Solid Growth and Accretive Asset Injections, Maintain Buy

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1 : AviChina (2357 HK) Sean Xiang 向宇豪公司报告 : 中航科工 (2357 HK) xiangyuhao@gtjas.com Solid Growth and Accretive Asset Injections, Maintain Buy 坚实的增长和盈利增厚的资产注入, 维持 买入 GTJA Research 国泰君安研究 Increasing military expenditure will drive demand for avionics systems. We project that the increasing procurement from China Air Force, replacement of the 2nd generation jet fighters and rising demand from civil aviation will create value over RMB2 billion for avionic systems annually over the next ten years, which we think is favorable for AviChina's subsidiaries Avic Avionics (6372CH) and Jonhon Optronic's (2179CH). Civil aviation is embracing a fast growth stage. China will face huge demand for medium to large size commercial aircrafts, and the opening up of low altitude air space will improve demand for general aircraft. We expect that both low-altitude air space free-up and the enormous demand for new commercial aircraft in China will benefit AviChina's subsidiaries Avicopter (638CH) and Hongdu Aviation (6316CH) in mid to long-term. Potential asset injections create further upside, maintain "Buy". We assessed the recently proposed and potential M&A transactions that might occur in FY16 and FY17, which would create a double digit accretion to AviChina's EPS in FY16 and FY17 once completed. As military and SOE reform is underway, we anticipate that more consolidations will happen between Avic and AviChina. We maintain "Buy" investment rating but revise down target price to HK$6.7 due to the recent plunge in the HSI. Our target price implies 33.6x/26.8x/2.5x PER for FY15/FY16/FY17, respectively 国防军费开支的上升最终会增加对航电系统及部件的需求 我们的测算显示来自中国空军加速的军备采购和 2 代战斗机的升级以及来自民用航空的需求上升将会在航电系统上未来 1 年每年创造人民币 2 亿元的产值, 将会对中航电子 (6372CH) 和中航光电 (2179CH) 构成直接的利好 民用航空业迎来快速增长的时期 未来中国对大中型商用飞机的需求强劲, 低空领域的逐步开放也将提振对通用飞机的需求 我们预计下属公司中直股份 (638CH) 和洪都航空 (6316CH) 将在中长期受益于低空领域开放和来自对民用飞行器的巨大需求 未来潜在的资产注入将会为公司创造更多的潜力, 维持 买入 评级 我们测算显示公司近期已公布和可能发生在 17 年的潜在并购整合交易一旦完成后会分别在 16 和 17 财年产生双位数的每股收益增厚 由于军队改制和国企改革正在进程中, 我们预计更多的整合将会在中航工业和中航科工间发生 我们维持 买入 评级, 但是由于恒生指数下挫, 下调目标价至港币 6.7 元 我们的目标价相当于 33.6 倍 /26.8 倍 /2.5 倍的 FY15/FY16/FY17 市盈率 Rating: Buy Maintained 评级 : 买入 ( 维持 ) 6-18m TP 目标价 : HK$6.7 Revised from 原目标价 : HK$9.95 Share price 股价 : Stock performance 股价表现 Change in Share Price 股价变动 Abs. % 绝对变动 % Rel. % to HS index 相对恒指变动 % Avg. share price(hk$) 平均股价 ( 港元 ) 1 M 1 个月 3 M 3 个月 HK$ % of return (2.) (4.) Feb-15 May-15 Jul-15 Oct-15 Jan-16 HSI Index AviChina 1 Y 1 年 (12.3) (12.4) Source: Bloomberg, Guotai Junan International. Year End 年结 12/31 Turnover 收入 (RMB m) Net Profit 股东净利 (RMB m) EPS 每股净利 (RMB) EPS 每股净利变动 ( %) PER 市盈率 (x) BPS 每股净资产 (RMB) PBR 市净率 (x) DPS 每股股息 (RMB) Yield 股息率 (%) ROE 净资产收益率 (%) FY13A 22, FY14A 25, FY15F 29, FY16F 35,339 1, FY17F 42,816 1, Shares in issue (m) 总股数 (m) 5,474.4 Major shareholder 大股东 AVIC 58.3% Market cap. (HK$ m) 市值 (HKD m) 29,288.2 Free float (%) 自由流通比率 (%) 38.% 3 month average vol. 3 个月平均成交股数 ( ) 12,484. FY16 Net gearing (%) FY16 净负债 / 股东资金 (%) net cash 52 Weeks high/low (HKD) 52 周高 / 低 1.5 / 3.9 FY16 Est. NAV (HK$) FY16 每股估值 ( 港元 ) 8.9 See the last page for disclaimer Page 1 of 13

2 A LEADING AVIATION PLAYER AND STRATEGIC LISTING VEHICLE AviChina Industry & Technology Company Ltd ( AviChina or the Company ) is a leading aviation conglomerate which has four mainland listed subsidiaries. AviChina currently has exposures to two categories of businesses, which are 1) manufacturing of entire aircraft, and 2) aero-systems and components. We think that AviChina is a good mixture between civil and military segments as it has indirectly presences in military and national defense business, such as its helicopter products (Z-9, Z-19 etc.) and being the leading provider of avionics systems for both combat and civil aircrafts. Its civil aviation business includes manufacturing general aircrafts and providing parts and components for commercial aircrafts. We think that the Company is positioned as a strategic listing vehicle of Aviation Industry Corporation of China's ( AVIC ) aviation sector and it has gone through several rounds of restructuring and asset injections from AVIC. We anticipate further asset injections to take place in the following years since reforms of military research institutes are underway and there are potentials for further consolidation under AVIC's aviation businesses. Figure-1: Major Business Segments and Corporate Structure AVIC AviChina (2357 HK) Harbin Aviation Group Hongdu Aviation Industry Group Ltd. (Hongdu Aviation 6316 CH) China AVIC Avionics Equipment Co., Ltd (Avic Avionics 6372 CH) Avic Optical- Electrical Technology Co. Ltd. (Jonhon Optronic 2179 CH) Tianjin Aviation Mechanical and Electrical Co.,Ltd. (Tianjin Aviation) China Aviation Publishing & Media Co.,Ltd. (CAPMC) China Aviation Planning and Design Institute (Avic Planning) 28.65% 43.63% 43.22% 41.57% 1% 53.63% 1% Avic Helicopter Ltd. (Avicopter 638 CH) 6.45% 1% AviChina