China: Aerospace & Defensepg.jrj.com.cn/acc/Res/CN_RES/INDUS/2015/7/29/0a5b962b-ce5c-4357-9cb6-e... · July 29, 2015 China: Aerospace & Defense Goldman Sachs Global Investment Research

July 29, 2015

China: Aerospace & Defense

Equity Research

Three key drivers as budget, AVIC restructuring & reforms remain in focus; Buy AviChina

China defense industry drivers remain intact

We expect China’s growing defense budget,

progress of asset injections by state-owned AVIC,

and more reform/policies to remain the main

drivers of defense stocks under our coverage. In

this report, we look to answer three key questions:

(1) Will slowing GDP growth impact defense

budget uptrend? We expect 10% p.a. growth in

China’s defense budget over 2015E-20E, totaling

US$1trn, as China continues its military build-out.

With its official/adj. defense budget at 1.3%/2.1% of

GDP (2014) vs. the 2.8% average for major peers

worldwide (3.5% US), this implies potential upside.

(2) Is AVIC asset restructuring on track? We

expect unlisted assets at aircraft manufacturer

AVIC to continue to be injected into its listco’s

over the next few years given its stated target to

achieve 80% of assets listed long-term. Unlisted

assets in the avionics segment are most profitable.

(3) When will budget, pricing, R&D, air space

reforms come? We expect defense pricing

reforms to be an ongoing process (lifting margins

closer to global peers by 2020E), and R&D and air

space reforms to be seen over 2015E-2017E.

Assessing the value of China’s defense stocks

Reflecting a more gradual trend in cost-plus pricing

improvement, we lower 2015E-17E EPS across our

coverage by 2%-15% on average, but our 12m TPs

(still based on P/B vs. ROE) increase 20%-55% on

valuation roll forward and updated M&A premium/

discount assumptions. We also cross check our

valuations using an implied 2020E P/E exit multiple,

referencing US defense stocks over 1995-2005, to

see where the best relative value can be found.

AviChina (Buy): A key consolidation platform

We value AviChina by referencing average P/B vs.

ROE over 2000-2005 for the global A&D sector

(from Asia A&D peers earlier), lifting our 12-m TP

by 35% to HK$8.50. Reiterate Buy as we expect

AVIC's ongoing asset restructuring to help solidify

AviChina as a key asset consolidating platform.

A-shares: Upgrade AVIC Avionics to Buy

Maintain Buy on AVIC Helicopter and upgrade

AVIC Avionics to Buy (from Neutral) on relatively

attractive valuations vs. peer group, and also

considering potential earnings accretion in the

future from unlisted asset injections. Sell AVIC

Aircraft and Hongdu Aviation on high valuations.

COVERAGE SUMMARY

Source: Datastream, Bloomberg, Goldman Sachs Global

Investment Research.

REASONS TO READ THE REPORT

We seek to answer the three key questions

currently faced by China’s defense industry.

On AVIC asset restructuring, we analyze the

profitability of AVIC’s unlisted assets and provide

sensitivity analysis on potential asset injections

We assess the long-term value of China defense

stocks as a cross check to make sense of current

valuations.

RELATED RESEARCH

China: Aerospace & Defense: Spotlight on AVIC amid high

sector valuations, December 18, 2014

Ronald Keung, CFA +852-2978-0856 [email protected] Goldman Sachs (Asia) L.L.C. Goldman Sachs does and seeks to do business with companies

covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S.

The Goldman Sachs Group, Inc. Global Investment Research

CodeHK-listed Aero & Defense (HK$)AviChina 2357.HK Buy HKD 8.50 38% 2.3X 32.7X

A-share listed Aero & Defense (Rmb)AVIC Avionics 600372.SS Buy CNY 37.90 26% 9.3X 78.3XAVIC Helicopter 600038.SS Buy CNY 71.30 13% 5.8X 100.6XAVIC Aviation Engine 600893.SS Neutral CNY 52.40 -6% 7.2X 102.2XHongdu Aviation 600316.SS Sell CNY 22.90 -22% 4.2X 179.7XAVIC Aircraft 000768.SZ Sell CNY 17.80 -49% 7.8X 234.8X

2015EP/E (X)

2015EP/B (X)12-m TP

Pot.up/downCompany Rating CCY

July 29, 2015 China: Aerospace & Defense

Goldman Sachs Global Investment Research 2

Exhibit 1: China Aerospace & Defense: Key drivers, valuations and stock recommendations

Source: Company data, Bloomberg, Goldman Sachs Global Investment Research.

Three key drivers as budget, AVIC restructuring & reforms remain in focus; Buy AviChinaThree key drivers What is priced in? Our stock recommendations

(1) China’s defense budget

(2) Asset injections

(3) Reform policies

-

5,000

10,000

15,000

20,000

25,000

30,000

AvionicsSystems

Electro-mechanical

Systems

AviationEngine

AircraftSegment

Helicopter DefenseSegment

Others Total

Profits from listed assets Profits from unlisted assets (Rmb mn)

2.9%

7.2%8.3% 8.4% 8.6%

0%

2%

4%

6%

8%

10%

China defensefinal assemblers

Europe defenseassemblers

Americas civilfinal assemblers

Europe civil finalassemblers

Americasdefense finalassemblers

2015E net margin (%)

Share price performance

A-share defense P/E trend

AviChina trades at a steep discount to A-shares

China is already the second largest spender on defense in the world, its economic growth is slowing, and its real defense spending (incl. R&D) is likely 60% higher than the announced budget. However, we expect China’s defense spending to maintain 10% p.a. growth over 2015E-2020E as the adjusted spending is still only at 40% of the US level and at 2.1% of China’s GDP for 2014 (vs. average of Top 7 countries of 2.8%). We expect a revenue multiplier of 1.3X over 2015-18E (vs. 1.6X over 2011-2014).

10%annualbudgetgrowthover 2015-2020E

1.3Xrevenuemultiplier

China’s aircraft manufacturer AVIC still has sizable profitable assets that have not yet been injected.

AVICaims to have

80%of its assets listed long-term

Avionics, Defense and Electro-mechanical segments are key unlisted areas. Past M&As have been EPS accretive.

We continue to expect pricing reforms over 2015-2020E to lift margins close to global peer levels.3%

net marginsin China’sfinal assemblers

vs. 7%-9% at itsglobal peers

A-share defense stocks have seen a strong rebound in share prices since the recent correction in June 2015

P/E multiples for A-share defense stocks are +1 s.d. from mean

We view AVIC Avionics and AVIC Helicopter as relatively undervalued vs. A-share peers, incl. M&A accretion

AviChina’s implied value taking into account potential M&A accretion looks attractive

Maintain Buy on AviChina with a revised 12-month target price of HK$8.50 (from HK$6.30).In A-shares, we upgrade AVIC Avionics to Buy (from Neutral) and maintain a Buy rating on AVIC Helicopter given attractive valuations. Maintain Sells on AVIC Aircraft and Hongdu Aviation on demanding valuations.

38%potential upsideto ourAviChina12-monthtarget price

H-share AviChina is currently trading at a steep NAV discount vs. its subsidiaries/history

107X

0X

20X

40X

60X

80X

100X

120X

140X

160X

180X

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Avg: 63X

-1 s.d.: 36X

+1 s.d.: 90X

Current: -55%

-80%

-70%

-60%

-50%

-40%

-30%

-20%

-10%

0%

Nov-09 Nov-10 Nov-11 Nov-12 Nov-13 Nov-14

AviChina market value discount vs. its attributable A-share subsidiaries market value

Averagediscount: -42%

0

50

100

150

200

250

300

350

400

Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15

A-share defense stocks avg. Shanghai Composite Index

y = 46.86x + 1.68R² = 0.79

0X

1X

2X

3X

4X

5X

6X

7X

8X

9X

10X

0% 2% 4% 6% 8% 10% 12% 14% 16%

AVIC Helicopter

Hongdu Aviation

JONHON Optronics

AVIC Aircraft AVIC Avionics

AVIC Aviation Engine

China State Shipbuilding

2016-17 ROE

2016

P/B

A-Share A&D P/B vs. ROE comps

CSSC Offshore & Marine

AviChina2357.HK

2020E EPS 0.33 2020E EPS with potential asset injection 0.40 2020E exit P/E multiple implied at current share price 17.8X2020E exit P/E multiple implied at our P/B vs. ROE derived target price 24.6X

Implied 2020E valuation (HK$) 12.22 Cost of equity (%) 9.5%Discounted to 2016E fair valuation 8.50

Cross-check with 2020E exit P/E multiples



Table of contents

Key questions on budget, M&A and reform drivers; understanding current valuations 4

Question 1: Will slower GDP growth affect China’s defense budget uptrend? 8

Question 2: Assessing profitability of AVIC’s unlisted assets and M&A potential 9

Question 3: When to expect R&D corporatization, pricing reforms and more? 12

AviChina: Beneficiary of China’s helicopter growth and asset injection events; Buy 25

AVIC Avionics: High returns and potentially accretive injections; upgrade to Buy 29

AVIC Helicopter: Strong earnings growth and attractive valuation; maintain Buy 32

AVIC Aviation Engine: Looks fairly valued against its returns outlook; maintain Neutral 34

AVIC Aircraft: Risk-reward unfavorable given demanding valuation; maintain Sell 36

Hongdu Aviation: Extremely demanding valuation vs. peers; maintain Sell 38

Disclosure Appendix 45

Prices in this report are based on the market close of July 27, 2015, unless otherwise stated.

The author would like to thank Jess Chen for her contribution to this report.

Exhibit 2: Maintain Buy ratings on AviChina and AVIC Helicopter; upgrade AVIC Avionics to Buy; maintain Sell ratings on AVIC Aircraft and Hongdu Aerospace & Defense – Asia valuation comparison vs. US and Europe

Notes: NC = Not Covered. Estimates for NC stocks are from Bloomberg. Korea Aerospace Industries is covered by Jinmook Kim. China average P/E excludes outliers (AVIC Aircraft and Hongdu Aviation).

Source: Datastream, Bloomberg, Goldman Sachs Global Investment Research.

Market GrowthGS Cap Current P/B P/B Avg. ROE EV/IC EV/GCI Avg. CROCI EPS CAGRRating (US$mn) Price 15E 16E 15E 16E 15E 15E 16E 16E-17E 15E 16E 16E-17E 15E 15E 15E 15E-17E

HK-listed Aerospace & DefenseAviChina Buy 4,351 HKD 6.16 8.50 38% 32.7 27.1 14.0 12.6 1.4 2.3 2.2 9% 1.3 1.2 10% 0% 3% -3% 21%Average 32.7 27.1 14.0 12.6 1.4 2.3 2.2 9% 1.3 1.2 10% 0% 3% -3% 21%China-listed Aerospace & DefenseAVIC Avionics Buy 8,301 CNY 30.16 37.90 26% 78.3 65.4 43.4 38.4 7.5 9.3 8.3 13% 5.8 4.6 11% 0% 9% 51% 17%AVIC Helicopter Buy 3,419 CNY 62.93 71.30 13% 100.6 82.5 46.8 41.6 2.5 5.8 5.5 8% 4.7 5.2 13% 0% 3% -43% 36%AVIC Aviation Engine Neutral 9,774 CNY 55.70 52.40 -6% 102.2 75.6 34.5 31.6 4.5 7.2 6.8 10% 4.0 3.2 10% 0% 4% 55% 30%Hongdu Aviation Sell 3,373 CNY 29.21 22.90 -22% 179.7 113.4 94.5 60.7 5.8 4.2 4.0 4% 4.2 3.6 6% 0% 3% 12% 52%AVIC Aircraft Sell 14,025 CNY 35.15 17.80 -49% 234.8 189.3 77.5 65.9 4.0 7.8 7.7 5% 5.4 4.9 7% 0% 2% 13% 28%JONHON Optronics NC 4,523 CNY 46.62 NA NA 60.6 46.0 36.4 29.1 6.1 9.1 7.8 18% NA NA NA 0% 10% 4% 34%Average 85.4 67.4 55.5 44.5 5.1 7.2 6.7 10% 4.8 4.3 9% 0% 5% 15% 33%

Other Asia Ex. Japan Aerospace & DefenseKorea Aerospace Ind. Neutral 7,308 KRW 87,500 79,000 -10% 49.4 37.6 26.1 20.6 3.1 7.3 6.3 15% 4.7 2.8 13% 0% 6% 53% NAST Engineering NC 7,567 SGD 3.33 NA NA 19.0 17.7 13.2 12.5 1.6 4.6 4.4 25% NA NA NA 4% 8% NA 7%Aerospace Ind. Dev. Corp. NC 1,085 TWD 37.70 NA NA 16.5 14.2 8.7 7.4 1.3 2.9 2.7 20% NA NA NA 3% 8% NA 13%Average 28.3 23.1 16.0 13.5 2.0 5.0 4.5 20% 4.7 2.8 13% 3% 7% 53% 10%

Average US Aerospace & Defense 15.8 14.1 9.8 8.9 1.7 7.8 8.8 46% 2.3 1.7 16% 2% 8% 70% 9%

Average Europe Aerospace & Defense 15.2 13.4 7.9 7.4 1.3 2.8 2.6 22% 1.7 1.1 12% 3% 8% 6% 13%

P/B vs ROE Director's Cut Div Yld Net Margin Net debt/Equity

Company CCY TP (12mth) P/E (X) EV/EBITDA (X)EV/ SalesUp/

down pot.

Earnings Multiples



Key questions on budget, M&A and reform drivers; understanding current valuations

Key industry thesis and investment recommendations; AviChina (Buy) is our top pick

We expect China’s defense budget, the progress of asset injections, and reform policies to remain as key drivers of the defense

stocks. Among the key listed entities we cover under state-owned aircraft manufacturer Aviation Industry Corporation of China

(AVIC), we maintain a Buy on Hong Kong-listed AviChina as we expect ongoing asset restructuring by AVIC to help solidify

AviChina’s position as a key offshore consolidating platform for the group. We also expect its subsidiaries – AVIC Avionics (upgrade

to Buy from Neutral) and AVIC Helicopter (Buy) – to be consolidators of respective unlisted assets, and see both stocks as relatively

undervalued versus peers. We view the valuation of AVIC Aviation Engine as fair against its returns outlook, particularly as the

company has already received a number of major aero engine assets from AVIC, and maintain our Neutral rating. Meanwhile, we

reiterate our Sell ratings on AVIC Aircraft and Hongdu Aviation on the back of overly demanding valuations, >230X and >170X on

2015E P/E respectively vs. other A-share defense peers at c.85X, which we believe are being driven by hopes of military-related asset

injections.

