionic related research institutes into AviChina in the future. See the last page for disclaimer age 11 of 21

12 Table-4: China Major Fighters Type Model Main Contractor Notes D/T/ Fighters J-7 Shenyang, Chengdu and Guizhou Aircraft Corporation Third-generation fighter based on the Russian MiG- 21 J-8 Shenyang Aircraft Corporation Second-generation fighter FC-1 Chengdu Aircraft Corporation, CATIC Multirole fighter,all-weather J-10 Chengdu Aircraft Design and Research Insitute Third-generation light fighter,supersonic speed,all-weather,multirole J-11/Su-27 Shenyang Aircraft Corporation and SUKHOI Multirole figthter based on the RussianSu-27SK J-15 Chengdu Aircraft Corporation Carrier based fighter T J-20 Chengdu Aircraft Design and Research Insitute Double heavy stealth fighter T J-31 Shenyang Aircraft Corporation Fifth-generation fighter, similar to USA F-35 Lightning II T Bombers H-6 Xian Aircraft Industry Corporation Based on the Russian Tu- 16, twin engine jet bomber JH-7 Xian Aircraft Industry Corporation Self-developed, supersonic speed, sea and ground attack Helicopters Z-8 Changhe Aircraft Industry Corporation Based on French SA321 Super Hornet, mid-sized with strong carrying ability Z-9 Z-10 Z-11 Harbin Aircraft Industry Corporation Changhe Aircraft Industries Corporation Changhe Aircraft Industries Corporation and China Helicopter Design and Research Institute Based on French SA365, multirole Attack helicopter with antitank and air-to-air capability Multirole helicopter based on French AS350 Z-15 Harbin Aircraft Industry Corporation and Europe Helicopter Corporation same as Eurocopter EC175, Medium utility helicopter Z-19 Harbin Aircraft Manufacturing Corporation Chinese reconnaissance/attack helicopter, improved variant of Z-9 Trainers K-8 Hongdu Aviation Industry Corporation two-seat intermediate jet trainer and light attack aircraft designed L-15 Hongdu Aviation Industry Corporation Supersonic training and light attack aircraft Special purpose Y-8/Y-9 Shaanxi Aircraft Company Medium size medium range transport aircraft Y-20 Source: AVIC, Guotai Junan International. Note: D=Development stage, T=Testing stage and =roduction stage. Xi'an Aircraft Industrial Corporation Large military transport aircraft D See the last page for disclaimer age 12 of 21

13 Table-5: Top Ten China s Defense Company Name roduct Range Number of Listed Companies Aviation Industry Corp of China (AVIC) Aerospace 28 China Aerospace Science & Technology Corp (CASC) Aerospace 9 China Aerospace Science & Industry Corp (CASIC) Aerospace 6 China North Industries Group Corp Armored vehicles and weapon systems 12 China South Industries Group Corp Vehicles and electro-optic systems 11 China Electronics Technology Group Corp Hi-tech and IT systems 7 China Shipbuilding Industry Corp (CSIC) Shipbuilding 3 China State Shipbuilding Corp (CSSC) Shipbuilding 3 China National Nuclear Corp Nuclear weapons 2 China Nuclear Engineering Group Source: Companies web sites, Guotai Junan International. Military engineering, nuclear engineering 0 Table-6: AVIC's Research Institutes (Related to Avionics in Bold) AVIC's Research Institutes 301 所中国航空综合技术研究所 ( 北京 ) 303 所北京航空精密机械技术研究所 ( 北京 ) 304 所北京长城计量测试技术研究所 ( 北京 ) 601 所沈阳飞机设计研究所 ( 沈阳 ) 602 所中国直升机设计研究所 ( 景德镇 ) 603 所中航工业第一飞机设计研究院 ( 原西安飞机研究所 )( 西安 ) 605 所中国特种飞行器研究所 ( 荆门 ) 606 所沈阳航空发动机研究所 ( 沈阳 ) 607 所中航雷达与电子设备研究院 ( 原雷华电子技术研究所 )( 苏州 ) 608 所中国航空动力机械研究所 ( 株洲 ) 611 所成都飞机设计研究所 ( 成都 ) 612 所中国空空导弹研究院 ( 洛阳 ) 613 所洛阳电光设备研究所 ( 洛阳 ) 614 所中国航空动力控制系统研究所 ( 无锡 ) 615 所中国航空无线电电子研究所 ( 上海 ) 618 所西安飞行自动控制研究所 ( 西安 ) 621 所北京航空材料研究院 ( 北京 ) 623 所中国飞机强度研究所 ( 西安 ) 624 所中国燃气涡轮研究院 ( 绵阳 / 成都 ) 625 所中国航空工业制造工程研究所 ( 北京 ) 626 所沈阳空气动力研究所 ( 并入中国航空工业空气动力研究院 )( 沈阳 ) 630 所中国飞行试验研究院 ( 西安 ) 631 所中国航空计算技术研究所 ( 西安 ) 633 所上海航空测控技术研究所 ( 上海 ) 634 所北京长城航空测控技术研究所 ( 北京 ) 637 所济南特种结构研究所 ( 济南 ) 648 所贵州飞机设计所 ( 贵阳 ) 原国防部第六研究院中国航空研究院中国航空工业经济技术研究院中国航空工业第三设计研究院中国航空工业规划设计研究院中航勘察设计研究院中航工业技术基础研究院 Source: AVIC, Guotai Junan International. See the last page for disclaimer age 13 of 21