Hong Kong Jingdezhen Helicopter Branch INCREASING MILITARY EXPENDITURE Increasing national military expenditure will support moderate growth in equipment procurement. China's national military expenses recorded USD216 billion in 214, ranking second in the world. However, in terms of proportion of the military expenses to GDP, the average level of military expenditure to GDP in 214 from all reporting nations was approximately 2.6%, where the proportion from China was 2.1%. Further, although China's military expenditure to government spending was higher than the world average level, it was significantly lower than nations with strong military power such as USA and Russia. We think that although China ranked the second in terms of expenditure, it was not as robust as it looks like while considering the China's huge country size and population. Looking forward, we are bullish on China's military expenditure against the backdrop of the complications in the regional politics, and combined with the military size cut and reallocation of the military budget, we think that the military reform has step into the implementation stage. We think that the military expenditure will continue to grow rapidly during the "13th Five Year" period and equipments procurement expenditure will be amplified as lots of China's military equipments are under-developed, which is especially the case for China's Air Force and Navy. Figure-2: China's National Military Expenditure Figure-3: Proportion of Military Expenditure to GDP USD billion Military expenditure % 3.% 26.6% % 22.4% 22.% 25.% % 35 2.% % 15.1% 15.2% 13.1% 13.5% % 12.5% 15.% 2 9.9% 1.3% 12.7% 14.% 13.% 7.9% 12.% 1.% % 5.% 2, 2,5 2,1 215F 22F Source: SIPRI, Guotai Junan International. YoY % 4.5% 5% 4% 3.5% 4% 3% 2.6% 2.4% 3% 2.1% 2.2% 2.2% 2% 2% 1% 1% % China UK France South Korea Inida USA Russia Source: SIPRI, Guotai Junan International. See the last page for disclaimer Page 2 of 13

3 China Air Force equipment upgrade and increasing R&D is the key catalyst for the growth of avionics. Avionics system is basically the integration of all electronic system on an aircraft. For civil aircraft, avionics system is mainly responsible for navigations and data processing and transmission, while for a combat aircraft, avionics system functions the data processing, navigation, aircraft control, firing system and target searching and tracking. The evolution of avionics system can be divided into four generations, and a modern combat aircraft's performance is highly dependent on its avionics system. For example, for a 4th generation jet fighter such as F-22, F-35 and T-5, avionics systems usually account for more than 4% of its total cost, which almost has a similar weight to the costs of its engine system. We anticipate that China's equipment upgrade and increasing R&D have facilitated fast growth of avionics system. Based on the data from World Air Force Survey issued by Flight Global, we find that China's 2nd generation jet fighters such as J-7 and J-8 account for around 39% of all combat aircrafts, and 55% of all jet fighters, which were significantly higher than the proportion compared to that from other nations with strong military power. While J-7 had stopped manufacturing in 215, we expect it to be gradually replaced by J-1, J-11 and J-2 over the next five to ten years. Figure-4: Breakdown of China Military Combat Aircraft Q5 JH-7 J-11/15/Su-27/3/35 J-1 J-8 J-7 H-6 Figure-5: Proportion of Jet Fighters in China Air Force 4th generation 3rd generation 2nd generation Unit 1,6 1,4 1,2 1, A 212A 213A 214A 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % 13% 4% 56% 41% 12% 45% 63% 57% 66% 55% 1% 33% 35% 59% 31% 22% 8% Japan Russia China USA France UK India Source: World Air Force 215, Guotai Junan International. Source: World Air Force 215, Guotai Junan International. Figure-6: J-1 Jet Fighter (the 3rd Generation) Figure-7: J-2 Jet Fighter (the 4th generation) Source: online resource. Source: online resource. We project the value of avionics systems created by jet fighter upgrades and procurement to reach RMB122 billion annually over the next ten years. We have modeled the fleet size and Air Force headcount for different nations, and we found that China ranked the second lowest among all selected nations in terms of aircraft per headcount in air force. For a conservative scenario, we assume that at least all J-7 jet fighter will be replaced by J-1 over the next 1 years. Given the average aircraft per headcount from selected nations, we estimate that jet fighter demand from China Air Force would reach 2,68 units in ten years. Subtracting existing 1,754 units, new demand of jet fighters are therefore 854 units. Our forecasts imply that the total demand of combat aircraft will reach 1,74 units, which includes the upgrade of 2nd generation jet fighters (J-7) and estimated demand from Ground and Navy (combat helicopters). Given these aircraft in demand are more advanced one such as J-1, J-2, Z-19 etc., we assume that the avionics system of these aircrafts account for approximately 35% of their total costs. As a result, value of avionics system in demand from the equipment upgrade and procurement is estimated to be about RMB122 billion in next ten years. While taking into account of the procurement and upgrade of other civil and general aircraft, we think that the actual demand for avionics system every year would be over RMB2 billion. Our estimation See the last page for disclaimer Page 3 of 13