We seek to answer the three key questions faced by China’s defense industry

1. Will slower GDP growth impact China’s defense budget uptrend? We expect the defense budget will grow at 10% p.a. over

2015E-20E, totaling US$1trn, as China remains focused on building up its military powers. This compares with our prior forecast

of 12% p.a. over 2014-17E, as we now factor in the lower-than-expected announced defense budget growth of 10% for 2015 and

extend our forecasts to 2020E. The current announced/adjusted (incl. R&D, according to Stockholm International Peace Research

Institute – SIPRI) defense budget in China only accounts for 1.3%/2.1% of GDP (2014), vs. the average for global world powers of

2.8% or the US at 3.5%, so we see room for further upside.

2. Assessing profitability of AVIC’s unlisted assets; is asset restructuring still on track? We continue to expect more unlisted

assets at AVIC will be injected into its listed companies over the next few years given its stated long-term target to achieve 80%

of its assets listed. AVIC still has substantial profitable assets that have not yet been injected into its listed companies (including

in the avionics, defense and electro-mechanical segments), while its unlisted avionics assets (R&D institutions that are involved

in system integration) look the most attractive in terms of profitability.

3. When could we expect R&D corporatization, pricing reforms and more? We expect China’s ongoing defense budget

reforms to drive improvements to the current cost-plus pricing mechanisms (lifting margins for final assemblers, as Chinese

final assemblers have seen declining margins over the years, and they now stand at less than half the level of global peers).

Meanwhile, while China’s air space is controlled and majority occupied by the military, we expect continued low altitude air

space opening over 2015E-2020E, as stipulated in the 12th Five Year Plan (aim to achieve initial opening of low altitude air space

by end-2015). On R&D corporatization, we believe the government remains committed to such SOE reforms, and any progress

on this front (we expect over 2015E-16E) could lead to the potential for R&D asset injections. We note that AVIC’s five avionics

R&D institutes are the most profitable of its 33 R&D institutes, and believe this is because instead of being cost centers, these

five are involved in system integration (putting avionics into an integrated flying control system), a critical process in aircraft

manufacturing.



Assessing the long-term value of China defense stocks and making sense of current valuations

We lower 2015E-17E EPS forecasts across our coverage by 2%-15% on average, reflecting limited cost-plus pricing

improvements year-to-date, but lift our 12-month target prices (still based on P/B vs. ROE valuation methodology) by 20%-55%

on: (1) roll forward of valuation to 2016E P/B vs. 2016E-17E ROE (from 2015E P/B vs. 2015E-16E ROE), and (2) updated M&A

premium/discount assumptions (see Exhibit 20 and Company Snapshots for details).

A-share defense stocks under our coverage currently trade at 78X-235X 2015E P/E, in our view driven not only by an A-

share investor focus on revenue growth from higher defense spending (we expect China’s defense budget to grow an average

of 10% p.a. over 2015E-20E, with potential for exports/civil growth), but also by the potential for higher margins (from pricing

reform) and earnings accretion from asset injections. Our earnings estimates for the sector assume pricing reforms over 2015E-

20E and margin improvement toward the level of global peers by 2020E.

Current share prices imply 2020E P/E exit multiples of 18X at AviChina and 34X-83X for A-share defense names. While

we continue to base 12-month target prices across our coverage on P/B vs. ROE methodology, which we view as appropriate

given the strong correlation and alpha-generation in valuation back-testing1, we use exit P/E-based valuations as a cross check.

Looking at implied valuations based on 2020E earnings and discounting back to 2016E (taking into account of time value of

money, discounted using cost of equity over 2016E-20E) captures the strong long-term growth outlook for the China defense

industry. By 2020E, we expect China’s adjusted defense budget (including R&D and equipment imports) to be on par with

absolute levels seen in the US in 2000 (c.US$290bn, US defense spending grew at a comparable 11% CAGR over 2000-2005).

Therefore, by comparing AviChina’s 2020E P/E exit multiple of 18X (using the current share price) with US defense stocks that

traded between 20X-30X P/E over 1995-2005, we believe its current valuation does not look demanding and continue to see

upside to the stock. Based on our cross check analysis, we also see relative value in AVIC Avionics and AVIC Helicopter, with

implied 2020E P/E exit multiples of 35X and 34X respectively, based on current share prices.

H-shares: Maintain Buy on Hong Kong-listed AviChina

We lift our P/B vs. ROE-based 12-m target price for AviChina to HK$8.50 (from HK$6.30) after incorporating: (1) the P/B vs. ROE

regression line over 2000-2005 for the Global Aerospace & Defense (A&D) sector (valued using Asia A&D peers previously), and (2) a

35% M&A premium (increased from 15% after factoring in potential accretion from helicopter, avionics, and other AVIC assets). As a

cross check our new target price implies a 24.6X 2020E exit P/E which looks attractive vs. peers. We reiterate our Buy on AviChina as

AVIC's ongoing asset restructuring should help solidify AviChina as a key offshore consolidating platform for the group, while we

expect its subsidiaries – AVIC Avionics and AVIC Helicopter – to be consolidators of AVIC’s unlisted avionics and helicopter assets.

1 For additional detail please see our December 18, 2014 report ‘China: Aerospace & Defense – Spotlight on AVIC amid high sector valuations’.



A-shares: Upgrade AVIC Avionics to Buy (from Neutral), maintain Buy on AVIC Helicopter; Sell on

AVIC Aircraft, Hongdu Aviation on demanding valuations

We maintain our Buy on AVIC Helicopter and upgrade AVIC Avionics to Buy (from Neutral) given their relative undervaluation vs.

the peer group, especially when we consider the potential for earnings accretion from unlisted helicopter and avionics asset

injections and also the long-term growth potential in China’s helicopter fleet. We continue to expect AVIC Avionics to benefit from

potential injection of unlisted avionics assets from AVIC (R&D facilities that are involved in system integration, in line with the

company’s stated strategy). Under our scenario analysis, a complete injection of unlisted avionics assets from AVIC could boost

AVIC Avionics’ 2014 EPS by c.60% (if funded by new share issuance at the current price) and lift the implied P/B vs. ROE valuation.

We view the valuation of AVIC Aviation Engine as fair against its returns outlook and peers, at 76X 2016E P/E and 6.8X 2016E P/B,

and maintain our Neutral rating. While we believe there are limited unlisted revenues/profits that could be injected from AVIC, we

do see the potential for further restructuring between the three listed aero-engine companies given the current highly complex

structure.

We reiterate our Sell ratings on AVIC Aircraft and Hongdu Aviation given current demanding 2015E P/E valuations of >230X and

>170X respectively. As a cross check, AVIC Aircraft and Hongdu Aviation’s 2020E exit P/E multiples of 74X and 83X (at current share

prices) also look demanding vs. other A-share defense peers’ implied 2020E exit multiples of 34X-44X.

Exhibit 3: We upgrade AVIC Avionics to Buy, and maintain Buy ratings on

AviChina and AVIC Helicopter Summary of rating and 12-month target price changes

Exhibit 4: We expect 10% p.a. defense budget growth over 2015-18E (from

12% over 2014-17E) Changes to our industry assumptions

Source: Datastream, Goldman Sachs Global Investment Research.

Source: MOF, Company data, Goldman Sachs Global Investment Research.

Company Ticker New Old Change New Old ChangeAviChina 2357.HK HK$ Buy Buy ↔ 8.50 6.30 35% 38%AVIC Avionics 600372.SS Rmb Buy Neutral ↑ 37.90 31.50 20% 26%AVIC Helicopter Co. 600038.SS Rmb Buy Buy ↔ 71.30 50.50 41% 13%AVIC Aviation Engine 600893.SS Rmb Neutral Neutral ↔ 52.40 33.90 55% -6%Hongdu Aviation 600316.SS Rmb Sell Sell ↔ 22.90 17.40 32% -22%AVIC Aircraft 000768.SZ Rmb Sell Sell ↔ 17.80 12.50 42% -49%

CCYPot. up/

downside Rating Target Price

2011-2014Old

(2014-17E)New

(2015E-18E) DifferenceChina defense spending growth (%) 10% 12% 10% -2.2ppTop line growth vs. defense spending 1.6X 1.1X 1.3X + 0.2XEBIT margin 6.6% 7.7% 7.6% -0.1ppNet margin 4.7% 5.4% 5.2% -0.3pp



AVIC group structure and key business segments

Exhibit 5: An overview of key entities under AVIC Group AVIC corporate structure (as of July 2015, red boxes denote companies that are under GS coverage)

Source: Company data, Goldman Sachs Global Investment Research.

AVIC

AviChina(2357.HK)

Tianjin Municipal

AVIC Helicopter

Harbin

Group

JingdezhenAircraftParts

HuiyangAviationPropeller

TianjinHelicopter

20.09%79.91%

GuizhouAircraft

GuizhouLiyang Aero

Engine Group

AVIC General Aviation

100%100%

AVIC Defense

HongduAviation

(600316.SS)

HarbinAviation(Group)

ChangheAviation

AVIC Avionics

(600372.SS)

JONHON Optronics

(002179.SZ)

HongduGroup

Chengdu AircraftGroup

ShenyangAircraftGroup

AVICHelicopter(600038.SS)

AVIC Aircraft

Aviation Industry Corporation of China (AVIC)

AviChina(2357.HK)

100%

Xi'an Aircraft Group

Shaanxi Aircraft Group

AVIC Aircraft (000768.SZ)

7.38%

43.77% 43.22% 41.57%

28.65%

100%100%

COMAC (ARJ21/C919)

26.3%

100%

6.56%18.78%

8.15%

AVIC Engine

GuizhouGaike

AVIC Avionics Systems

AVIC Electro-mechanical Systems

(002013.SZ)

ZhonghangHeibao

(600760.SS)

LuoyangInstitute of

Electro-OpticalEquipment

Xian FlightAutomatic Control

ResearchInstitute

AVIC RadioElectronics

Research Institute

Xian AviationComputingTechnology

Research Institute

AVIC Capital(600705.SS)

7.92%

2.81%

Aircraft

54.85%

17.80%

AVIC ElectricalMechanical Systems

70%

TianjinAviation

AVICAvionics

(600372.SS)

Institute ofRadar andElectronicEquipment

Chengfei Integration(002190.SZ)

4.38%

Classified as same segment despite no shareholding relationship

AVIC TechnologyFoundation

10.72%

51.33%

35.8%

10.55%

13.752%2.00%

AVIC International

62.29%

39.80%

42.37%

43.17%

15.97%

97.89%

34.34%

(232.HK)

AVIC International Holding (HK)

AVIC International Holdings(161.HK)

AVIC International (HK) Group

AVIC Shenzhen

35.63%

100%

39.37%

AVIC Joy(260.HK)

11.24%

62.52%

100%

23.01%

listed companies

Under GS coverage

Key segmentsunder AVIC

94.15% 100%

100% 100%100%

100%

100%

Direct holding by AVIC

AVIC Commercial Aircraft Engine

40%

BaoshengGroup

AVIC LeihuaRockwell Collins

Avionics

AVIC GE Civil Avionics

Systems

50% (JV)

50% (JV)

100%

100%

100%

100%

100%

AVIC AeroEngine Controls(000738.SZ)

40.97%

30.61%

17.39%

10.29%

GuizhouLiyang

Aviation

GuizhouAviation Power

Shenyang Liming

Shanxi Aero-Engine

Maintenance

Jilin Aviation Maintenance

Shenzhen Sanye

Precision

100%100%

100%100%

100%

Xi'an Aero Engine(Group)

AVIC AviationEngine

(600893.SS)

91.05%

100%100%

ChengfaGroup

ChengfaS&T

(600391.SS)

52.85%

36.02%

AVIC South Aviation

BaoshengS&T Innovation

(600973.SS)

75%

35.66%

AVICEmerging Industry

Investment

AVICInvestment

Holding

AVICAviation Industry

Investment

China Aero Polytechnic Establish.

(301)

Precision Engineering

Institute (303)

Institute of Metrology &

Measurement(304)

Institute of Aeronautical

Materials (621)

Aircraft Strength

Institute (623)

Aeronautical Manu.

Technology(625)

Aerodynamic ResearchInstitute

(626/627)

Aeronautical Measure-

Controlling Institute (633)

Aeronautical Measurement-Controlling

Institute (634)

TontecTechnology(600862.SS)

AviationComposites

ExcellentAviation

Excellent Bermuda Material

100%100% 100%

42.86%

Hefei Aero-Electric Physics

Technology

Institute for Special Structures

of Aeronautical Composite (637)

Civil aviation programs100%

100%

100%

100%

8.892%

7.03%

1.086%

0.47%



Question 1: Will slower GDP growth affect China’s defense budget uptrend?

10% growth p.a. in defense spending for China over 2015E-20E despite slowing GDP growth

While China is already the second largest spender in the world on defense and its economic growth is slowing, we believe there is

still room for upside surprise given its low proportion of spending as a percentage of GDP. China’s officially announced defense

budget of Rmb890bn (US$140bn) for 2015 is at 1.3% of our Global Macro Research teams GDP forecast for 2015E (similar to 2014 of

1.3%). This compares to the average of its major peers worldwide of 2.8% of GDP in 2014. If we use the SIPRI adjusted budget for

China (taking into account weapon imports and R&D that are not included in China’s official budget), this would put China’s

adjusted defense spending at US$230bn for 2014, or at 2.1% of 2014 GDP, still below the average of the world’s top powers at 2.8%

and substantially below the US (3.5%) and Russia (4.5%).

While our forecasts assume a similar percentage of GDP for China’s official defense budget (10% growth p.a., nominal, 1.5% of GDP

by 2020E), we highlight the potential for China’s defense spending to significantly surprise on the upside vs. our base case

assumption in the event of any sustained heightened territorial conflicts in the region. Based on 10% p.a. growth in China’s defense

budget, we estimate its official/adjusted defense spending could reach US$222bn/US$375bn by 2020E, putting China on par with the

defense spending levels seen in the US over 2000-2005.

Exhibit 6: We expect China’s official defense budget to grow 10% p.a. in

2015E-20E, amounting to US$1trn in total over the six years China’s official defense budget (Rmb bn)

Exhibit 7: Our base case assumes no radical change in China’s defense

spending as a % of GDP, but any sustained territorial conflicts in the region

could pose upside risk to our assumptions Defense spending in 2014 (US$ bn)

Note: China’s adjusted defense budget for 2014 (including R&D and weapon imports) is used in the

chart for comparison purposes.

Source: MOF, SIPRI, Goldman Sachs Global Investment Research. Source: MOF, SIPRI.