14 Financial Analysis & Earnings Forecasts AviChina experienced a fast growth phase from FY09 to FY14. Revenue grew from RMB5,654 million for FY09 to RMB25,710 million for FY14, representing a CAGR of 35.4%. The strong revenue growth was mainly due to a series of assets injection and restructuring during that period, and the Company became a leading civil aircraft and aviation tools and aero-parts manufacturer. The revenue growth is expected to slow down amid stable government orders but remains at a relatively high double digit growth rate driven by helicopter sales growth and aero systems & equipments demand. We forecast a three year CAGR of 21.5% from FY14-17F for the revenue growth. The Company was able to take advantage of its parent: AVIC s dominated position in China s aerospace & defense industry. After assets injections and restructuring, Helicopter contributed about 40% revenue of in FY14, and aero systems and equipments contributed for about 56% of revenue in FY14, respectively. We forecast a three year CAGR of 10.0% from FY14-17F for the Company s helicopter business and expect the business segment to account for about 30% of total revenue in FY17F. Moreover, we believe aero systems & equipments to continue to experience solid growth in the future given that we believe China s defense spending would keep at high level with potential upside which should eventually increase the demand of aero systems & equipments. Moreover, in the civil market, we see significant demand to come from commercial aircraft orders from subcontracting and domestic commercial aircraft projects (C919 etc) in the mid to long run. We forecast a three year CAGR of 22.5% of aero systems & equipments revenue growth from FY14-17F. Figure-13: AviChina Total Revenue Breakdown in FY12-17F (Amount) RMB mn Aero systems & equipments Other entire aircraft Helicopter 50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5, A 2013A 2014A 2015F 2016F 2017F Source: the Company, Guotai Junan International. Figure-15: AviChina Total Revenue Breakdown in FY15F Figure-14: AviChina Total Revenue Breakdown in FY12-17F (%) Aero systems & equipments Other entire aircraft Helicopter 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2012A 2013A 2014A 2015F 2016F 2017F Source: the Company, Guotai Junan International. Helicopter 35.0% Aero systems & equipments 57.8% Source: Guotai Junan International. Other entire aircraft 7.2% See the last page for disclaimer age 14 of 21