4 has not taken into account of the upgrade of avionics system itself in the lifespan of a jet fighter. Table-1: Value of avionics system created by combat aircraft upgrade and new procurement from China military. Aircraft per Nations Air Force Air Force fleet thousand population size in 214 headcounts in Air Force USA 4, 5, PRC 3, 1, India 3, 1, Russia 33, 3, Japan 47, France 88, UK 54, Average aircraft per thousand headcount in Air Force of selected nations 8.7 Forecasted aircraft demand from China Air Force (a) 2,68 Replacement of 2nd generation combat aircraft (b) 4 Forecasted aircraft demand from Ground and Navy (helicopters and others) (c) 485 Existing fleet size of China Air Force (d) 1754 Implied total demand of aircraft from China military (a)+(b)+(c)-(d) 1,74 Assumed ASP (RMB Mn) 2 Value for aircraft demanded (RMB Mn) 347,93 Average avionics system cost for 3rd to 4th generation aircraft to total cost 35% Implied value for avionics system demand (RMB Mn) 121,766 Time for replacement and upgrade (Yr) 1 Value of avionics system in demand per year (RMB Mn) 12,177 Source: World Air Force 215, Guotai Junan International. RISING GENERAL AND CIVIL AVIATION MARKET Plans of opening up low-altitude air space will fuel up the demand for general aircraft. In 21, China Aviation Administration of China ( CAAC ) issued programs to progressively open up low-altitude air space before 22. Currently the program is tested across 1 cities and is expected to roll out across the nation from 216. Based on our estimation, we think that once the new policy has come into effect, demand for general aircraft will be lifted dramatically and the quantity of the fleet size in China would hopefully triple by 22. Data regarding general aviation licenses indicate that general aviation pilots are increasing rapidly, doubled by 214 as compared to it was in 212. The hours of flight in general aviation in 214 reached.675 million hours, and was nearly 3.8 times longer than it was in 21. CAGR of numbers of general aviation operator, national fleet size and hours of flight was recorded 21.%, 18.3% and 14.6%, respectively. However, we observe that in per capita terms, general aviation industry in China was heavily under-developed. The hours of flight and fleet size per capita was only 9% and 3% of the world average level. According to the State Council's target that the hours of flight reaches 2 million hours in 22, given currently general aircraft utilisation rate, we expect that the fleet size in 22 would reach 5,327 units, implying CAGR of 19.8%. Figure-8: General Aviation Industry Data Pilots General aircraft General aviation business provider 2,5 2,191 2, 1,651 1,5 1, ,92 1, A 213A 214A Source: CAAC, Guotai Junan International. Figure-9: General Fleet Size and Hours of Flight Unit 6, 5, 4, 3, 2, 1, Quantity of general aircraft Operation hours of general aircraft (' hrs) ' hrs 1,669 1,392 1, A 211A 213A 215E 217E 219E Source: CAAC, Guotai Junan International. 2, 2,5 2, 1,5 1, 5 See the last page for disclaimer Page 4 of 13

5 C919 will drive the value chain of commercial aviation in the medium to long-term. China's largest self-designed and built commercial aircraft had finished assembling in November 215 and is expected to be tested in 216. The aircraft is designed to compete with A32 and Boeing 737 with considerably lower price and higher fuel efficiency. Based on the forecasts from Aviation Industry Development Research Centre of China (ADR), total fleet size for commercial aircraft in China will reach up to 5,545 units in 231, among which the demand for aircrafts with 15 to 2 seats will be 3,18 units and we think C919 will be a good fit. Up to November 215, C919 had won 517 orders and purchase intentions from domestic and foreign customers. We think that C919 will be supported by policies from government regarding commercial aircraft procurement and the increasing procurement of C919 will boost the value chain of China's civil aviation manufacturing industry. AviChina is one of the key provider of various parts and components of C919. For example, Jonhon Optronic is the sole provider of connectors for the aircraft and Hongdu Aviation is the supplier of part of the fuselage. We anticipate that AviChina, through its subsidiaries, will benefit from the long-term growth of China's commercial aviation market. Figure-1: Commercial Fleet Size Forecasts Figure-11: Commercial Aircraft Demand in 231 New aircraft demanded Replacement 6, Aircraft in operation Current