-30%

-20%

-10%

0%

10%

20%

30%

40%

0

200

400

600

800

1,000

1,200

1,400

1,600

1950 1960 1970 1980 1990 2000 2010 2020EChina defense expenditure (Rmb bn) Defense spending yoy growth

3.5%

2.1%

4.5%

10.4%

2.2% 2.2% 2.4%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

-

100

200

300

400

500

600

700

USA China Russia Saudi Arabia France UK India

2014 Defense spending (US$bn) As % of GDP

Top 7 countries average 2.8% of GDP (ex. Saudi Arabia)



Question 2: Assessing profitability of AVIC’s unlisted assets and M&A potential

In the chart below, we look into AVIC Group performance in 2014, and the source of group profits that have not been injected into its

listed companies. AVIC’s avionics and defense assets are the two single largest segments with sizable profits in unlisted entities.

Exhibit 8: Key financials of AVIC Group


Group revenue trendThe overall AVIC Group recorded 11% revenue growth in 2014, where aeronautical products revenue grew 17% yoy

(implying a revenue multiplier of 1.4X vs. 12% growth in China’s defense budget in 2014).

AVIC Group: Key financials at a glance

Aeronautical products gross profit breakdown

Aeronautical products gross margins in 2014 (%)

15%

22%26%

14% 16%11%

0%5%10%15%20%25%30%

0

100,000

200,000

300,000

400,000

500,000

2008 2009 2010 2011 2012 2013 2014Total aeronautical products revenue (Rmb mn)Total AVIC Group revenue (Rmb mn)Total AVIC Group revenue growth (%)

AvionicsSystems

23%

Electro-mechanical

Systems12%Aviation

Engine16%

Aircraft Segment

11%

Defense Segment

10%

Helicopter7%

Other aeronautical gross profits

21%

AVIC Group’s aeronautical products gross profit reached Rmb24.84bn in 2014, with the avionics, engine, and electro-mechanical segments (listed + unlisted) the key contributors.

22% 20%

25% 26%21%

27% 26%

10%

14%

18%

22%

26%

30%

2008 2009 2010 2011 2012 2013 2014Aeronautical products gross margin (%)AVIC Group overall gross margin (%)

Group gross margin trend (%)Overall aeronautical products gross margins have edged higher over the years, an indication of gradual improvement in cost-plus pricing of defense products.

Group revenue breakdown

Aeronautical products

25%

Non-aeronautical

products44%

Servicing and others

30%

Aeronautical products gross profits: listed vs. unlisted25% of AVIC Group revenues in 2014 were from aeronautical products. Non-aero products incl. gas turbines, electronics, automobiles. Servicing incl. leasing, finance, airlines, general aviation services, property development, etc.

-

5,000

10,000

15,000

20,000

25,000

30,000

AvionicsSystems

Electro-mechanical

Systems

AviationEngine

AircraftSegment

Helicopter DefenseSegment

Others Total

Profits from listed assets Profits from unlisted assets (Rmb mn)

AVIC Group has sizable aeronautical products profits that have not yet been injected into its listed companies (2014).

34% 32%26%

19%

12% 10% 10%

0%

10%

20%

30%

40%

Electro-mechanical

Systems

AvionicsSystems

Overall AviationEngine

AircraftSegment

DefenseSegment

Helicopter

AVIC’s avionics and electro-mechanical segments generate the highest margins, while its final assembly lines generate lower gross margins. We expect pricing reforms to gradually lift final assemblers margins over 2015E-2020E.



Sensitivity analysis of potential impact on avionics segment

Past M&A deals at AVIC entities have mostly been accretive, helped by the issuance of new shares at a significant premium to book

value, while acquiring assets that were on average priced at 1.4X P/B. The average trailing P/E of assets acquired has been 23X,

which compares with the A-share defense stocks currently trading at 78X-235X 2015E P/E. Our sensitivity analysis shows that there

could be significant EPS accretion for AVIC Avionics in the event of a potential injection of the unlisted assets of AVIC Avionics

System (after the corporatization of such entities, including the key R&D avionics institutes as listed below).

Exhibit 9: Sensitivity analysis shows c.60% potential earnings accretion (based on 2014 EPS) for AVIC Avionics in the event that an

injection of unlisted assets from AVIC Avionics System is funded by new share issuance at current price AVIC Avionics: listed vs. unlisted assets


Avionics

Key avionics assets still at unlisted AVIC Avionics Systems

• 100% Xian Flight Automatic Control Research Institute

• 100% Xian Aviation Computing Technology Research Institute

• 100% Luoyang Institute of Electro-OpticalEquipment

• 100% AVIC Radio Electronics Research Institute• 100% Institute of Radar and Electronic

Equipment• 100% Beijing Qingyun Aviation Instrument• 50% AVIC Leihua Rockwell Collins Avionics (JV)• 50% AVIC GE Civil Avionics Systems (JV)

Note that the above research institutes are not only cost centers, but also revenue sources as they are involved in avionics system integration

AVIC

AviChina(2357.HK)


AVIC Avionics

(600372.SS)

JONHON Optronics

(002179.SZ)

Relationships

100% 54.85%

41.57%43.22%17.99%

15.91%

*AVIC has entrusted AVIC Avionics (600372.SS) to have full operational control of AVIC Avionics Systems since July 2014

Avionics products revenue (unlisted vs. listed assets)

Avionics products gross profit(unlisted vs. listed assets)

11%

14%

6%

12%

0%2%4%6%8%10%12%14%16%

-

2,000

4,000

6,000

8,000

10,000

12,000

2012 2013 2014AVIC Avionics Systems' avionics revenue -unlisted (Rmb mn)AVIC Avionics (600372.SS) - avionics revenue(Rmb mn)AVIC Avionics Systems' avionics revenue growth- unlistedAVIC Avionics (600372.SS) - avionics revenuegrowth

44% 41%

30%37% 34%

34%

0%5%10%15%20%25%30%35%40%45%50%

- 500

1,000 1,500 2,000 2,500 3,000 3,500 4,000

2012 2013 2014AVIC Avionics Systems' avionics gross profit -unlisted (Rmb mn)AVIC Avionics (600372.SS) - avionics gross profit(Rmb mn)AVIC Avionics Systems' avionics gross margin -unlistedAVIC Avionics (600372.SS) - avionics grossmargin

Asset injection: EPS accretion sensitivity analysis

• Assuming all of AVIC Avionics System unlisted assets are injected into AVIC Avionics (600372.SS)

• Such sensitivities indicate the lower bound of accretion as non-aero and loss-making assets are included

Asset injection: P/B vs. ROE accretion sensitivity analysis

• Such a transaction, if fully funded by issuance of new shares, could increase book value per share significantly, although with a decline in group ROE => but with positive net impact on P/B vs. ROE

We believe margins have declined for unlisted assets on staff benefit reforms

AVIC Avionics’ current share

price

EPS accretion for AVIC AvionicsIf unlisted assets are acquired at P/E => 20X 25X 30X 35X

Total value of acquisition (Rmb mn) 16,751 20,939 25,127 29,315 Implied P/B of unlisted assets 0.98 1.22 1.46 1.71 If funded by AVIC Avionics new share

placement at: ↓40X P/E (implied 4.7X P/B) 41% 28% 17% 8%45X P/E (implied 5.2X P/B) 48% 35% 24% 15%50X P/E (implied 5.8X P/B) 54% 41% 30% 21%55X P/E (implied 6.4X P/B) 59% 47% 36% 27%60X P/E (implied 7.0X P/B) 63% 51% 41% 32%65X P/E (implied 7.6X P/B) 68% 56% 46% 37%70X P/E (implied 8.2X P/B) 71% 60% 50% 41%

PB-ROE accretion based on acquired/funded P/EIf unlisted assets are acquired at P/E => 20X 25X 30X 35X

Total value of acquisition (Rmb mn) 16,751 20,939 25,127 29,315 Implied P/B of unlisted assets 0.98 1.22 1.46 1.71 If funded by AVIC Avionics new share

placement at: ↓40X P/E (implied 4.7X P/B) 32% 25% 18% 11%45X P/E (implied 5.2X P/B) 35% 29% 23% 17%50X P/E (implied 5.8X P/B) 38% 32% 27% 21%55X P/E (implied 6.4X P/B) 40% 35% 30% 25%60X P/E (implied 7.0X P/B) 42% 37% 32% 28%65X P/E (implied 7.6X P/B) 43% 39% 34% 30%70X P/E (implied 8.2X P/B) 44% 40% 36% 32%



Assessing AVIC’s helicopter, aero-engine and aircraft segments

Helicopter: For AVIC Helicopter, our sensitivity analysis indicates EPS accretion (based on 2014) from any potential injection of

unlisted combat helicopter assets from AVIC if the P/B multiple is above 2.5X (current 2015E P/B for AVIC Helicopter is 5.8X).

Aero-Engine: For AVIC Aviation Engine, we believe there are limited unlisted revenues/profits that could be injected from AVIC.

However, we see potential for further restructuring between the three listed aero-engine companies given the highly complex

structure shown in the chart below.

Aircraft: Based on our current assessment, we do not see sizable unlisted aircraft assets outside of AVIC Aircraft.

Exhibit 10: AVIC’s helicopter and aero-engine assets: unlisted vs. listed


Helicopter

AVIC

AviChina(2357.HK)

AVIC Helicopter

Co.

AVIC Helicopter

(600038.SS)

Relationships

79.91% 54.85%

35.21%26.93%

*Simplified ownership relationship chart.Key unlisted assets are the final assembly lines for AVIC’s combat helicopters

Helicopter segment revenue and profits

(unlisted vs. listed assets)

Asset injection: EPS accretion sensitivity analysis

• Assuming all of AVIC Helicopter Co.’s unlisted assets are injected into AVIC Helicopter (600038.SS)

• Such sensitivities indicate the lower bound of accretion as non-aero and loss-making assets are included

Asset injection: P/B vs. ROE accretion sensitivity analysis

• Such a transaction, if fully funded by issuance of new shares, could increase book value per share, but a decline in group ROE

• The net impact on P/B vs. ROE would be neutral if funded shares at 5.0X P/B or above

04,0008,000

12,00016,000

2012 2013 2014

0100200300400500

2012 2013 2014AVIC Helicopter Co. - unlisted assets (Rmb mn)AVIC Helicopter (600038.SS) - (Rmb mn)

Revenue

Profit before tax

EPS accretion sensitivityIf unlisted assets are acquired at P/B => 1.00X 1.05X 1.10X 1.15XTotal value of acquisition (Rmb mn) 5,201 5,461 5,721 5,981

If funded by AVIC Helicopter's new share placement at P/B: ↓

1.5X -11% -13% -14% -16%2.0X -2% -4% -5% -7%2.5X 4% 2% 1% 0%3.0X 8% 7% 6% 5%3.5X 12% 11% 10% 9%4.0X 15% 14% 13% 12%4.5X 17% 16% 15% 14%5.0X 19% 18% 17% 16%

PB-ROE: M&A premium based on acquired/funded P/EIf unlisted assets are acquired at P/B = 1.00X 1.05X 1.10X 1.15XTotal value of acquisition (Rmb mn) 5,201 5,461 5,721 5,981

Assuming funded by AVIC Helicopter's new share placement at

P/B: ↓1.5X -34% -36% -38% -41%2.0X -22% -23% -25% -27%2.5X -14% -16% -17% -19%3.0X -10% -11% -12% -13%3.5X -6% -7% -8% -9%4.0X -4% -4% -5% -6%4.5X -2% -2% -3% -4%5.0X 0% -1% -1% -2%5.5X 1% 1% 0% -1%

AVIC Helicopter’s current share price

Aero-Engine

AVIC

AVIC General Aviation

Guizhou Aircraft

Relationships

10.29%

*Simplified ownership relationship chart.While there are limited unlisted revenues/profits that could be injected, we think the above structure is still highly complex and that further restructuring is possible for the Aviation Engine segment longer-term.

AVIC Engine listed and unlisted revenue and profits

AVIC Engine

Xian Aero Engine (Group)

Guizhou LiyangAero Engine Group Guizhou Gaike

AVIC Aviation Engine (600893.SS) Chengfa S&T (600391.SS)

AVIC Aero Engine Controls (000738.SZ)

ChengfaGroup

100% 70%

91.05%

30.61% 10.55%

13.75%

2.0%

17.39%

35.8%

52.85%

36%

100%

100% 40.97%

Aeronautical products revenue (Rmb mn)

Aeronautical products gross margin (%)Pre-tax profit (Rmb mn)

Overall revenue (Rmb mn)

-

5,000

10,000

15,000

20,000

25,000

30,000

AVIC AviationEngine

(600893.SS)

Sichuan ChengfaAero (600391.SS)

AVIC AeroEngine Controls

(000738.SZ)

Unlisted AVICEngine assets

20132014

(400)

-

400

800

1,200

1,600

AVIC AviationEngine

(600893.SS)


AVIC Aero EngineControls

(000738.SZ)


20132014

-

4,000

8,000

12,000

16,000

20,000

AVIC AviationEngine

(600893.SS)


AVIC AeroEngine Controls

(000738.SZ)


20132014

20%16%

22%18%20%

23%

15%20%

0%

5%

10%

15%

20%

25%

AVIC AviationEngine

(600893.SS)


AVIC Aero EngineControls

(000738.SZ)


2013

2014



Question 3: When to expect R&D corporatization, pricing reforms and more?

Pricing reform: We expect defense industry reforms to lead to cost-plus pricing improvements

In February 2013, Premier Xi ordered tightening on the accountability of China’s defense budget.

China’s defense budget roughly covers three areas – personnel expenses, training & maintenance expenses, and equipment

expenses – with each taking up approximately one third of the budget.

Since 2013, China started emphasizing structural reforms and reorganization for the military, and in 2014 the defense budget

stressed a shift towards training and investment in new high-technology weapons and equipment, and encouraged more

private enterprises to enter military procurement.

We expect China’s ongoing defense reform and anti-corruption initiatives to contribute to even more effective use of the budget

ahead towards equipment modernization, particularly given higher accountability, standard protocols and optimized

management systems set for the upcoming 3-6 years.

Any pricing reform for defense products could represent key margin upside for China defense companies

China’s final assemblers have seen margins declining over recent years as labor/material costs continued to rise, but the military did

not increase procurement prices according to cost inflation. Given our anticipation of larger fleet batch size productions over the

next few years, and potential improvements to military products’ cost-plus pricing mechanism, we expect China’s final assembler

margins to slowly improve on scale effect and improved pricing. We expect net margin for AVIC Helicopter to expand from 2.7% in

2014 to 3.7% by 2017E and then to reach 5.6% by 2020E (with margins closer to global peers).