15 Gross margin is expected to be stable and trend upward slightly in the coming years. AviChina showed stable gross margin of around 20% in last three years. AviChina has relatively stable gross margin is mainly due to existing cost-plus pricing mechanism for government orders (price their products at cost, plus 5% margin) and stable orders from its aero systems & equipments. AviChina s entire aircraft gross margin was only around 7-8% in the last three years, and we expect the gross margin for its entire aircraft to remain at similar level in FY15-17F due to the existing costs-plus mechanism. AviChina s aero systems & equipments enjoyed a higher gross margin in the past, and we also expect its gross margin to remain at similar level in FY15-17F. We forecast blended gross margin will largely flat of 19.1% in FY15F and reach 19.3% in FY16F as we believe growth of aero systems and equipments to outpace entire aircraft growth in FY15-17F. Higher growth in revenue of aero systems & equipments will slightly increase blended gross margin. Figure-16: AviChina Revenue of Entire Aircraft & GM in FY12-17F RMB mn Entire aircraft GM Figure-17: AviChina Revenue of Aero Systems & Equipments & GM in FY12-17F RMB mn Aero systems & equipments GM 1,600 1,400 1,200 1, A 2013A 2014A 2015F 2016F 2017F 8.2% 8.0% 7.8% 7.6% 7.4% 7.2% 7.0% 6.8% 6.6% 6.4% 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1, A 2013A 2014A 2015F 2016F 2017F 40.0% 38.0% 36.0% 34.0% 32.0% 30.0% 28.0% 26.0% 24.0% 22.0% 20.0% Source: the Company, Guotai Junan International. Source: the Company, Guotai Junan International. Operating margin will bottom out in FY15F and see slight uptrend in FY15-16F. We forecast AviChina s operating margin will bottom out in FY15F, and will gradually recover to 8.0% and 8.0% in FY16-17F due to economies of scale. China s aerospace and defense industry intends to improve efficiency and deliver solid growth. As one of the key overseas capital platforms of AVIC, AviChina is believed to deliver solid earnings growth by effective costs control. Figure-18: AviChina Margins in FY12-17F Goss margin Operating margin Net margin 25% 20% 15% 10% 5% 0% Source: the Company, Guotai Junan International. 2012A 2013A 2014A 2015F 2016F 2017F See the last page for disclaimer age 15 of 21

16 Net profit is expected to see growth of 21.2%, 22.4% and 20.4% over FY15-17F. The Company s net profit reported a significant growth of 33.1% for FY12, which is attributable to the assets injection/restructuring. The net profit growth of FY13 slowed down to 7.3% YoY and the net profit growth was 9.6% YoY in FY14. We expect the net profit for FY15-17F to grow by 25.0%, 22.4% and 20.4%, respectively. Net profit margin is expected to reach from 3.0% in FY14 to 3.1% in FY15F to factor in effective expenses control. Our ES forecasts for FY15/16/17 are RMB0.179/0.219/0.264, respectively. The earnings growth drivers in FY15-17F would come from 1) decent aircraft backlogs, 2) solid government orders outlook and 3) robust aero systems & equipments demand. Figure-19: AviChina Net rofit in FY12-17F RMB mn Net profit YoY 1,600 1,400 1,200 1, A 2013A 2014A 2015F 2016F 2017F 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Source: the Company, Guotai Junan International. The Company is in a strong liquidity position to participate in any potential assets injection/restructuring. The Company was in a net cash position as of end of FY14. We forecast operating cash flow of RMB2,092 million in FY15F. We believe AviChina s CAEX to remain at similar level in FY15-17F. For entire aircraft segment, there is no significant increase in CAEX over FY15-17F. The CAEX is expected to spend more on aero systems & equipments of which will be used in commercial aircraft projects (C919 etc), including airborne sensor, precision control component and control devices etc. Moreover, we forecast dividend payout to remain at around 15% in FY15-17F. The Company is likely