fleet size 4-seater 3-seater 2-seater 15-seater 11-seater 7/9-seater 3/5-seater 5, 445 4, 3, , 2, 2, , 1, A 1, E Source: ADR, Guotai Junan International. Source: ADR, Guotai Junan International. Figure 12: AviChina's Exposures to C919 CONTINUING ASSET INJECTIONS AND CONSOLIDATIONS Acquisition of Avic Planning. AviChina entered into a transaction with AVIC to acquire 1% of Avic Planning by share issuance in September 215. By acquiring Avic Planning, AviChina has expanded its business to a more front-end segment along the aviation value chain, including design, consulting in aviation industry. Avic Planning's net profit recorded RMB217 million in FY14, an assumption of 5% constant growth in Avic Planning's net profit in FY16 and FY17 would respectively imply 2.7% and 16.6% boosts of AviChina's bottom line. In addition, since the deal was planned to complete by issuing approximately million new shares, EPS post the transaction will therefore be RMB.234 and RMB.296 for FY16 and FY17, implying accretion of 1.8% and 7.1% to our previous forecasts, respectively. See the last page for disclaimer Page 5 of 13

6 Table-2: Impact of acquisition of Avic Planning before transaction Year Net profit (RMB Mn) Share outstanding (Mn) EPS Net profit (RMB Mn) after transaction Share outstanding (Mn) FY16 1,156 5, ,395 5, FY17 1,513 5, ,764 5, EPS Capital increase in Shenyang Aircraft and Chengdu Aircraft. AviChina has tapped into national defense sector by injecting capital into Shenyang Aircraft and Chengdu Aircraft, which are the manufacturers of combat fighters such as J-1 and J-2. Based on the Company announcement, while details of the transaction is pending,we assume the transaction is completed at a PBR of 1.x and hence we anticipate that the stake of AviChina post the transaction (including Avic Avionics) to be 12.4%. We therefore calculate that the investment would strengthen AviChina's bottom line and EPS by approximately 8.9% based on our estimates. We think that when self-developed jet engine such as WS-1 is ramped-up, the upgrade of jet fighters will be accelerated and exports of these jet fighters will be possible, which will further enhance AviChina's results in mid to long run. Table-3: Impact of the Capital Increase in Shenyang Aircraft and Chengdu Aircraft As of 31th Dec. 214 (RMB Mn) Company Name Total Effective Implied Revenue PBT assets tax rate* NPAT Net assets Shenyang Aircraft 15,521 12, % 356 5,66 Chengdu Aircraft 18,881 11, % 398 5,872 Valuation of two companies based on 1.x PBR 11,477 Capital increase details AviChina 1,96 Avic Capital (675 CH) 1,96 Avic Avionics (6372 CH) 539 Avic Aricraft (6768 CH) 441 AMES (213 CH) 196 Assumed annual net profit growth for Shenyang Aircraft and Chengdu Aircraft 5% AviChina's (including Avic Avionics) stake post the transaction 12.4% AviChina's FY16 net profit prior to the transaction 1,156 Profit attributable to AviChina in FY * Tax rate is assumed based on the average effective tax rate in FY12 and FY13. Asset injections and restructuring are expected to continue. AviChina is positioned as the listing platform of AVIC and has gone through several rounds of restructuring and assets injections from 28. The Company's operation is now exposed to two categories, which are entire aircraft manufacturing and aero-equipment & systems. We think that the next round major consolidation in AVIC Avionics will likely be the injection of five research institutes, which are the most profitable assets from the AVIC Avionics Systems Co. Ltd. (AVIC Avionics Systems) and has been entrusted by AVIC Avionics. According to the latest news, the guidance regarding the reform of research institutes from state-owned military enterprises are about to be issued in the near term. We believe that it will accelerate the injection of the research institutes into AVIC Avionics. We have also modeled the impact of such transactions and it implies that the injection of the five research institutes may boost AviChina's EPS by a double digit increase (23.8% in our scenario). Given limited public available information, our forecasts are based on assumptions of: 1) AviChina does not participate in the placement scheme from AVIC Avionics; 2) the transaction will be traded at 11.x FY17 PER, which was the implied historical average PER from the previous avionic related assets injections from AVIC to AviChina (estimations are shown in Table-5); 3) issue price from Avic Avionics is RMB3 per share based on current Bloomberg estimates; 4) the consideration is paid 1% by share placements; 5) total net profit from the five research institutes is growing at CAGR of 1% from 213 to 217. See the last page for disclaimer Page 6 of 13