Exhibit 11: China’s defense companies have very low margins Defense companies net margin in China vs. peers in Americas/Europe

Exhibit 12: AVIC Helicopter margins should gradually improve over 2015E-20E Global key helicopter manufacturers (bubble size: 2014 revenue in US$)

Note: *2011-14 average

Source: Company data, Goldman Sachs Global Investment Research. Source: Company data, Goldman Sachs Global Investment Research.

2.9%

7.2%8.3% 8.4% 8.7%

0%

2%

4%

6%

8%

10%

China defensefinal assemblers

Europe defenseassemblers

Americas civilfinal assemblers

Europe civil finalassemblers

Americasdefense finalassemblers

2015E net margin (%)

Eurocopter

Sikorsky Agusta Westland

Russian Helicopters

Bell

AVIC Helicopter - 2020E

0.0%

3.0%

6.0%

9.0%

12.0%

15.0%

18.0%

21.0%

24.0%

27.0%

30.0%

-10% -5% 0% 5% 10% 15% 20% 25% 30%

2014

EBI

T Ma

rgin

Revenue yoy growth*

Average: 8.7% (ex. Russian Helicopters)

Aver

age

AVIC Helicopter: 2014 EBIT margin: 3.2%



R&D corporatization: Timing dependent on SOE reform progress

On R&D corporatization, we believe the government remains committed to such SOE reforms, and any progress on this front (we

expect over 2015E-16E, until policies surrounding the transfer of governmental R&D personnel into SOEs are in place, alongside

China’s ongoing defense reform) could lead to the potential injection of these assets once they are corporatized. AVIC has 33 R&D

institutes in total, of which its five avionics R&D institutes are the most profitable.

Air space reform: National low altitude air space usage legal framework near finalization, full low-

altitude air space opening in sight

In July 2014, China’s State Council, People’s Liberation Army (PLA) and the Civil Aviation Administration of China (CAAC) jointly

published a draft ‘Low-altitude airspace management regulation’ for consultation with all related general aviation parties/companies,

which will define the legal framework, authorization for entry, flight plan approval, related services and industry regulations for

<1,000m air space usage once it is officially stipulated. In the past, any flight plans had to be first approved by the military, then by

the CAAC, which would take at least a few days ahead of a helicopter flight. Reforms have already begun in select provinces’ pilot

zones:

In November 2013, the PLA and CAAC announced that besides specified cross-border/military-sensitive General Aviation

activities, other General Aviation flights will only need to submit their flight plans in the future to the CAAC for approval.

In November 2013, the CAAC lowered requirements for obtaining a private pilot’s license.

In November 2014, a national low altitude air space reform working meeting was held in Beijing where the ‘Low-altitude

airspace management regulation’ was discussed.

Under the 12th Five Year Plan, China’s low altitude airspace is set to be opened nationwide by end-2015, and according to the CAAC,

the general aviation industry will realize considerable scale by 2020. The total flying hours of general aviation aircrafts was only

0.6mn in 2013 and the CAAC expects this number to reach 2mn by 2020, implying a 19% CAGR. In addition, based on the estimate of

AVIC, the number of GA aircrafts will expand to 9,000 from 2,500 in 2015. We expect a formal stipulation of China’s low altitude air

space legal framework to be a cornerstone to the development of China’s general aviation industry, helicopter and fixed-wing

propeller aircraft. According to CAAC, general aviation infrastructure development will be promoted. The National Air Traffic Control

office will draft low-altitude flying map. CAAC will assist in the planning of low-altitude service stations. The construction of general

aviation airports will be coordinated among CAAC, PLA and local governments. Communication, air control and avionics systems

for general aviation will be developed in scale as the policy specifies the entry requirement for areas of different classifications.

Exhibit 13: China is set to finalize the draft low altitude airspace management regulations, which we expect will pave the way to complete opening of the

<1,000m air space for general aviation General Aviation draft policy summary

Source: CAAC

Classification of flight areas Authorization for entry Flight plan approval Related services Industry regulation

Restricted area Flight plan approved, ADS-B and wireless communication equipped, pilot properly licensed

File application 4 hours prior to departure

Surveillance area Flight plan recorded, wireless communication equipped, pilot properly licensed, speed less than 450km/hour

Record application 2 hours prior to departure

Report area Flight plan recorded, pilot properly licensed, speed less than 450km/hour

Record application 1 hours prior to departure

Low-altitude flying system will be mapped out; Low-altitude service station will be set up and associated personnel will be trained.

Low-altitude Airspace Management Regulations (Drafted Policy)

A set of detailed rules will be sought to systematically regulate violation of general aviation.



Using lessons from history to analyze current valuations

Why compare valuations for China’s defense stocks with global A&D stocks over 2000-2005?

As discussed earlier in the report, based on 10% p.a. growth of China’s defense budget, we estimate official/adjusted defense

spending could reach US$222bn/US$375bn by 2020E, putting China on par with the defense spending levels seen in the US over

2000-2005. Referencing valuations of Global Aerospace & Defense stocks over 1995-2005, key US peers generally traded on P/Es of

20X-30X, and the 1995-2000 and 2000-2005 periods saw US defense budget CAGR of 3% and 11% respectively.

Exhibit 14: Referencing adjusted data from SIPRI, we estimate China’s actual

defense spending could be 60% higher than the announced numbers (which

do not include R&D and imports) China’s defense budget (announced vs. adjusted)

Exhibit 15: Such adjusted spending would put China by 2020E at the defense

spending levels of the US seen in 2000 Average US defense budget and P/E multiples of selected US A&D companies

Source: MOF, US DoD, SIPRI, Goldman Sachs Global Investment Research.

Source: US DoD, Company data, Goldman Sachs Global Investment Research.

Where are the China defense stocks currently trading?

AviChina currently trades at 33X 2015E P/E while the A-share defense stocks under our coverage currently trade at 78X-235X 2015E

P/E (above 1 s.d. of long-term average). We believe A-share investors focus not only on revenue growth from higher defense

spending (we expect China’s defense budget to grow an average of 10% p.a. over 2015E-2020E, with potential for exports/civil

growth), but also on higher margin potential (from pricing reform) and earnings accretion from asset injections.

-50

50

150

250

350

450

550

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015E2016E2017E2018E2019E2020E

China's official defense budget (US$bn) China's adjusted defense budget (US$bn)

US defense budget in 1990, 2000: US$290bn

US defense budget in 1995: US$255bn

US defense budget in 2005: US$484bn 1990-1995 1995-2000 2000-2005 2005-2010 2010-2014US defense budget (bn USD) 270.931 266.002 389.807 609.4 632.9Average US defense spending CAGR -3% 3% 11% 8% -5%Average P/E 1990-1995 1995-2000 2000-2005 2005-2010 2011-2014Boeing 24.3X 30.3X 19.4X 17.9X 13.0XGE 18.8X 33.9X 21.3X 14.5X 11.1XUnited Technologies 16.6X 20.0X 17.4X 14.8X 12.9XLockheed Martin 22.6X 20.3X 21.4X 11.5X 9.9XGeneral Dynamics 13.1X 16.8X 16.9X 12.5X 9.5XNorthrop Grumman 20.9X 13.5X 17.4X 11.7X 9.6XRaytheon 12.8X 17.0X 22.5X 13.1X 9.4XAverage P/E 18.5X 21.7X 19.5X 13.7X 10.8X



Exhibit 16: Anticipation of policy and M&A progress have driven up shares

A-share defense stock performance vs. Shanghai Composite index

Exhibit 17: Average P/E multiple of the sector is at >1 s.d. above average

China A-share defense stocks 1-year forward P/E

Source: Datastream.


AviChina valuation based on P/B vs. ROE regression line of the global A&D sector over 2000-2005

Given the similarities in earnings growth profiles of China’s defense stocks (over the 2015E-2020E period) to US defense stocks over

the 1995-2005 decade, we derive our new 12-month target price for AviChina of HK$8.50 (from HK$6.30) based on the global A&D

sector’s P/B vs. ROE regression line over 2000-2005 (vs. our prior valuation against Asia A&D peers), as shown in Exhibit 18. We also

apply a 35% M&A premium (increased from 15%) to our valuation based on weighted potential EPS accretion from helicopter and

avionics asset injections (assuming 20% accretion based on our sensitivity analysis shown in Exhibits 9 and 10) and from other AVIC

assets (assuming 15% accretion, referencing past injections, e.g. Tianjin Aviation).

We value A-share defense companies using a sector relative P/B vs. ROE regression line

For A-share defense companies, we continue to value the stocks under our coverage using the best fit P/B vs. ROE regression line

(Exhibit 19), which we view as most appropriate given the strong correlation and alpha-generation in valuation back-testing2. Overall,

we raise our 12-month target prices for the A-shares by 20%-55% after incorporating: (1) roll forward of valuation to 2016E P/B vs.

2016E-17E ROE (from 2015E P/B vs. 2015E-16E ROE)3, and (2) updated M&A premium/discount assumptions (Exhibit 20).

2 For additional detail please see our December 18, 2014 report ‘China: Aerospace & Defense – Spotlight on AVIC amid high sector valuations’.

3 Note AVIC Helicopter roll forward to 2016E P/B vs. 2017E ROE as we expect a step increase in ROE for this company in 2017E.

0

50

100

150

200

250

300

350

400

Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15

A-share defense stocks avg. Shanghai Composite Index

107X

0X

20X

40X

60X

80X

100X

120X

140X

160X

180X

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Avg: 63X

-1 s.d.: 36X

+1 s.d.: 90X



Valuing AviChina and China A&D A-share companies: Using P/B vs. ROE

Exhibit 18: Using Global A&D P/B vs. ROE (2000-2005) as our regression line

for AviChina P/B vs. ROE target price for AviChina

Exhibit 19: We use current A-share A&D P/B vs. ROE as our regression line

for valuing A-share defense stocks, and apply M&A premiums/discounts

based on each company’s M&A potential P/B vs. ROE target price for A-share defense stocks

Note: China State Shipbuilding, CSSC Offshore & Marine and JONHON Optronics are not covered by GS, data based on Bloomberg estimates


Source: Datastream, Bloomberg, Goldman Sachs Global Investment Research.

Using exit P/E-based valuations as a cross check

Current share prices imply 2020E P/E exit multiples of 18X at AviChina and 34X-83X for A-share defense names (Exhibit 20). Looking

at implied valuations based on 2020E earnings and discounting back to 2016E (taking into account of time value of money,

discounted using cost of equity over 2016E-2020E) captures the strong long-term growth outlook for the China defense industry. By

2020E, we expect China’s adjusted defense budget (including R&D and equipment imports) to be on par with absolute levels seen in

the US in 2000 (c.US$290bn, US defense spending grew at a comparable 11% CAGR over 2000-2005). Therefore, by comparing

AviChina’s 2020E P/E exit multiple of 18X (using the current share price) with US defense stocks that traded between 20X-30X P/E

over 1995-2005, we believe its current valuation does not look demanding and continue to see upside to the stock; maintain Buy.

Based on this cross check analysis, we also see relative value in AVIC Avionics (upgrade to Buy from Neutral) and AVIC Helicopter

(maintain Buy), with implied 2020E P/E exit multiples of 35X and 34X respectively, based on current share prices.

For the A-share defense companies under our coverage, our P/B vs. ROE-based 12-month target prices imply 2020E exit P/E

multiples of 37X-44X (taking into account cost of equity over 2016E-2020E; excl. Hongdu at 65X exit multiple). We reiterate our Sell

ratings on AVIC Aircraft and Hongdu Aviation given current demanding 2015E P/E valuations of >230X and >170X respectively, and

also the demanding 2020E exit multiples of 74X and 83X implied at current prices.

AviChina - 2011

AviChina - 2012AviChina - 2013AviChina - 2014

AviChina- 2016E

AviChina -2020E

0.0X

0.5X

1.0X

1.5X

2.0X

2.5X

3.0X

3.5X

4.0X

4.5X

0% 5% 10% 15% 20%

P/B

ROE (%)

Global A&D

2014

20032005

200220012004

y = 46.86x + 1.68R² = 0.79

0X

1X

2X

3X

4X

5X

6X

7X

8X

9X

10X

0% 2% 4% 6% 8% 10% 12% 14% 16%

AVIC Helicopter

Hongdu Aviation

JONHON OptronicsAVIC Aircraft AVIC Avionics


China State Shipbuilding

2016-17 ROE

2016

P/B

A-Share A&D P/B vs. ROE comps

CSSC Offshore & Marine



Exhibit 20: We upgrade AVIC Avionics to Buy; maintain Buys on AviChina and AVIC Helicopter, and Sells on AVIC Aircraft and Hongdu Aviation Our target price derivation

Notes: We forecast 9.7% and 9.2% growth in China’s defense spending for 2019E and 2020E, respectively, as well as an average revenue multiplier for the industry of 1.02X in 2019E and 1.11X in 2020E, and continued EBIT margin expansion for the industry (average EBIT margin of 8.7% in 2019E and 9.0% in 2020E, vs. 8.3% in 2018E).