to retain more cash for potential assets injections/restructuring purpose. The Company s net gearing ratios are expected to maintain at net cash position in FY15-17F, which we think to be in a strong liquidity position to support potential assets injection or restructuring. Valuation AviChina s share price largely discount to market value of its four subsidiaries. Our target price is HK$ Our target price translates into an implied FY15F ER of 59.6x. In H-share market, there are basically no comparable firms. The only listed firm has China s military industry-related business is Guangzhou Shipyard Int l (00317 HK), while the Company was injected marine defense assets in late As such, we think AviChina is a unique company with dominant position in civil and military aircraft listed in Hong Kong. As AviChina s main profit contributors come from its four subsidiaries, we believe that SOT valuation could justify the share price is undemanding. AviChina s share price is trading at 46.1% discount to our SOT valuation and the discount was around 20% in Our target price is 28.4% discount to SOT valuation. Therefore we think the stock s current valuation is undemanding. Moreover, we also pick global players as comparable companies for AviChina. Our comparable companies including global names which manufacture civil aircraft, military aircraft and aerospace related parts and components. AviChina s FY15F ER of 45.0x is trading at 74.0% discount to A-share peers and 166.6% premium to global peers. We believe the premium is mainly due to 1) rich cash position and 2) potential assets injection and 3) much faster growth of aircraft market in China and 4) mutual market access between Hong Kong and A-Share market. Initiating with Accumulate. AviChina is the only overseas listed company of China s aerospace and defense that holds four A-share subsidiaries, namely AVIC Helicopter, Hongdu, AVIC Avionics and Jonhon Optronic, and these four subsidiaries basically cover the full value chain of helicopter manufacturing. Since the A-share defense sector is trading at around weighted average of 173.3x FY15F ER valuation, we think AviChina is a good investment to ride on China s fast growing defense sector given that its 46.1% discount to the market value of AviChina s shareholdings of its four A-share subsidiaries. We See the last page for disclaimer age 16 of 21

17 believe AviChina is also the major beneficiary of military spending, as around 80% of AviChina s revenue comes from government orders. AviChina should benefit from China s upgrading of fighters and military use helicopter. On the civil market, we see opportunity from commercial aircraft development in China. C919 project is just the first millstone of China s commercial aircraft development, and AviChina is the one of the major beneficiaries of growing demand of commercial aircraft given that its parent AVIC is the biggest Chinese state-owned aerospace and defense company. Moreover, AviChina being the major overseas platform of AVIC, we see opportunity of further assets injection potential. AviChina has a long history of participation in assets injection & restructuring. We believe AviChina could acquire quality assets from AVIC to enhance its assets quality and to add value to its shareholders. Table-11: SOT Valuation of AviChina RMB/HKD 0.79 AviChina share outstanding 5,474.4 SOT Valuation Listed Subsidiaries Stock code Market Value (Rmb mn) Avichina Stake Market value to AviChina (HKD mn) er share value AVIC Helicopter CH 50, % 22, Hongdu Aviation CH 35, % 19, AVIC Avionics CH 82, % 45, JONHON Optronic CH 25, % 13, Sum 100, Unlisted Assets FY15F earnings 232 E(X) 10.0 Valuation of unlisted HKD mn 2, SOT Value of AviChina Source: the Company, Guotai Junan International. See the last page for disclaimer age 17 of 21