7 Table-4: Estimation of EPS Accretion from Research Institutes Assets Injection Research institutes As of 31th Dec. 213 (RMB Mn) Total assets Net assets Revenue Net profit ROA ROE AVIC Luoyang Optronic Research Institute 5,35 1,321 2, % 1.8% Aeronautical Radio Electronics Research Institute 4,492 1,797 2, % 15.1% AVIC Xi`an Flight Control Research Institute 6,73 1,492 2, % 1.7% AVIC Xi`an Aeronautics Computing Research Institute 4,73 1,65 2, % 2.6% AVIC Leihua Electronics Research Institute 5, , % 5.8% Total 26,456 7,16 11, % 13.4% Forecasted FY17 Net Profit for AviChina w/o injection 1,513 Forecasted FY17 Net Profit for AVIC Avionics w/o injection 1,12 AVIC Avionics Share outstanding (RMB Mn) 1,759 Issue price of the transaction (RMB) 3. AviChina's current stake in AVIC Avionics 43.22% Estimated FY17 Net Profit from 5 Research Institutes 1,44 Estimated FY17 PER of the Transaction 11.x. Assumed consideration of the transaction 15,449 Share at issuance for the transaction (RMB Mn) 515 AviChina's stake in AVIC Avionics after assets injection 33.43% Profit for AVIC Avionics in 217 after transaction 2,525 Profit accounted for AviChina 844 Profit accounted for AviChina prior to the transaction 484 Profit from other companies under AviChina 1,29 Total Profit post the transaction 1,873 Share of AviChina outstanding (million) 5,474 EPS after transaction (RMB).342 EPS before transaction (RMB).276 EPS accretion 23.8% Table-5: Sensitivity Analysis on the Research Institutes Assets Injection Sensitivity Analysis for EPS Acquisition PER Accretion 7.x 9.x 11.x 13.x 15.x % 21.7% 18.8% 16.3% 13.9% % 23.5% 2.8% 18.3% 16.1% % 25.% 22.4% 2.1% 18.% % 26.2% 23.8% 21.6% 19.5% % 27.2% 25.% 22.9% 2.9% % 28.1% 26.% 24.% 22.1% % 28.9% 26.9% 25.% 23.2% Issue price (RMB) Source: Guotai Junan International. See the last page for disclaimer Page 7 of 13

8 Table-6: Major Consolidations Carried Out by AviChina from 28 Transaction Details Avic Avionics (6372 CH) Restructuring Year of Announcement Jun. 28 Consideration BV of net assets (RMB Mn) Net profit Implied PE Implie d PB Business Disposal Changhe Auto's assets to AVIC n.a. n.a. 1.3 Automobile Acquisition of : 1% of Lanzhou Aviation Electric Avionics 1% of Shanghai Aviation Electric Avionics Acquire 2 companies from AVIC 86.74% of Kaitian Electronics Avionics Jun. 21 1% of Lanzhou Flight Control Avionics Assets injection of 6 companies to AVIC Avionics 8% of Huayan Areo-Instruments from AVIC Avionics 1% of Qianshan Avionics from AVIC Avionics 1% of Baocheng Areo-Instruments from AVIC Jun Avionics 1% of Taihang Areo-Instruments from AVIC Avionics 86.74% of Kaitian Electronic from AVIC Avionics 1% of Lanzhou Flight Control from AVIC Avionics Acquisition of 3 companies in 213 Acquire 1% of Beijing Qingyun Avionics and Changfeng Avionics Jun , Avionics Acquire 1% of Dongfang Avionics Avionics AviChina (2357 HK) Disposal Harbin Auto and Changhe Suzuki to AVIC in 29 Apr. 29 1% of Harbin Auto 1 (672) (894) n.a. n.a. Automobile 1% of Changhe Suzuki 19 1,94 (393) n.a. 1. Automobile Acquire Tianjin Aviation in 211 Jan % of Tianjin Aviation Aviation Disposal 51% of Jiujiang in 212 Mar (2) n.a. 1.1 Automobile Disposal additional 49% of Jiujiang in 214 Dec (3) n.a. 1.5 Automobile Capital injection in Shenyang Aircraft and Chengdu Aircraft Aug ,445 11, n.a. n.a. National Defense Acquire 1% of AVIC Planning from AVIC in 215 Oct ,164 n.a n.a. Design Avicopter (638 CH) Injecting helicopter assets in 212 Acquire 1% of Changhe Aviation Helicopter Acquire 1% of Changfei Parts and Components Helicopter May. 212 Acquire 1% of Helicopter Tianjin (1) n.a 1. Helicopter Acquire 1% of AVIC Huiyang Helicopter Acquire 1% of Harbin Aviation n.a. n.a. 1.2 Helicopter Jonhon Optronic (2179 CH) Equity Swap Disposal of 54.51% Dongan Motor to AVIC Nov. 29 2,368 1, Automobile Acquire 43.34% of Jonhon Optronic from AVIC 1, Optronics Acquire 48.18% of Xi`an Fostar 127 n.a n.a. Optronics Nov. 213 Acquire additional 1% of Xi`an Fostar by Jonhon Optronic 27 n.a n.a. Optronics Implied weighted average deal price of all transactions Implied weighted average deal price of all avionic related assets transactions Source: the Companies, Guotai Junan International. See the last page for disclaimer Page 8 of 13

9 EARNINGS ESTIMATION Avicopter (638 CH): Revenue from helicopters accounted more than 95% of its revenue in 214. According to the research from Flight Global in 215, China ranked the third in terms of quantity of combat helicopters owned in the world. However, in terms of combat helicopters per 1, headcount in air force, the number is far behind when compared with developed countries. We think that as national military spending is boosting, procurement of helicopters will increase. Since the majority of orders came from government, we think that a moderate increase in orders will be supported in the following years. On the civil helicopter aspects, since helicopters have relatively lower requirement to infrastructures than other aircraft, we anticipate Avicopters will benefit from free-up of low-altitude air space. We modeled 1%/15%/2% growth for Avicopters top line in FY15/FY16/FY17, respectively. Figure-13: Combat Helicopters Owned by Air Force in Different Nations Figure-14:Combat Helicopters Per 1, Air Force Headcount Unit Combat