H-shareAviChina AVIC Aviation Engine AVIC Helicopter AVIC Avionics Hongdu Aviation AVIC Aircraft2357.HK 600893.SS 600038.SS 600372.SS 600316.SS 000768.SZ

ROE (%) ROE (%)ROE (2014) 7.5% ROE (2014) 7.7% 5.5% 12.0% 2.0% 3.0%ROE (2015E) 7.4% ROE (2015E) 7.3% 5.8% 12.4% 2.3% 3.3%ROE (2016E) 8.3% ROE (2016E) 9.3% 6.8% 13.3% 3.6% 4.1%ROE (2017E) 9.4% ROE (2017E) 10.8% 9.6% 13.5% 5.1% 5.4%ROE (2018E) 10.0% ROE (2018E) 12.5% 12.0% 13.6% 5.3% 7.6%ROE (2019E) 10.5% ROE (2019E) 14.0% 14.1% 13.7% 5.5% 10.4%ROE (2020E) 10.8% ROE (2020E) 15.8% 14.7% 13.7% 5.7% 13.6%Average 2016-17E ROE 8.9% Average 2016-17E ROE 10.0% 9.6% 13.4% 4.4% 4.7%

Target price derivation Target price derivationBasis P/B vs. ROESector valued against Global Aerospace & Defense Sector valued againstSector regression line Ave. P/B vs. ROE trend lines (2000-2005) Sector regression lineReference year for ROE (%) Average 2016E-2017E Reference year for ROE (%)M&A premium/discount 35% M&A premium/discount 0% 0% 30% -15% 0%Target 2016E PB 3.01 Target 2016E PB 6.38 6.19 10.37 3.16 3.892016E BVPS 2.26 2016E BVPS 8.21 11.52 3.65 7.25 4.57CNY/HKD 1.25 HK$ Rmb Rmb Rmb Rmb Rmb12-month target price 8.50 12-month target price 52.40 71.30 37.90 22.90 17.80 Current price 6.16 Current price 55.7 62.93 30.16 29.21 35.15Potential up / downside 38% Potential up / downside -6% 13% 26% -22% -49%Rating Buy Rating Neutral Buy Buy Sell SellImplied 2015E P/E 45.1X Implied 2015E P/E 96.1X 114.0X 98.5X 140.8X 118.9XImplied 2016E P/E 37.4X Implied 2016E P/E 71.1X 93.5X 82.2X 88.9X 95.9X

AviChina AVIC Aviation Engine AVIC Helicopter AVIC Avionics Hongdu Aviation AVIC Aircraft2357.HK 600893.SS 600038.SS 600372.SS 600316.SS 000768.SZ

2020E EPS 0.33 2020E EPS 1.78 2.35 0.76 0.50 0.67 2020E EPS with potential asset injection 0.40 2020E EPS with potential asset injection 1.78 2.58 1.21 0.50 0.67 2020E exit P/E multiple implied at current share price 17.8X 2020E exit P/E multiple implied at current

share price 44.2X 34.4X 35.2X 83.3X 73.8X2020E exit P/E multiple implied at our P/B vs. ROE derived target price 24.6X 2020E exit P/E multiple implied at our P/B

vs. ROE derived target price 41.6X 39.0X 44.3X 65.3X 37.4X

Implied 2020E valuation (HK$) 12.22 Implied 2020E valuation (Rmb) 73.97 100.65 53.50 32.33 25.13 Cost of equity (%) 9.5% Cost of equity (%) 9.0% 9.0% 9.0% 9.0% 9.0%Discounted to 2016E fair valuation 8.50 Discounted to 2016E fair valuation 52.40 71.30 37.90 22.90 17.80

In Rmb, unless otherwise stated

A-shares

P/B vs. ROEA-share Aerospace & Defense

2016E P/B vs. 2016-17E ROE (y = 46.86x + 1.68)Average 2016E-2017E

Cross-check with 2020E exit P/E multiples

Note: our ROE forecasts assume defense product pricing reform, but have not factored in asset injectionsWe have used 2017E solely for AVIC Helicopter's ROE reference year, on expectations of air space reforms that could lift returns materially from 2017E

New M&A premium/discount Old M&A premium/discount Rationale

AVIC Avionics 30% 30% GSe weighted potential P/B-ROE accretion from unlisted avionics assetsAviChina 35% 15% Weighted potential EPS accretion from avionics and helicopter injections (20%) + 15% M&A premium from other group restructuringsAVIC Helicopter 0% -5% Removed discount of -5% as profitability of unlisted assets are improvingHongdu Aviation -15% -15% Discount of -15% applied to current loss-making unlisted assets that could be injected longer-termAVIC Aviation Engine 0% -15% Discount of -15% removed as restructuring of aero engine assets is still possible upon our re-assessmentAVIC Aircraft 0% -25% Removed M&A discount (-25%) as M&A potential is still possible given AVIC's ongoing fighter restructuring



AviChina’s P/B vs. ROE valuation compared with global A&D peers

Exhibit 21: Comparing AviChina’s valuation vs. global A&D peers: While the current P/B vs. ROE valuation for AviChina is above the level of its global A&D peers,

the increase in its profitability and ROE could see its valuation converge to global A&D levels by 2020E P/B vs. ROE of global A&D peers (2016E P/B vs. 2016E-17E ROE)

Note: Bharat, Kawasaki Heavy and ST Engineering are not covered by GS, data based on Bloomberg estimates

Source: Datastream, Bloomberg, Goldman Sachs Global Investment Research

Rockwell Collins

AviChina Precision Castparts

Embraer

General Dynamics

L-3

Northrop Grumman

RaytheonHuntington Ingalls

Airbus

Meggitt

MTU Aero Engines

Rolls-Royce

SafranBAE Systems

Cobham

Finmeccanica

Qinetiq

Saab Group

Thales

Korea Aerospace

Bharat

ST Engineering

Kawasaki Heavy

AviChina - 2020E

R² = 0.89

0X

1X

2X

3X

4X

5X

6X

7X

8X

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

2016E-17E ROE

2016

E P/

B



China A-share defense companies P/B vs. ROE valuation vs. historic global P/B-ROE defense

sector valuations

Exhibit 22: Comparing A-share defense stocks’ best-fit line over the years vs. global A&D regression lines: While current valuations for A-share defense names

are substantially above global A&D levels, based on the rise in profitability and ROEs we expect for these companies (and potential asset injections), valuations

could converge closer to global A&D levels by 2020E (in particular, AVIC Avionics and AVIC Helicopter) Trajectory of how the P/B vs. ROE relationship for A-share defense stocks could progress as returns improve


Avicopter

Avicopter- 2020E

AVIC Avionics

AVIC Avionics - 2020E (inc. injection, equity-

funded)


AVIC Aviation Engine -2020EHongdu

Hongdu - 2020E

AVIC Aircraft

AVIC Aircraft - 2020E

AVIC Avionics - 2020E

0.0X

2.0X

4.0X

6.0X

8.0X

10.0X

12.0X

14.0X

0% 5% 10% 15% 20% 25% 30%

2014 A-shares

2013 A-shares

2011 A-shares

2012 A-shares

Current A-share A&D

Global A&D2014

Global A&D2015

P/B

ROE



Changes to our earnings estimates

We lower 2015E-17E EPS forecasts across our HK/China A&D coverage by 2%-15% on average, reflecting limited cost-plus pricing

improvements year-to-date.

Exhibit 23: We revise our 2015E-17E earnings lower by 2%-15% on average, and introduce our 2018E EPS Our earnings revisions

Source: Goldman Sachs Global Investment Research.

Our estimates vs. Bloomberg consensus

We believe our 2015E-17E earnings are below consensus across the board (2%-10% on average) because we do not factor in

any potential EPS accretion from asset injections. Our forecasts assume 10% defense budget growth p.a., a 1.3X defense

revenue multiplier, and a gradual improvement in China final assemblers’ margins to closer to global peers by 2020E.

Our forecasts for Hongdu Aviation are in-line with consensus over 2015E-16E, while we expect higher export orders to drive

further margin and EPS improvement in 2017E. However, despite our higher than consensus forecast for 2017E, it is currently

trading on a 2015E P/E of >170X, which looks extremely demanding vs. other A-share defense peers at c.85X.

Exhibit 24: We are below consensus for AVIC Aircraft, AVIC Avionics and AVIC Helicopter in 2016E Our forecasts vs. consensus

Note: Bloomberg data as of July 22, 2015.

Source: Bloomberg, Goldman Sachs Global Investment Research.

Company Ticker 2015E 2016E 2017E 2018E 2015E 2016E 2017E 2015E 2016E 2017EAviChina 2357.HK 0.15 0.18 0.22 0.26 0.17 0.20 0.22 -11% -9% -1%AVIC Aircraft 000768.SZ 0.15 0.19 0.25 0.35 0.19 0.24 0.27 -21% -23% -9%AVIC Avionics 600372.SS 0.38 0.46 0.52 0.59 0.43 0.51 0.57 -11% -9% -7%AVIC Helicopter Co. 600038.SS 0.63 0.76 1.15 1.56 0.77 0.98 1.10 -19% -22% 5%Hongdu Aviation 600316.SS 0.16 0.26 0.38 0.41 0.13 0.30 0.36 25% -16% 6%AVIC Aviation Engine Corp. 600893.SS 0.55 0.74 0.92 1.16 0.65 0.82 0.98 -16% -10% -6%Average -9% -15% -2%

New EPS Old EPS Change

Company Ticker 2015E 2016E 2017E 2015E 2016E 2017E 2015E 2016E 2017E 2015E 2016E 2017EAviChina 2357.HK 0.15 0.18 0.22 0.16 0.20 0.24 -8% -7% -7% In-line In-line In-lineAVIC Aircraft 000768.SZ 0.15 0.19 0.25 0.20 0.27 0.41 -26% -32% -40% Below Below BelowAVIC Avionics 600372.SS 0.38 0.46 0.52 0.43 0.52 0.64 -10% -12% -18% In-line Below BelowAVIC Helicopter Co. 600038.SS 0.63 0.76 1.15 0.71 0.90 1.12 -11% -15% 3% Below Below In-lineHongdu Aviation 600316.SS 0.16 0.26 0.38 0.16 0.24 0.25 4% 7% 51% In-line In-line AboveAVIC Aviation Engine Corp. 600893.SS 0.55 0.74 0.92 0.61 0.69 0.92 -10% 7% 0% Below In-line In-lineAverage -10% -9% -2%

Above/Below ConsensusOur EPS Forecast Consensus Difference



China Aerospace & Defense companies’ P/B time series at a glance

Exhibit 25: AviChina — 1 year forward P/B

Exhibit 26: AVIC Avionics — 1 year forward P/B

Exhibit 27: AVIC Helicopter — 1 year forward P/B

Source: Datastream, Goldman Sachs Global Investment Research. Source: Datastream, Goldman Sachs Global Investment Research.


Exhibit 28: AVIC Aircraft — 1 year forward P/B

Exhibit 29: Hongdu — 1 year forward P/B

Exhibit 30: AVIC Aviation Engine — 1 year

forward P/B



0X

1X

2X

3X

4X

2009 2010 2011 2012 2013 2014 2015

Avg: 1.8X

0X

2X

4X

6X

8X

10X

12X

14X

16X

2011 2012 2013 2014 2015

Avg: 6.5X

0X

1X

2X

3X

4X

5X

6X

7X

8X

9X

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Avg: 3.8X

0X

2X

4X

6X

8X

10X

12X

200120022003200420052006200720082009201020112012201320142015

Avg: 2.8X

0X

2X

4X

6X

8X

10X

200120022003 2004 20052006200720082009201020112012 2013 2014 2015

Avg: 3.2X

0X1X2X3X4X5X6X7X8X9X

10X11X

2009 2010 2011 2012 2013 2014 2015

Avg: 3.6X



China Aerospace & Defense companies’ P/E time series at a glance

Exhibit 31: AviChina — 1 year forward P/E

Exhibit 32: AVIC Avionics — 1 year forward P/E

Exhibit 33: AVIC Helicopter — 1 year forward P/E



Exhibit 34: AVIC Aircraft — 1 year forward P/E

Exhibit 35: Hongdu Aviation — 1 year forward

P/E

Exhibit 36: AVIC Aviation Engine — 1 year

forward P/E



0X

10X

20X

30X

40X

50X

2009 2010 2011 2012 2013 2014 2015

AviChina sold its Hafei Auto and Changhe Suzuki assets to AVIC Auto

AVIC exchanged its 43.34% stake in JONHON Optronics for AviChina's stake in Dongan Auto Engine (600178.SS)

Avg: 26X

0X

20X

40X

60X

80X

100X

120X

2011 2012 2013 2014 2015

Avg: 60X

0X

20X

40X

60X

80X

100X

120X

140X

200120022003200420052006200720082009201020112012201320142015

Avg:53X

0X

40X

80X

120X

160X

200X

240X

280X

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Avg:95X

0X

50X

100X

150X

200X

250X

300X

350X

400X

200120022003200420052006200720082009201020112012201320142015

Avg: 105X

0X

20X

40X

60X

80X

100X

120X

140X

2009 2010 2011 2012 2013 2014 2015

Avg: 49X



Exhibit 37: Maintain Buy ratings on AviChina and AVIC Helicopter; upgrade AVIC Avionics to Buy (from Neutral) Global Aerospace & Defense – valuation comparables

Notes: *Denotes stock is on our regional Conviction List. NC = Not Covered. RS = Rating Suspended. Estimates for NC and RS stocks are from Bloomberg. All target prices are based on a 12-month timeframe. Our US Aerospace & Defense analyst is Noah Poponak and our Europe Aerospace & Defense analyst is Chris Hallam. Korea Aerospace Industries is covered by Jinmook Kim. The China average P/E excludes outliers AVIC Aircraft and Hongdu Aviation. Source: Datastream, Bloomberg, Goldman Sachs Global Investment Research.

Market Earnings growth

GS Cap Current EV/ Sales P/B P/B Avg. ROE EV/IC EV/GCI Avg. CROCI EPS CAGR

Rating (US$mn) Price 15E 16E 15E 16E 15E 15E 16E 16E-17E 15E 16E 16E-17E 15E 15E 15E 15E-17EHK-listed Aerospace & DefenseAviChina Buy 4,351 HKD 6.16 8.50 38% 32.7 27.1 14.0 12.6 1.4 2.3 2.2 9% 1.3 1.2 10% 0% 3% -3% 21%Average 32.7 27.1 14.0 12.6 1.4 2.3 2.2 9% 1.3 1.2 10% 0% 3% -3% 21%China-listed Aerospace & DefenseAVIC Helicopter Buy 3,419 CNY 62.93 71.30 13% 100.6 82.5 46.8 41.6 2.5 5.8 5.5 8% 4.7 5.2 13% 0% 3% -43% 36%Hongdu Aviation Sell 3,373 CNY 29.21 22.90 -22% 179.7 113.4 94.5 60.7 5.8 4.2 4.0 4% 4.2 3.6 6% 0% 3% 12% 52%AVIC Aviation Engine Neutral 9,774 CNY 55.70 52.40 -6% 102.2 75.6 34.5 31.6 4.5 7.2 6.8 10% 4.0 3.2 10% 0% 4% 55% 30%AVIC Aircraft Sell 14,025 CNY 35.15 17.80 -49% 234.8 189.3 77.5 65.9 4.0 7.8 7.7 5% 5.4 4.9 7% 0% 2% 13% 28%AVIC Avionics Buy 8,301 CNY 30.16 37.90 26% 78.3 65.4 43.4 38.4 7.5 9.3 8.3 13% 5.8 4.6 11% 0% 9% 51% 17%JONHON Optronics NC 4,523 CNY 46.62 NA NA 60.6 46.0 36.4 29.1 6.1 9.1 7.8 18% NA NA NA 0% 10% 4% 34%Average 85.4 67.4 55.5 44.5 5.1 7.2 6.7 10% 4.8 4.3 9% 0% 5% 15% 33%