18 Table-12: eers Comparison Table Company E (fiscal year) B (fiscal year) ROE(%) Stock Code Currency Last price 14A 15F 16F 17F 14A 15F 16F 17F 15F HK - Listed defense corporation Avichina Industry & Tech-H 2357 HK HKD Cssc Offshore And Marine Eng 317 HK HKD n.a. Simple Average Weighted Average China Listed defense corporation Avic Aircraft Co Ltd-A CH CNY Avic Aviation Engine Corp-A CH CNY China Avionics Systems Co -A CH CNY China Spacesat Co Ltd -A CH CNY Avic Helicopter Co Ltd-A CH CNY Jiangxi Hongdu Aviation-A CH CNY Xi'An Tian He Defense Tech-A CH CNY n.a. Changchun Up Optotech Co-A CH CNY n.a. n.a n.a. n.a. n.a. n.a. Cssc Offshore And Marine E-A CH CNY China Aviation Optical -A CH CNY China Shipbuilding Industr-A CH CNY Avic Aero-Engine Controls-A CH CNY n.a. n.a. n.a n.a. n.a. n.a. n.a. Avic Heavy Machinery Co Lt-A CH CNY n.a. 6.8 n.a. n.a. n.a. n.a. Avic Electromechanical Sy-A CH CNY n.a. 7.3 n.a. n.a. n.a. n.a. Aerospace Hi-Tech Holdings-A CH CNY n.a. n.a. n.a n.a. n.a. n.a. n.a. Guizhou Space Appliance Co-A CH CNY n.a. 8.0 n.a. n.a. n.a. n.a. China Aerospace Times Elec-A CH CNY n.a. 4.9 n.a. n.a. n.a. n.a. Simple Average Weighted Average Gobal Listed defense corporation United Technologies Corp UTX US USD Boeing Co/The BA US USD Honeywell International Inc HON US USD Lockheed Martin Corp LMT US USD General Dynamics Corp GD US USD Airbus Group Nv AIR F EUR Northrop Grumman Corp NOC US USD Raytheon Company RTN US USD Safran Sa SAF F EUR n.a Rolls-Royce Holdings lc RR/ LN GBp 1, Bae Systems lc BA/ LN GBp Textron Inc TXT US USD Thales Sa HO F EUR L-3 Communications Holdings LLL US USD Finmeccanica Spa FNC IM EUR n.a Huntington Ingalls Industrie HII US USD Exelis Inc XLS US USD Booz Allen Hamilton Holdings BAH US USD General Electric Co GE US USD Oshkosh Corp OSK US USD Computer Sciences Corp CSC US USD n.a (0.2) Babcock Intl Group lc BAB LN GBp 1, Saab Ab-B SAABB SS SEK Rheinmetall Ag RHM GR EUR Caci International Inc -Cl A CACI US USD Mitsubishi Heavy Industries 7011 JT JY Harris Corp HRS US USD Embraer Sa EMBR3 BZ BRL Bombardier Inc-B BBD/B CN CAD n.a (12.1) Mtu Aero Engines Ag MTX GR EUR Eaton Corp lc ETN US USD See the last page for disclaimer age 18 of 21

19 Rockwell Collins Inc COL US USD Cae Inc CAE CN CAD Cobham lc COB LN GBp Ultra Electronics Hldgs lc ULE LN GBp 1, Simple Average Weighted Average Source: Bloomberg, Guotai Junan International. Investment Risks Delay in full opening of low-altitude airspace. The market is expecting a full opening of low-altitude airspace in 2015; therefore any further delays could lower the demand of civil aircraft. Lower than expected government orders. AviChina heavily relies on the government orders, and around 80% of its orders come from government purchase. Any slowdown in government orders will reduce AviChina s earnings significantly. Disclosure is limited. Disclosure is limited on AviChina orders and military related products mainly due to its sensitiveness. Operational size is still very small. AviChina is the largest helicopter manufacturer in China. However, its size is still very small compared to global peers namely, Airbus Helicopters, Sikorsky and Bell etc, in terms of revenue and size. See the last page for disclaimer age 19 of 21