helicopters Unit Combat helicopters per 1, air force headcount USA Russia China South Korea Japan India France UK USA Russia China South Korea Japan India France UK Source: Flight Global, Guotai Junan International. Source: Flight Global, Guotai Junan International. Hongdu Aviation (6316 CH): Aviation products contribute to more than 9% of its revenue. Main products from Hongdu Aviation include trainers such as K-8 and L-15. K-8 accounted for more than 7% of the mid-class trainer in the world and was also the trainer that has been exported the most. We think that since K-8 was designed in 198s, it has already stepped into the middle to late stage of its lifespan and was facing competitions from other trainer providers. L-15 is a newly designed trainer for the third generation jet fighters, and is the few jet trainers in the world that are capable to fly at supersonic speed. We think that the decrease of Hongdu s margin lately was mainly due to the increasing R&D in L-15 and lower margin from K-8. We are bullish on the landscape of L-15 as upgrade of jet fighters to the 3rd and 4th generation will stimulate the demand for L-15 in mid to long run. We expect the top line to increase 5%/15%/15% for FY15/FY16/FY17, respectively. AVIC Avionics (6372 CH): AVIC Avionics is the leading manufacturer of avionics systems in China. After three rounds of assets injections, AVIC Avionics is now comprised of subsidiaries that cover almost the entire area of avionics systems. Our analysis implies that the increasing procurement and replacement from China Air Force and the rising demand from civil and general aviation will jointly fuel up the demand for avionics systems and other parts and components. In addition, the injection of research institutes, once completed, will also boost AVIC Avionics revenue and profitability remarkably. We anticipate revenue of AVIC Avionics to grow at 12%/15%/17% in FY15/FY16/FY17, respectively. Jonhon Optronic (2179 CH): Jonhon Optronic is the largest manufacturer and technical solutions providers of connectors in China. Connectors are commonly used in Aerospace, aviation, military weapons, telecommunications and clean energy vehicles. Jonhon Optronic have maintained stable growth, with its revenue grew at CACR of 21.7% since 28. Gross margin has remained high at over 3% for past few years consistently. Jonhon Optronic has entered into strategic co-operation with Tyco, which is the largest and most advanced in technologies connector provider in the world. We believe the co-operation will enhance Jonhon Optronic presence globally. Catalysts for Jonhon Optronic is similar to that of AVIC Avionics, that the rising procurement from military and accelerating equipment upgrade will lift up the demand for connectors, while the rising demand from civil markets, such as new energy vehicles, railways and telecommunications will also benefit Jonhon Optronic. We believe that Jonhon Optronic will continue to deliver high growth and its top lines are expected to grow at a CAGR of 3% from FY15 to FY17. See the last page for disclaimer Page 9 of 13

10 Table-7: Earnings Estimations of AviChina RMB Mn 213A 214A 215E 216E 217E A-share listed subsidiaries revenue Avicopter (638 SH) 1,831 12,455 13,715 15,84 18,992 Hongdu Aviation (6316 SH) 2,86 3,451 3,623 4,167 4,792 AVIC Avionics (6372 SH) 5,999 6,67 7,399 8,59 9,956 Jonhon Optronic (2179 SZ) 2,62 3,491 4,539 6,127 8,272 Total 22,292 26,4 29,276 34,67 42,11 A-share listed subsidiaries net profit Avicopter (638 SH) Hongdu Aviation (6316 SH) AVIC Avionics (6372 SH) ,12 Jonhon Optronic (2179 SZ) ,19 Total 1,247 1,421 1,745 2,266 3,46 AviChina's interests Avicopter (638 SH) 35.1% 35.1% 35.1% 35.1% 35.1% Hongdu Aviation (6316 SH) 43.6% 43.6% 43.6% 43.6% 43.6% AVIC Avionics (6372 SH) 43.2% 43.2% 43.2% 43.2% 43.2% Jonhon Optronic (2179 SZ) 41.6% 41.6% 41.6% 41.6% 41.6% Profit to AviChina Avicopter (638 SH) Hongdu Aviation (6316 SH) AVIC Avionics (6372 SH) Jonhon Optronic (2179 SZ) Total ,241 Profit attributed by other non-listed companies Net profit for the year ,156 1,513 Source: the Companies, Guotai Junan International. VALUATION Maintain Buy rating but revise down TP to HK$6.7. AviChina is one of the pioneers of civil and military mixture and we expect that AviChina will continue to deliver organic growth given China s increasing military expenses and upgrades of military equipments. The free-up of low-altitude air space will enhance operation in civil aviation segment. We also see plenty upside from the continuing potential assets injection, which will materially affect its subsidies results. We maintain our Buy rating but revise down TP to HK$6.7 due to plunged Hong Kong market lately. We derived our TP from Sum-of-The-Parts (SoTP) valuation and we have not priced in the recent M&A since they are still in progress and uncertainties remained. Assumptions regarding the SoTP method include: 1) A holding discount of 1% due to AviChina s holding nature. 2) Exchange rate between HKD to RMB is.85 in 216. Our target price represents 33.6x/26.8x/2.5x PER for FY15/FY16/FY17 respectively. Figure-15: PER (Next Year) Curve for AviChina Figure-16: PBR (Current Year) Curve for AviChina 213/1 5 (x) 214/1 215/1 216/ /1 (x) 214/1 215/1 216/ AviChina PER (historical mean) PER (current) PER (High) PER (Low) AviChina PER band Source: Bloomberg, Guotai Junan International.. AviChina P/B (historical mean) P/B (current) P/B (High) P/B (Low) AviChina PBR band Source: Bloomberg, Guotai Junan International. See the last page for disclaimer Page 1 of 13