Other Asia Ex. Japan Aerospace & DefenseKorea Aerospace Ind. Neutral 7,308 KRW 87,500 79,000 -10% 49.4 37.6 26.1 20.6 3.1 7.3 6.3 15% 4.7 2.8 13% 0% 6% 53% NAST Engineering NC 7,567 SGD 3.33 NA NA 19.0 17.7 13.2 12.5 1.6 4.6 4.4 25% NA NA NA 4% 8% NA 7%Aerospace Ind. Dev. Corp. NC 1,085 TWD 37.70 NA NA 16.5 14.2 8.7 7.4 1.3 2.9 2.7 20% NA NA NA 3% 8% NA 13%Average 28.3 23.1 16.0 13.5 2.0 5.0 4.5 20% 4.7 2.8 13% 3% 7% 53% 10%

US-listed AerospaceThe Boeing Company Sell 98,566 USD 141.03 128.0 -9% 17.5 16.0 11.2 10.3 1.2 10.5 10.8 71% 3.5 2.6 18% 3% 6% -17% 9%BE Aerospace, Inc. Buy 5,034 USD 47.94 63.0 31% 15.6 14.2 11.2 10.7 2.4 30.2 52.7 138% 2.8 2.5 23% 1% 12% 1001% 20%Precision Castparts Corp. Neutral 26,357 USD 187.33 206.0 10% 21.9 14.8 13.0 10.1 3.8 3.1 2.3 16% 2.2 1.6 12% 0% 17% 37% 14%Spirit AeroSystems Neutral 7,269 USD 51.77 52.0 0% 13.0 13.5 7.2 7.1 1.1 24% 1.8 1.5 16% 0% 8% 16% 3%Rockwell Collins Corp. Sell 11,148 USD 83.44 82.0 -2% 16.0 15.7 10.8 10.4 2.6 4.9 3.9 27% 2.5 1.8 15% 2% 13% 78% 6%Embraer Neutral 5,138 USD 27.93 32.0 15% 21.0 11.1 8.2 6.9 1.1 1.2 1.1 10% 1.0 0.7 7% 2% 4% 32% 36%Bombardier Inc. RS 3,089 CAD 1.78 NA NA 6.0 8.8 3.1 3.1 0.2 4.2 2.9 26% NA NA NA 1% 2% NA -28%United Technology Corp. Buy 87,895 USD 98.87 123.0 24% 15.2 13.5 9.2 8.7 1.6 3.7 3.9 30% 1.7 1.4 12% 3% 9% 66% 12%Average 15.8 13.5 9.2 8.4 1.8 8.3 11.1 43% 2.2 1.7 15% 1% 9% 173% 9%US-listed DefenseGeneral Dynamics Corp. Neutral 47,665 USD 142.41 162.0 14% 16.6 15.9 10.5 10.2 1.6 3.6 3.6 23% 2.5 2.2 17% 2% 9% -4% 5%Harris Corporation Neutral 8,375 USD 79.91 89.0 11% 15.7 15.9 11.5 9.7 2.5 83% 3.1 2.1 24% 2% 9% -612% 9%L-3 Communications Buy 10,072 USD 120.19 141.0 17% 16.3 13.8 10.6 9.7 1.2 1.6 1.6 12% 1.2 1.0 10% 2% 5% 60% 17%Lockheed Martin Corp. Buy* 63,590 USD 201.17 237.0 18% 17.6 15.6 10.2 9.3 1.5 26.8 20.0 136% 4.6 2.6 24% 3% 8% 218% 9%Northrop Grumman Corp. Buy* 32,593 USD 162.56 191.0 17% 16.8 14.9 11.6 10.7 1.7 5.2 5.5 39% 2.5 1.8 16% 2% 8% 71% 15%Raytheon Company Neutral 31,897 USD 104.34 110.0 5% 15.6 15.0 11.8 11.0 1.8 2.9 2.8 22% 2.1 1.7 14% 3% 9% 25% 7%Huntington Ingalls Neutral 5,467 USD 112.25 128.0 14% 12.8 12.4 6.3 6.1 0.8 3.6 3.3 27% 1.2 1.0 14% 0% 6% 31% 3%Average 15.9 14.8 10.4 9.5 1.6 7.3 6.1 49% 2.5 1.8 17% 2% 8% -30% 9%Europe-listed AerospaceAirbus Group Neutral 54,391 EUR 60.30 66.0 9% 17.1 15.9 7.3 7.6 0.7 5.0 4.7 33% 1.3 0.7 10% 2% 4% -101% 19%Meggitt Neutral 5,390 GBp 449.20 593.0 32% 13.7 12.4 10.1 9.3 2.6 1.7 1.6 16% 1.2 1.1 8% 3% 15% 40% 13%MTU Aero Engines Neutral 4,301 EUR 79.35 104.0 31% 14.5 12.3 9.5 8.4 1.2 2.1 1.9 14% 1.5 1.2 10% 2% 6% 33% 21%Rolls-Royce Not Rated 20,686 GBp 718.00 NA NA 10.3 9.6 5.0 4.6 0.8 1.9 1.8 20% 1.0 1.0 16% 4% 8% -28% 8%Safran Buy* 26,932 EUR 59.94 84.0 40% 16.2 14.6 7.8 7.0 1.4 3.4 3.0 22% 3.0 1.5 16% 2% 9% 14% 11%Average 14.4 12.9 7.9 7.4 1.3 2.8 2.6 21% 1.6 1.1 12% 3% 8% -9% 14%Europe-listed DefenseBAE Systems Buy 13,010 GBp 458.70 611.0 16% 14.6 13.2 7.1 6.6 0.8 2.9 2.6 50% 2.1 1.4 11% 2% 6% -36% 6%Cobham Neutral 4,203 GBp 251.10 329.0 31% 11.1 10.7 6.7 6.2 1.8 2.5 2.4 16% 1.4 1.0 13% 4% 11% 98% 6%Finmeccanica Buy 7,943 EUR 12.39 14.0 13% 23.8 15.9 7.6 6.9 1.0 2.0 1.9 17% 1.1 0.8 10% 0% 2% 82% 36%Qinetiq Neutral 2,335 GBp 230.50 208.0 -10% 16.5 15.3 10.6 10.1 1.6 4.6 4.2 26% 2.6 1.0 10% 2% 11% -46% 7%Saab Group Neutral 2,521 SEK 202.90 241.0 19% 15.9 14.1 7.5 6.8 0.8 1.8 1.7 12% 1.4 0.9 9% 3% 5% 9% 11%Thales Buy* 13,010 EUR 59.57 69.0 16% 14.6 13.2 7.1 6.6 0.8 2.9 2.6 21% 2.1 1.4 17% 2% 6% -36% 15%Ultra Electronics Neutral 1,843 GBp 1,720.00 1,833.0 7% 14.0 13.8 8.3 8.0 1.9 3.4 3.1 19% 2.2 1.6 14% 3% 12% 44% 3%Average 15.8 13.8 7.9 7.3 1.3 2.9 2.6 23% 1.8 1.2 12% 2% 8% 16% 12%

Net Margin

Net debt/Equity

Company CCYTP (12mth) P/E (X) EV/EBITDA (X)

Up/down pot.

Earnings Multiples P/B vs ROE Director's CutDiv Yld



Company Snapshots



AviChina: Beneficiary of China’s helicopter growth and asset injection events; Buy

Source of opportunity

AviChina is a HK-listed holding company (listed since 2003) that consolidates AVIC’s listed aviation assets

including AVIC Helicopter, AVIC Avionics, Hongdu Aviation and JONHON Optronics, and it owns 25% stakes in

JVs Schneider Tianjin and Schneider Shanghai. We maintain our Buy on AviChina, with 38% potential upside to

our new 12-month target price of HK$8.50, as we expect AVIC's ongoing asset restructuring to help solidify

AviChina as a key offshore consolidating platform for the group, while its subsidiaries AVIC Avionics and AVIC

Helicopter remain consolidators of respective segmental assets. Key drivers of our positive investment thesis:

Beneficiary of potentially accretive avionics system integration assets once the corporatization of AVIC

Avionics Systems’ R&D institutions is completed, given high profitability of these unlisted assets.

Exposed to a fast growing high potential civil helicopter market; we expect China’s civil helicopter fleet to

increase from current 300+ to 6,000+ in 20 years, reaching levels similar to Europe, which implies 15% CAGR

per annum.

One of the best risk-reward propositions in our China Aerospace & Defense coverage given a less demanding

valuation vs. A-shares, potential M&A upside, and the high NAV discount vs. its A-share listed subsidiaries.

Ample foreign aerospace acquisition potential that could become future earnings contributors for the group.

Catalyst

Policy announcements regarding further opening of China’s low altitude air space this year, as stipulated in

China’s 12th Five-Year Plan.

Further asset restructurings at its subsidiaries or at the AviChina level, including avionics R&D injection (once

corporatization is completed) and potential combat helicopter assembly line injections.

Valuation

We cut our 2015-17E earnings for AviChina by 1%-11% on the back of lower estimates for AVIC Avionics based on

higher costs related to its new R&D facilities (investing for the future) and also our earnings revisions for AVIC

Helicopter and Hongdu Aviation. We also introduce our 2018E EPS forecast of Rmb0.26. However, we lift our 12-

month target price to HK$8.50 (up from HK$6.30) based on: (1) a 2016E P/B of 3.0X vs. 2016-17E ROE of 8.9% (roll

forward from 2.4X 2015E P/B vs. 2015-16E ROE of 8.7%) derived using Global Aerospace & Defense sector

regression line (2000-2005) and (2) applying a 35% M&A premium (up from a 15% premium, increased to reflect

not only potential earnings accretion from helicopter and avionics (20%), but also from other AVIC assets (15%,

referencing past injections, e.g. Tianjin Aviation)).

Key risks

Regulations on military equipment cost-plus pricing, pace of defense industry reform, decision by government on

new plane orders, and progress on low altitude air space opening.

Growth

Returns *

Multiple

Volatility Volatility

Multiple

Returns *

Growth

Investment Profile

Low High

Percentile 20th 40th 60th 80th 100th

* Returns = Return on Capital For a complete description of the investment

profile measures please refer to the

disclosure section of this document.

AviChina (2357.HK)

Asia Pacific Industrials Peer Group Average

Key data Current

Price (HK$) 6.16

12 month price target (HK$) 8.50

Market cap (HK$ mn / US$ mn) 33,722.5 / 4,350.4

Foreign ownership (%) --

12/14 12/15E 12/16E 12/17E

EPS (Rmb) 0.14 0.15 0.18 0.22

EPS growth (%) 9.6 5.6 20.8 21.5

EPS (diluted) (Rmb) 0.14 0.15 0.18 0.22

EPS (basic pre-ex) (Rmb) 0.14 0.15 0.18 0.22

P/E (X) 27.0 32.7 27.1 22.3

P/B (X) 1.9 2.3 2.2 2.0

EV/EBITDA (X) 12.9 14.0 12.6 11.0

Dividend yield (%) 0.5 0.4 0.5 0.6

ROE (%) 7.5 7.4 8.3 9.4

CROCI (%) 10.8 9.3 9.6 10.1

10,000

11,000

12,000

13,000

14,000

15,000

16,000

17,000

4

5

6

7

8

9

10

11

Jul-14 Oct-14 Feb-15 May-15

Price performance chart

AviChina (L) Hang Seng China Ent. Index (R)

Share price performance (%) 3 month 6 month 12 month

Absolute (33.0) 23.4 40.6

Rel. to Hang Seng China Ent. Index (12.1) 32.2 37.7

Source: Company data, Goldman Sachs Research estimates, FactSet. Price as of 7/27/2015 close.



Exhibit 38: We further cross check our P/B vs. ROE derived AviChina target price with a SOTP analysis AviChina SOTP – based on our target prices for its subsidiaries

Source: Company data, Datastream, Goldman Sachs Global Investment Research.

Exhibit 39: AviChina has historically traded at a 42% NAV discount vs. its listed A-share subsidiaries

AviChina market value discount vs. its attributable A-share subsidiaries market value

Source: Company data, Datastream.

Ownership (%)

2016E net profit after minority interest -

ownership adjusted (Rmb mn)

Earnings contribution to

AviChina (%)Equity value

(Rmb mn)Implied 2016E

P/E Basis/CommentsAVIC Helicopter (600038.SS) - helicopters 35% 158 16% 14,797 93.5X Using our 12-month target price of Rmb71.30Hongdu Aviation (600316.SS) - trainers 44% 81 8% 7,188 88.9X Using our 12-month target price of Rmb22.90AVIC Avionics (600372.SS) - avionics 43% 351 35% 28,816 82.2X Using our 12-month target price of Rmb37.90JONHON Optronic (002179.SZ) - connectors 42% 207 21% 11,677 56.4X Using last close priceTianjin Aviation (unlisted) - mechanical systems, and Schneider JVs 100% 159 16% 2,569 16.1X At 2.0X book value, 16X 2016E P/EOther investment assets - Airbus Composite; Publishing & Media Co. etc. Various 41 4% 608 15.0X Ascribing 15X 2016E P/E for remaining unlisted assetsTotal 996 100% 65,895 66.1XNet cash at AviChina group level 1,787 GSe: 2015E

NAV discount vs. market value of its listed subsidiaries (%) 45%vs. long-term average of 42% NAV discount. A slightly higher discount given lower ownership % in its subsidiaries vs. history

Number of shares (mn) 5,474 SOTP value/H share (HK$) 8.50 37.4X

Current: -55%

-80%

-70%

-60%

-50%

-40%

-30%

-20%

-10%

0%

Nov-09 Nov-10 Nov-11 Nov-12 Nov-13 Nov-14

Averagediscount: -42%



Exhibit 40: Hafei Aviation is AviChina’s largest revenue

contributor… Revenue breakdown (2015E)

Exhibit 41: …but AVIC Avionics is AviChina’s largest

“earnings” contributor given its higher profitability Net profit contribution (2015E)

Source: Goldman Sachs Global Investment Research. Source: Goldman Sachs Global Investment Research.