20 Financial statements & ratios Income Statement Balance Sheet Year end Dec (RMB m) 2013A 2014A 2015F 2016F 2017F Year end Dec (RMB m) 2013A 2014A 2015F 2016F 2017F Entire aircraft 10,198 11,275 13,164 15,744 19,565 Fixed assets 10,803 12,150 12,710 13,150 13,445 Aero systems & equipments 11,995 14,435 17,996 22,282 26,565 Interests in asso/jv 1, ,003 1,148 1,314 Available-for-sale financial assets 1,152 1,238 1,362 1,498 1,648 Total revenue 22,193 25,710 31,160 38,026 46,131 Others Cost of sales (17,885) (20,812) (25,200) (30,685) (37,243) Non-current assets 13,369 14,687 15,539 16,306 16,969 Gross profit 4,308 4,899 5,960 7,341 8,888 Inventories 14,780 16,593 17,950 21,437 24,999 Other revenue Trade and other receivables 8,958 10,974 11,098 13,543 16,430 Other net income Other receivables 1,183 1,772 1,949 2,144 2,358 Selling expenses (415) (470) (561) (684) (830) Deposits 4,692 3,849 3,878 3,908 3,938 Administrative expenses (2,386) (2,750) (3,334) (4,069) (4,936) Cash at bank and in hand 6,726 5,798 6,597 6,721 6,652 Others 1,220 1,050 1,154 1,270 1,397 Operating profit 1,758 1,995 2,439 3,044 3,675 Current assets 37,559 40,035 42,627 49,024 55,774 Net financial cost (74) (136) (85) (124) (137) Share of profits of asso/jv Total Assets 50,928 54,722 58,165 65,329 72,743 rofit before tax 1,761 2,003 2,496 3,072 3,698 Bank loans and overdrafts 4,207 5,633 5,915 6,211 6,521 Taxation (250) (267) (324) (415) (499) Trade and bill payables 14,032 15,050 15,189 18,495 21,428 Other payables 3,740 3,810 4,191 4,611 5,072 rofit for the year 1,511 1,736 2,171 2,657 3,199 Others 4,449 4,227 4,627 5,065 5,547 Minority interest (798) (954) (1,194) (1,461) (1,759) Current liabilities 26,428 28,721 29,922 34,382 38,567 Net profit ,196 1,439 Bank loans 1,911 1,785 1,874 1,968 2,066 Others ,006 1,107 1,217 ES (RMB) Non-current liabilities 2,693 2,699 2,880 3,074 3,283 DS (RMB) Total Liabilities 29,121 31,420 32,802 37,456 41,850 Minority interest 11,684 12,486 13,680 15,141 16,901 Shareholders' equity 10,123 10,815 11,683 12,732 13,992 Total Liabilities and Equity 50,928 54,722 58,165 65,329 72,743 Cash flow Statement BS (RMB) Year end Dec (RMB m) 2013A 2014A 2015F 2016F 2017F Financial Ratios rofit before tax 1,761 2,003 2,496 3,072 3,698 Year end Dec (RMB m) 2013A 2014A 2015F 2016F 2017F Depreciation & amortisation Net finance cost Growth (%): Other items (266) (249) (141) (151) (160) Revenue Working capital change (1,436) (2,696) (876) (2,114) (2,953) Gross profit Interest & Tax paid (275) (388) (329) (450) (539) Operating profit Cash flow from operation 572 (392) 2,092 1,406 1,173 Net profit CAEX (2,862) (1,831) (1,729) (1,702) (1,647) rofitability (%): Others (546) Gross margin Cash flow from investing (3,409) (1,470) (1,554) (1,524) (1,472) Operating margin Net margin Increase in bank loans 1,506 1, ROA Dividends paid (223) (387) (109) (147) (179) ROE Others 2, Cash flow from financing 3, Liquidity & Solvency Current Ratio (x) Cash balance change 1,140 (954) (69) Quick Ratio (x) Cash balances at year begin 5,606 6,726 5,798 6,597 6,721 Net gearing (%) net cash net cash net cash net cash net cash Effect of FX changes (20) Interest coverage (x) Cash balances at year end 6,726 5,798 6,597 6,721 6,652 Dividend payout ratio (%) Source: the Company, Guotai Junan International. See the last page for disclaimer age 20 of 21