11 Table-8: Summary of SoTP Valuation RMB Mn Market Cap. PER FY16E Net Profit Shareholding Net profit to AviChina A-share Listed Subsidiaries Avicopter (638 CH) 27, x % 185 Hongdu Aviation (6316 SH) 14, x % 58 AVIC Avionics (6372 SH) 38, x % 37 Jonhon Optronic (2179 CH) 22, x % 312 Total net profit attribute to AviChina 925 FY16 PER 32.x. Holding company discount 1% NAV of listed subsidiaries 26,628 Market Cap. attributable to AviChina 42,216 Implied H/A discount of listed subsidiaries 37% Unlisted subsidiaries 4,554 Total NAV of AviChina 31,183 Share outstanding 5,474 NAV per share 5.7 RMB/HKD Target price (HKD) 6.7 Source: Guotai Junan International. Table-9: Peer Comparisons PE (fiscal year) PB (fiscal year) GP Net Market Company ROE(%) Margin(%) Margin(%) Cap Stock Code Currency Last price 14A 15F 16F 17F 14A 15F 16F 17F 15F 15F 15F HKD mil HK - Listed Defense Company AviChina Industry & Tech-H 2357 HK HKD ,288 Cssc Offshore & Marine Eng-H 317 HK HKD n.a (2.5) n.a. (.9) 3,268 Simple Average Weighted Average China Listed Defense Company Avic Aircraft Co Ltd-A 768 CH CNY ,998 Avic Aviation Engine Corp-A 6893 CH CNY ,425 China Avionics Systems Co -A 6372 CH CNY ,91 China Spacesat Co Ltd -A 6118 CH CNY ,64 Avicopter Co Ltd-A 638 CH CNY ,833 Jiangxi Hongdu Aviation-A 6316 CH CNY ,53 Xi'An Tian He Defense Tech-A 3397 CH CNY n.a. n.a. n.a. 4.9 n.a. n.a. n.a. n.a. n.a. n.a. 7,579 Changchun Up Optotech Co-A 2338 CH CNY n.a. n.a. n.a. 8.3 n.a. n.a. n.a. n.a. n.a. n.a. 6,983 Cssc Offshore And Marine E-A 6685 CH CNY (.1) 2.7 (.9) 3,268 China Aviation Optical -A 2179 CH CNY ,349 China Shipbuilding Industr-A CH CNY ,177 Avic Aero-Engine Controls-A 738 CH CNY ,647 Avic Heavy Machinery Co Lt-A 6765 CH CNY n.a. 3.5 n.a. n.a. n.a. n.a. n.a. n.a. 14,613 Avic Electromechanical Sy-A 213 CH CNY ,814 Simple Average Weighted Average Global Listed Defense Company United Technologies Corp UTX US USD ,572 Boeing Co/The BA US USD ,962 Honeywell International Inc HON US USD ,191 Lockheed Martin Corp LMT US USD ,846 General Dynamics Corp GD US USD ,89 Raytheon Company RTN US USD ,261 Northrop Grumman Corp NOC US USD ,696 Airbus Group Se AIR FP EUR ,7 Mitsubishi Heavy Industries 711 JT JPY ,888 Thales Sa HO FP EUR ,552 Simple Average Weighted Average Source: Bloomberg, Guotai Junan International. See the last page for disclaimer Page 11 of 13

12 Financial Statement and Ratios Income Statement Balance Sheet Year end Dec (RMB m) 213A 214A 215F 216F 217F Year end Dec (RMB m) 213A 214A 215F 216F 217F Total revenue 22,193 25,71 29,942 35,339 42,816 Fixed assets 1,83 12,15 12,741 13,551 14,436 Cost of sales (17,885) (2,812) (23,953) (28,95) (33,825) Interests in asso/jv 1, ,111 1,251 Available-for-sale financial assets 1,152 1,238 1,387 1,553 1,74 Gross profit 4,38 4,899 5,988 7,244 8,991 Others Other revenue Non-current assets 13,369 14,687 15,57 16,71 17,967 Other net income Selling expenses (415) (47) (539) (636) (771) Inventories 14,78 16,593 17,63 19,628 22,74 Administrative expenses (2,386) (2,75) (3,53) (4,64) (4,838) Trade and other receivables 8,958 1,974 1,664 12,586 15,25 Other receivables 1,183 1,772 1,931 2,15 2,294 Operating profit 1,758 1,995 2,36 2,968 3,896 Deposits 4,692 3,849 3,879 3,99 3,939 Net financial cost (74) (136) (88) (15) (169) Cash at bank and in hand 6,726 5,798 7,669 7,717 8,173 Share of profits of asso/jv Others 1,22 1,5 1,154 1,27 1,397 Current assets 37,559 4,35 42,36 47,215 53,757 Profit before tax 1,761 2,3 2,359 2,969 3,888 Total Assets 5,928 54,722 57,93 63,925 71,724 Taxation (25) (267) (37) (41) (525) Bank loans and overdrafts 4,27 5,633 6,28 6,45 6,91 Profit for the year 1,511 1,736 2,52 2,568 3,363 Trade and bill payables 14,32 15,5 15,94 17,319 2,388 Minority interest (798) (954) (1,129) (1,413) (1,849) Other payables 3,74 3,81 4,115 4,527 5,7 Others 4,449 4,227 4,552 4,91 5,278 Net profit ,156 1,513 Current liabilities 26,428 28,721 29,789 33,196 37,637 EPS (RMB) Bank loans 1,911 1,785 1,892 1,949 2,7 DPS (RMB) Others ,6 1,17 1,217 Non-current liabilities 2,693 2,699 2,898 3,55 3,224 Total Liabilities 29,121 31,42 32,686 36,251 4,861 Minority interest 11,684 12,486 13,615 15,27 16,877 Shareholders' equity 1,123 1,815 11,629 12,647 13,986 Total Liabilities and Equity 39,244 42,236 44,316 48,898 54,848 Cash flow Statement BPS (RMB) Year end Dec (RMB m) 213A 214A 215F 216F 217F Financial Ratios Profit before tax 1,761 2,3 2,359 2,969 3,888 Year end Dec (RMB m) 