Exhibit 42: We forecast Rmb825mn net profit for AviChina in 2015E AviChina – key subsidiaries’ net profit forecasts


AVIC Helicopter (600038.SS)

48%

Hongdu Aviation (600316.SS)

8%

AVIC Avionics (600372.SS)

26%

JONHON Optronic

(002179.SZ)13%

Tianjin Aviation2%

Other unlisted businesses

3%

AVIC Helicopter (600038.SS)

16% Hongdu Aviation (600316.SS)

6%


35%

JONHON Optronic

(002179.SZ)22%

Tianjin Aviation18%

Other unlisted businesses

3%

(Mainly from Schneider JVs)

Rmb mn, unless specified otherwise 2011 2012 2013 2014 2015E 2016E 2017EDivisional sales (net of business taxes)AVIC Helicopter (600038.SS) - helicopters 2,769 2,858 10,831 12,455 13,680 16,085 18,472Changhe Aviation - helicopters 4,076 5,931Hongdu Aviation (600316.SS) - trainers 1,745 1,781 1,999 2,133 2,340 2,596 2,984AVIC Avionics (600372.SS) - avionics 3,656 4,293 5,989 6,593 7,479 8,439 9,326JONHON Optronic (002179.SZ) - connectors 1,630 1,938 2,280 3,053 3,649 4,156 4,735Tianjin Aviation - power/fire-proofing systems NM 416 437 459 496 520 546Others and inter-segmental elimination (606) (417) 1,210 1,018 1,018 1,018 1,018Total 13,271 16,800 22,746 25,710 28,661 32,815 37,083Net profit contribution to AviChina (after minority interest)AVIC Helicopter (600038.SS) - helicopters 55 58 87 116 130 158 239Changhe Aviation - helicopters 51 97Hongdu Aviation (600316.SS) - trainers 36 38 40 43 51 81 119AVIC Avionics (600372.SS) - avionics 183 208 271 260 293 351 399JONHON Optronic (002179.SZ) - connectors 86 86 102 141 180 207 237Tianjin Aviation - power/fire-proofing systems NM 120 127 137 152 159 167Others and inter-segmental elimination 88 (7) 86 84 21 41 51AviChina total attributable net profit 499 600 713 781 825 996 1,211

Consolidation into AVIC Helicopter

Consolidation into AVIC Helicopter



AviChina: Summary financials

Profit model (Rmb mn) 12/14 12/15E 12/16E 12/17E Balance sheet (Rmb mn) 12/14 12/15E 12/16E 12/17E

Total revenue 25,710.4 28,661.0 32,814.6 37,082.6 Cash & equivalents 8,660.5 8,220.2 7,425.9 6,818.9

Cost of goods sold (20,811.6) (23,174.4) (26,556.7) (29,931.3) Accounts receivable 12,745.4 14,208.1 16,267.2 18,383.0

SG&A (3,220.0) (3,474.8) (3,831.7) (4,160.1) Inventory 16,593.5 18,477.4 21,174.2 23,864.8

R&D -- -- -- -- Other current assets 2,035.7 2,035.7 2,035.7 2,035.7

Other operating profit/(expense) 0.0 0.0 0.0 0.0 Total current assets 40,035.1 42,941.4 46,903.0 51,102.4

EBITDA 2,498.3 2,824.5 3,288.9 3,913.2 Net PP&E 10,441.1 11,130.8 11,977.2 12,981.5

Depreciation & amortization (819.5) (812.8) (862.7) (922.0) Net intangibles 1,669.7 1,628.8 1,587.8 1,546.8

EBIT 1,678.7 2,011.7 2,426.2 2,991.2 Total investments 2,154.2 2,308.0 2,508.1 2,741.8

Interest income 233.4 607.1 614.6 628.7 Other long-term assets 421.7 421.7 421.7 421.7

Interest expense (369.1) (789.0) (789.9) (786.2) Total assets 54,721.8 58,430.6 63,397.7 68,794.2

Income/(loss) from uncons. subs. 143.7 153.8 200.1 233.8

Others 316.3 228.6 208.6 208.6 Accounts payable 18,860.4 21,001.7 24,066.9 27,125.1

Pretax profits 2,003.0 2,212.3 2,659.5 3,276.1 Short-term debt 5,633.4 5,633.4 5,633.4 5,633.4

Income tax (267.3) (304.5) (365.3) (454.8) Other current liabilities 4,227.4 4,233.5 4,257.5 4,287.5

Minorities (954.4) (1,082.7) (1,297.7) (1,610.6) Total current liabilities 28,721.1 30,868.6 33,957.8 37,046.0

Long-term debt 1,784.7 1,784.7 1,784.7 1,784.7

Net income pre-preferred dividends 781.3 825.1 996.5 1,210.7 Other long-term liabilities 914.6 914.6 914.6 914.6

Preferred dividends 0.0 0.0 0.0 0.0 Total long-term liabilities 2,699.3 2,699.3 2,699.3 2,699.3

Net income (pre-exceptionals) 781.3 825.1 996.5 1,210.7 Total liabilities 31,420.5 33,567.9 36,657.1 39,745.4

Post-tax exceptionals 0.0 0.0 0.0 0.0

Net income 781.3 825.1 996.5 1,210.7 Preferred shares 0.0 0.0 0.0 0.0

Total common equity 10,815.4 11,524.9 12,381.7 13,422.8

EPS (basic, pre-except) (Rmb) 0.14 0.15 0.18 0.22 Minority interest 12,485.9 13,337.8 14,358.9 15,626.1

EPS (basic, post-except) (Rmb) 0.14 0.15 0.18 0.22

EPS (diluted, post-except) (Rmb) 0.14 0.15 0.18 0.22 Total liabilities & equity 54,721.8 58,430.6 63,397.7 68,794.2

DPS (Rmb) 0.02 0.02 0.03 0.03

Dividend payout ratio (%) 14.0 14.0 14.0 14.0 BVPS (Rmb) 1.98 2.11 2.26 2.45

Free cash flow yield (%) (6.4) (0.2) (0.9) (0.2)

Growth & margins (%) 12/14 12/15E 12/16E 12/17E Ratios 12/14 12/15E 12/16E 12/17E

Sales growth 15.9 11.5 14.5 13.0 CROCI (%) 10.8 9.3 9.6 10.1

EBITDA growth 11.4 13.1 16.4 19.0 ROE (%) 7.5 7.4 8.3 9.4

EBIT growth 11.4 19.8 20.6 23.3 ROA (%) 1.5 1.5 1.6 1.8

Net income growth 9.6 5.6 20.8 21.5 ROACE (%) 9.3 8.9 9.6 10.5

EPS growth 9.6 5.6 20.8 21.5 Inventory days 275.1 276.2 272.5 274.6

Gross margin 19.1 19.1 19.1 19.3 Receivables days 162.5 171.6 169.5 170.5

EBITDA margin 9.7 9.9 10.0 10.6 Payable days 321.2 313.9 309.7 312.1

EBIT margin 6.5 7.0 7.4 8.1 Net debt/equity (%) (5.3) (3.2) 0.0 2.1

Interest cover - EBIT (X) 12.4 11.1 13.8 19.0

Cash flow statement (Rmb mn) 12/14 12/15E 12/16E 12/17E Valuation 12/14 12/15E 12/16E 12/17E

Net income pre-preferred dividends 781.3 825.1 996.5 1,210.7

D&A add-back 819.5 812.8 862.7 922.0 P/E (analyst) (X) 27.0 32.7 27.1 22.3

Minorities interests add-back 954.4 1,082.7 1,297.7 1,610.6 P/B (X) 1.9 2.3 2.2 2.0

Net (inc)/dec working capital (3,003.9) (1,205.3) (1,690.7) (1,748.2) EV/EBITDA (X) 12.9 14.0 12.6 11.0

Other operating cash flow 56.7 (153.8) (200.1) (233.8) EV/GCI (X) 1.2 1.3 1.2 1.1

Cash flow from operations (392.0) 1,361.4 1,266.1 1,761.3 Dividend yield (%) 0.5 0.4 0.5 0.6

Capital expenditures (1,750.4) (1,433.0) (1,640.7) (1,854.1)

Acquisitions 0.0 0.0 0.0 0.0

Divestitures 0.0 0.0 0.0 0.0

Others 280.4 (28.4) (27.4) (31.1)

Cash flow from investments (1,470.0) (1,461.4) (1,668.1) (1,885.3)

Dividends paid (common & pref) (109.5) (109.5) (115.6) (139.6)

Inc/(dec) in debt 1,273.5 0.0 0.0 0.0

Common stock issuance (repurchase) 0.0 0.0 0.0 0.0

Other financing cash flows (257.1) (230.8) (276.7) (343.4)

Cash flow from financing 907.0 (340.3) (392.3) (483.0)

Total cash flow (955.0) (440.3) (794.3) (607.0) Note: Last actual year may include reported and estimated data.

Source: Company data, Goldman Sachs Research estimates.



AVIC Avionics: High returns and potentially accretive injections; upgrade to Buy


AVIC Avionics is China’s monopolist military avionics manufacturer under AVIC, and is the sole supplier of

avionics and systems to military planes within the AVIC group. We continue to expect AVIC Avionics to benefit

from potential injection of unlisted avionics assets from AVIC (R&D facilities that are involved in system

integration, in line with the company’s stated strategy). Under our scenario analysis (Exhibit 9), a complete

injection of unlisted avionics assets from AVIC could boost the 2014 EPS of AVIC Avionics by c.60% (if funded by

new share issuance at the current price) and lift the implied P/B vs. ROE valuation. We upgrade AVIC Avionics to

Buy (from Neutral) given its relatively attractive valuation vs. the peer group (see Exhibit 19) considering the

potential for P/B-ROE accretion from unlisted asset injections over the next few years. We see 26% potential

upside to our new 12-month target price of Rmb37.90.

Catalyst

Steady growth of its core avionics business, driven by higher China defense spending and the introduction of

more new military aircraft models by AVIC.

Potential for accretive avionics asset injections over 2015E-16E once progress is made on R&D

corporatization.

Valuation

We cut our 2015-17E earnings by 7%-11% due to continued pressure on the pace of margin expansion on higher

costs from new facilities, SG&A and finance costs. We also introduce our 2018E EPS forecast of Rmb0.59. Our

new 12-month target price of Rmb37.90 (up from Rmb31.50) is based on: (1) a 2016E P/B of 10.4X vs. 2016-17E

ROE of 13.4% (roll forward from 9.2X 2015E P/B vs. 2015-16E ROE of 13.6%), derived using our A-share A&D

sector regression line, and (2) applying a 30% M&A premium (unchanged) to account for the potential injection of

unlisted R&D assets.

Key risks

Unfavorable defense reform policies, slower-than-expected China military fleet expansion and/or fleet avionics

upgrade.

Growth

Returns *

Multiple


Multiple

Returns *

Growth

Investment Profile

Low High







Key data Current

Price (Rmb) 30.16

12 month price target (Rmb) 37.90

Market cap (Rmb mn / US$ mn) 51,547.5 / 8,301.4


12/14 12/15E 12/16E 12/17E

EPS (Rmb) 0.34 0.38 0.46 0.52

EPS growth (%) (4.3) 12.8 19.8 13.6

EPS (diluted) (Rmb) 0.34 0.38 0.46 0.52


P/E (X) 69.4 78.3 65.4 57.5

P/B (X) 8.1 9.3 8.3 7.4

EV/EBITDA (X) 37.6 43.4 38.4 34.7

Dividend yield (%) 0.2 0.2 0.2 0.3

ROE (%) 12.0 12.4 13.3 13.5

CROCI (%) 13.1 10.8 11.1 11.2

2,000

2,500

3,000

3,500

4,000

4,500

5,000

5,500

15

20

25

30

35

40

45

50



AVIC Avionics (L) Shanghai SE A Share Index (R)


Absolute (15.4) 2.3 44.2

Rel. to Shanghai SE A Share Index 2.8 (7.9) (17.7)




Exhibit 43: AVIC Avionics is not currently involved in system integration, as this is done by AVIC’s R&D centers AVIC Avionics’ key products vs. global peers

Source: Company data.

Exhibit 44: Broad product offerings across AVIC Avionics AVIC Avionics revenue breakdown (2015E)

Exhibit 45: AVIC Avionics has comparable margins vs. global A&D peers Global key avionics manufacturers (bubble size: 2014 revenue in US$)

Source: Goldman Sachs Global Investment Research. Source: Company data.

Avionics Systems

Navigation

‧Nav/GPS‧Autopilot‧Landing Airds‧Accident data

Weapons

‧Aiming system‧Fire control

computer‧Fire control

Sensors

‧Cockpit displays‧Mission Displays‧Head Up Displays

APU (Auxiliary power unit)

‧Load compressor‧Gearbox‧Jet fuel starter

Communications

‧VHF/UHF/HF‧Data link‧SatCom

Displays &

Systemintegration

‧Radar‧ESM‧Electro-Optics

AVIC Avionics


Honeywell

Rockwell, Garmin Rockwell, GarminHamilton (UTC)

Display21%

Data Systems7%

Autopilot11%

Warning systems6%

Sensors12%Lighting

4%

GPS5%

APU Systems3%

Flight indicators8%

Other avionics5%

Textile machinery3%

Otherbusinesses

15%

BAE Systems

Honeywell

Rockwell Collins

L-3

AVIC Avionics + AVIC Avionics

Systems

0%

5%

10%

15%

20%

25%

-4% -2% 0% 2% 4% 6% 8% 10% 12%

2014

EBI

T Ma

rgin

Revenue yoy growth (2013-2014 avg )

Average EBIT margin: 16%

Average growth ex. AVIC Avionics



AVIC Avionics: Summary financials




SG&A (1,233.3) (1,396.9) (1,576.3) (1,742.4) Inventory 2,527.0 3,257.3 3,253.5 3,930.7

R&D -- -- -- -- Other current assets 379.5 379.5 379.5 379.5


EBITDA 1,195.8 1,300.4 1,467.5 1,625.2 Net PP&E 3,221.7 3,500.0 3,823.8 4,184.9

Depreciation & amortization (278.4) (304.1) (329.4) (357.6) Net intangibles 674.5 643.9 613.3 582.8

EBIT 917.4 996.4 1,138.2 1,267.6 Total investments 270.6 275.6 285.6 295.6




Others (33.4) 0.0 0.0 0.0 Accounts payable 3,940.7 569.5 4,507.2 1,094.5

Pretax profits 722.2 812.6 972.1 1,104.1 Short-term debt 4,150.0 4,150.0 4,150.0 4,150.0

Income tax (109.0) (121.1) (144.3) (164.1) Other current liabilities 62.7 73.9 93.6 109.8

Minorities (12.6) (14.3) (16.2) (18.0) Total current liabilities 8,153.4 4,793.4 8,750.8 5,354.3

Long-term debt 872.0 0.0 0.0 0.0

Net income pre-preferred dividends 600.6 677.2 811.6 922.0 Other long-term liabilities 64.9 64.9 64.9 64.9

Preferred dividends 0.0 0.0 0.0 0.0 Total long-term liabilities 936.9 64.9 64.9 64.9

Net income (pre-exceptionals) 600.6 677.2 811.6 922.0 Total liabilities 9,090.3 4,858.3 8,815.7 5,419.2


Net income 600.6 677.2 811.6 922.0 Preferred shares 0.0 0.0 0.0 0.0


EPS (basic, pre-except) (Rmb) 0.34 0.38 0.46 0.52 Minority interest 239.5 253.7 269.9 287.9



DPS (Rmb) 0.05 0.06 0.07 0.08


Free cash flow yield (%) (0.9) 0.0 0.4 0.0




EBIT growth 18.2 8.6 14.2 11.4 ROA (%) 4.3 5.3 6.2 6.5

Net income growth (4.3) 12.8 19.8 13.6 ROACE (%) 10.2 9.8 10.4 10.7

EPS growth (4.3) 12.8 19.8 13.6 Inventory days 192.6 207.0 207.0 207.0



EBIT margin 13.9 13.3 13.5 13.6 Net debt/equity (%) 55.0 51.3 44.4 41.1



Net income pre-preferred dividends 600.6 677.2 811.6 922.0


Minorities interests add-back 12.6 14.3 16.2 18.0 P/B (X) 8.1 9.3 8.3 7.4

Net (inc)/dec working capital (1,009.8) (458.1) (326.4) (589.2) EV/EBITDA (X) 37.6 43.4 38.4 34.7


Cash flow from operations 91.1 532.4 820.8 698.4 Dividend yield (%) 0.2 0.2 0.2 0.3

Capital expenditures (486.5) (551.8) (622.6) (688.1)

Acquisitions (697.7) 0.0 0.0 0.0


Others 717.7 0.0 0.0 0.0

Cash flow from investments (466.5) (551.8) (622.6) (688.1)


Inc/(dec) in debt 732.8 (872.0) 0.0 0.0


Other financing cash flows (245.7) 0.0 0.0 0.0


Total cash flow 23.7 (979.3) 99.0 (108.6) Note: Last actual year may include reported and estimated data.