213A 214A 215F 216F 217F Depreciation & amortisation Net finance cost Growth (%): Other items (266) (249) (141) (151) (16) Revenue Working capital change (1,436) (2,696) 221 (1,823) (2,15) Gross profit Interest & Tax paid (275) (388) (31) (459) (592) Operating profit Cash flow from operation 572 (392) 3,43 1,579 2,172 Net profit CAPEX (2,862) (1,831) (1,729) (2,39) (2,224) Profitability (%): Others (546) Gross margin Cash flow from investing (3,49) (1,47) (1,563) (1,871) (2,53) Operating margin Net margin Increase in bank loans 1,56 1, ROA Dividends paid (223) (387) (19) (139) (173) ROE Others 2, Cash flow from financing 3, Liquidity & Solvency Current Ratio (x) Cash balance change 1,14 (954) 1, Quick Ratio (x) Cash balances at year begin 5,66 6,726 5,798 7,669 7,717 Net gearing (%) net cash net cash net cash net cash net cash Effect of FX changes (2) 27 Interest coverage (x) Cash balances at year end 6,726 5,798 7,669 7,717 8,173 Dividend payout ratio (x) 15.4% 15.% 15.% 15.% 15.% See the last page for disclaimer Page 12 of 13

13 Company Rating Definition The Benchmark: Hong Kong Hang Seng Index Time Horizon: 6 to 18 months Rating Definition Buy Relative Performance >15%; or the fundamental outlook of the company or sector is favorable. Accumulate Relative Performance is 5% to 15%; or the fundamental outlook of the company or sector is favorable. Neutral Relative Performance is -5% to 5%; or the fundamental outlook of the company or sector is neutral. Reduce Relative Performance is -5% to -15%; or the fundamental outlook of the company or sector is unfavorable. Sell Relative Performance <-15%; or the fundamental outlook of the company or sector is unfavorable. Sector Rating Definition The Benchmark: Hong Kong Hang Seng Index Time Horizon: 6 to 18 months Rating Definition Outperform Relative Performance >5%; or the fundamental outlook of the sector is favorable. Neutral Relative Performance is -5% to 5%; or the fundamental outlook of the sector is neutral. Underperform Relative Performance <-5%; or the fundamental outlook of the sector is unfavorable. DISCLOSURE OF INTERESTS (1) The Analysts and their associates do not serve as an officer of the issuer mentioned in this Research Report. (2) The Analysts and their associates do not have any financial interests in relation to the issuer mentioned in this Research Report. (3) Except for SMI Holdings Group Limited (198), Guangshen Railway Company Limited-H shares (525), China All Access (Holdings) Limited (633), Guotai Junan International Holdings Limited (1788), Binhai Investment Company Limited (2886) and Link Holdings Limited (8237), Guotai Junan and its group companies do not hold equal to or more than 1% of the market capitalization of the issuer mentioned in this Research Report. (4) Guotai Junan and its group companies have had investment banking relationships with the issuer mentioned in this Research Report within the preceding 12 months. DISCLAIMER This Research Report does not constitute an invitation or offer to acquire, purchase or subscribe for securities by Guotai Junan Securities (Hong Kong) Limited ("Guotai Junan"). Guotai Junan and its group companies may do business that relates to companies covered in research reports, including investment banking, investment services and etc. (for example, the placing agent, lead manager, sponsor, underwriter or invest proprietarily). Any opinions expressed in this report may differ or be contrary to opinions or investment strategies expressed orally or in written form by sales persons, dealers and other professional executives of Guotai Junan group of companies. Any opinions expressed in this report may differ or be contrary to opinions or investment decisions made by the asset management and investment banking groups of Guotai Junan. Though best effort has been made to ensure the accuracy of the information and data contained in this Research Report, Guotai Junan does not guarantee the accuracy and completeness of the information and data herein. This Research Report may contain some forward-looking estimates and forecasts derived from the assumptions of the future political and economic conditions with inherently unpredictable and mutable situation, so uncertainty may contain. Investors should understand and comprehend the investment objectives and its related risks, and where necessary consult their own financial advisers prior to any investment decision. This Research Report is not directed at, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any jurisdiction where such distribution, publication, availability or use would be contrary to applicable law or regulation or which would subject Guotai Junan and its group companies to any registration or licensing requirement within such jurisdiction. 216 Guotai Junan Securities (Hong Kong) Limited. All Rights Reserved. 27/F., Low Block, Grand Millennium Plaza, 181 Queen s Road Central, Hong Kong. Tel.: (852) Fax: (852) Website: See the last page for disclaimer Page 13 of 13