AVIC Helicopter: Strong earnings growth and attractive valuation; maintain Buy


We maintain our Buy on AVIC Helicopter as we continue to expect double-digit growth from military helicopter

sales, and higher AC-series civil helicopter deliveries (from current <20 per year to 78 per year by 2017E vs.

ultimate capacity of 200, driven by its rising backlog of AC-series orders) to drive earnings growth. Our new 12-

month target price for AVIC Helicopter of Rmb71.30 implies potential upside of 13%. Key drivers of our positive

investment thesis:

We expect double-digit growth from military helicopter demand, with continued contribution from Z-19

deliveries over next few years, and from Z-10 from Changhe Aviation. Longer-term, we expect Z-15 and Z-20

to be a long-term growth driver.

Steady civil helicopter delivery, as we expect AC-series civil helicopter deliveries to reach 78 by 2017E with

China’s low altitude air space opening up, serial production of EC175/AC352, and contribution from the rest

of its 1-ton to 13-ton helicopter model offerings. Its 3-ton helicopter AC3X2, which was displayed at the

Zhuhai Air Show in 2014, could also be a long-term growth driver once design and certifications are finalized.

Our forecasts assume a gradual improvement in margins, where any defense reforms/improvements in

cost-plus pricing mechanisms would mean a significant upside for AVIC Helicopter, given its <3% net profit

margin vs. global average of 5% or above.

Attractive valuations: We view the valuation of AVIC Helicopter as still relatively attractive vs. the peer

group on P/B vs. ROE (see Exhibit 19, where AVIC Helicopter is below the line).

Catalysts

Policy announcements regarding further opening of China’s low altitude airspace this year, as stipulated in

China’s 12th Five-Year Plan.

Certification of new aircraft models (AC352, Z-15, Z-20) over the next few years.

Valuation

We lower our 2015-16E EPS by 19%-22% but raise 2017E EPS by 5%, reflecting our revised expectations of the

gradual improvement in cost-plus pricing and progress in civil helicopter growth from 2017E. We also introduce

our 2018E EPS of Rmb1.56. We lift our 12-month target price to Rmb71.30 (from Rmb50.50) after incorporating:

(1) a 2016E P/B of 6.2X vs. 2017E ROE of 9.6% (we use 2017E returns – instead of 2016E-17E returns for the rest of

the sector – as we expect a step increase in ROE for this company; we roll forward from 4.6X 2015E P/B vs. 2015E-

16E ROE of 8.0%), derived using our A-share A&D sector regression line, and (2) the removal of a 5% M&A

discount previously applied as the profitability of unlisted assets has improved.

Key risks

Increased competition from foreign firms, new helicopter product lines not being injected into the listco.

Growth

Returns *

Multiple


Multiple

Returns *

Growth

Investment Profile

Low High





AVIC Helicopter Co. (600038.SS)


Key data Current

Price (Rmb) 62.93




12/14 12/15E 12/16E 12/17E

EPS (Rmb) 0.56 0.63 0.76 1.15

EPS growth (%) 14.5 11.2 21.9 50.7

EPS (diluted) (Rmb) 0.56 0.63 0.76 1.15


P/E (X) 53.8 100.6 82.5 54.7

P/B (X) 2.9 5.8 5.5 5.1

EV/EBITDA (X) 21.9 46.8 41.6 31.4

Dividend yield (%) 0.5 0.2 0.3 0.5

ROE (%) 5.5 5.8 6.8 9.6

CROCI (%) 14.3 11.8 12.0 14.0

2,000

2,500

3,000

3,500

4,000

4,500

5,000

5,500

20

30

40

50

60

70

80

90



AVIC Helicopter Co. (L) Shanghai SE A Share Index (R)


Absolute 25.3 44.2 131.1

Rel. to Shanghai SE A Share Index 52.3 29.8 31.8




AVIC Helicopter Co.: Summary financialsProfit model (Rmb mn) 12/14 12/15E 12/16E 12/17E Balance sheet (Rmb mn) 12/14 12/15E 12/16E 12/17E



SG&A (1,004.8) (1,103.6) (1,297.7) (1,490.2) Inventory 11,249.1 12,919.4 14,857.3 16,692.4



EBITDA 690.6 733.1 824.5 1,090.5 Net PP&E 2,804.6 2,813.1 2,864.8 2,955.7


EBIT 397.9 443.0 529.5 786.9 Total investments 255.3 255.3 262.4 280.9



Income/(loss) from uncons. subs. (2.6) 0.0 7.1 18.6


Pretax profits 394.5 437.9 532.4 801.1 Short-term debt 375.0 375.0 375.0 375.0


Minorities 0.0 0.0 0.0 0.0 Total current liabilities 13,442.3 15,021.1 17,061.5 18,631.5

Long-term debt 159.7 159.7 159.7 159.7










DPS (Rmb) 0.14 0.16 0.19 0.29






EBIT growth 28.2 11.3 19.5 48.6 ROA (%) 1.6 1.7 1.9 2.6





EBIT margin 3.2 3.2 3.3 4.3 Net debt/equity (%) (44.1) (43.5) (41.0) (38.7)






Net (inc)/dec working capital (970.2) (218.8) (347.9) (435.7) EV/EBITDA (X) 21.9 46.8 41.6 31.4

Other operating cash flow 89.2 0.0 (7.1) (18.6) EV/GCI (X) 2.8 5.8 5.2 4.7

Cash flow from operations (256.4) 440.1 389.6 527.0 Dividend yield (%) 0.5 0.2 0.3 0.5




Others 0.3 0.0 0.0 0.0



Inc/(dec) in debt 1,469.7 0.0 0.0 0.0


Other financing cash flows (1,413.5) 0.0 0.0 0.0

Cash flow from financing (20.4) (82.5) (91.7) (111.8)

Total cash flow (506.4) 84.0 (23.8) 45.7 Note: Last actual year may include reported and estimated data.




AVIC Aviation Engine: Looks fairly valued against its returns outlook; maintain Neutral

What’s changed

We maintain a Neutral rating on AVIC Aviation Engine as we see its valuations, at 76X 2016E P/E and 6.8X 2016E

P/B, as fair against its returns outlook. While we believe there are limited unlisted revenues/profits that could be

injected from AVIC, we do see the potential for further restructuring between the three listed aero-engine

companies given the current highly complex structure.

While we expect aero engines to continue to be one of the key focuses of China with potential further

government support/restructuring, alternative proposals may be possible, including a potential formation of a

new state-owned turbine engine company. However, in the event of any reclassification of ownership of engine

assets away from AVIC and further asset restructuring as a result, the potential impact on minority shareholders

of AVIC Aviation Engine remains uncertain.

Implications

We cut our 2015-17E EPS by 6%-16% on limited cost-plus pricing improvement seen year-to-date on aviation

engine products. We also introduce our 2018E EPS of Rmb1.16.

Valuation

Our new 12-month target price of Rmb52.40 (from Rmb33.90) incorporates: (1) a 2016E P/B of 6.4X vs. 2016E-17E

ROE of 10.0% (roll forward from 5.2X 2015E P/B vs. 2015E-16E ROE of 11.2%), derived using our A-share

Aerospace & Defense sector regression line, and (2) the removal of a 15% M&A discount previously applied as we

now believe restructuring of aero engine assets is still possible upon our re-assessment of AVIC’s asset

restructurings.

Key risks

Upside risks: Larger-than-expected government support/funding into the segment, better-than-expected broader

aero engine asset restructuring that is accretive to AVIC Aviation Engine’s minority shareholders.

Downside risks: Unfavorable policies, competition from imported engines (mainly from Russia/Ukraine), less

emphasis on indigenous engines.

Growth

Returns *

Multiple


Multiple

Returns *

Growth

Investment Profile

Low High





AVIC Aviation Engine Corp. (600893.SS)


Key data Current

Price (Rmb) 55.70




12/14 12/15E 12/16E 12/17E

EPS (Rmb) 0.48 0.55 0.74 0.92

EPS growth (%) 58.8 13.4 35.2 24.8

EPS (diluted) (Rmb) 0.48 0.55 0.74 0.92


P/E (X) 52.1 102.2 75.6 60.5

P/B (X) 3.4 7.2 6.8 6.3

EV/EBITDA (X) 21.4 34.5 31.6 28.5

Dividend yield (%) 0.6 0.3 0.4 0.5

ROE (%) 10.0 7.3 9.3 10.8

CROCI (%) 17.7 9.6 9.9 10.2

2,000

3,000

4,000

5,000

6,000

7,000

8,000

20

30

40

50

60

70

80



AVIC Aviation Engine Corp. (L) Shanghai SE A Share Index (R)


Absolute (0.2) 71.7 141.0

Rel. to Shanghai SE A Share Index 21.3 54.6 37.5




AVIC Aviation Engine Corp.: Summary financials




SG&A (2,310.9) (2,271.2) (2,563.3) (2,901.1) Inventory 10,782.1 9,024.6 13,309.3 11,921.0

R&D -- -- -- -- Other current assets 1,182.2 1,182.2 1,182.2 1,182.2


EBITDA 2,834.8 3,451.5 3,769.0 4,117.7 Net PP&E 14,298.4 14,019.4 13,792.0 13,702.9

Depreciation & amortization (1,104.4) (1,473.3) (1,445.8) (1,436.0) Net intangibles 2,302.9 2,193.4 2,084.0 1,974.5

EBIT 1,730.5 1,978.2 2,323.2 2,681.7 Total investments 1,603.8 1,653.8 1,703.8 1,753.8


Interest expense (1,057.6) (965.3) (860.8) (780.3) Total assets 43,976.0 40,624.0 47,340.1 44,579.6



Pretax profits 1,179.5 1,325.6 1,779.6 2,213.6 Short-term debt 11,402.1 11,402.1 11,402.1 11,402.1



Long-term debt 5,278.3 4,278.3 3,778.3 2,278.3

Net income pre-preferred dividends 936.5 1,062.4 1,436.5 1,792.6 Other long-term liabilities 317.1 317.1 317.1 317.1


Net income (pre-exceptionals) 936.5 1,062.4 1,436.5 1,792.6 Total liabilities 28,354.1 24,194.1 29,831.2 25,732.3


Net income 936.5 1,062.4 1,436.5 1,792.6 Preferred shares 0.0 0.0 0.0 0.0


EPS (basic, pre-except) (Rmb) 0.48 0.55 0.74 0.92 Minority interest 1,371.4 1,435.7 1,509.1 1,592.8



DPS (Rmb) 0.15 0.16 0.22 0.28




Sales growth 237.6 (1.7) 13.1 13.2 CROCI (%) 17.7 9.6 9.9 10.2


EBIT growth 201.0 14.3 17.4 15.4 ROA (%) 3.5 2.5 3.3 3.9








Net income pre-preferred dividends 936.5 1,062.4 1,436.5 1,792.6

D&A add-back 1,104.4 1,473.3 1,445.8 1,436.0 P/E (analyst) (X) 52.1 102.2 75.6 60.5


Net (inc)/dec working capital (2,684.7) 269.3 (1,480.2) 184.4 EV/EBITDA (X) 21.4 34.5 31.6 28.5


Cash flow from operations 164.7 2,819.3 1,425.5 3,446.6 Dividend yield (%) 0.6 0.3 0.4 0.5

Capital expenditures (455.6) (920.7) (892.7) (1,010.3)



Others (1,189.2) (164.1) (216.3) (227.0)

Cash flow from investments (1,644.8) (1,084.8) (1,109.0) (1,237.3)

Dividends paid (common & pref) 0.0 (282.6) (318.7) (430.9)

Inc/(dec) in debt 3,142.1 (1,000.0) (500.0) (1,500.0)


Other financing cash flows (1,153.8) 0.0 0.0 0.0

Cash flow from financing 1,988.3 (1,282.6) (818.7) (1,930.9)

Total cash flow 508.1 451.9 (502.1) 278.4 Note: Last actual year may include reported and estimated data.




AVIC Aircraft: Risk-reward unfavorable given demanding valuation; maintain Sell


We maintain our Sell on AVIC Aircraft with our new 12-month target price of Rmb17.80 implying 49% potential

downside, the most significant downside in our sector coverage. Key drivers of our negative investment thesis:

Limited scope for further M&As within its parent segment; market appears to hope for participation in

future revised fighter jet asset restructuring, but we think current share valuations look too

demanding: The completion of AVIC Aircraft asset injection in 2012 leads to limited room for further asset

acquisitions within the aircraft segment. However, its current high valuation premium (see Exhibit 19) implies

the market is pricing AVIC Aircraft as a potential consolidator of a future revived fighter jet asset

restructuring. We believe its current valuation of >230X 2015E P/E suggests an unfavorable risk-reward.

Civil products deliver steady growth but at low margins, with slow progress in ARJ21 part deliveries.

MA60/600 turboprop continue steady growth but at lower-than-defense product margins. We expect higher

costs to be involved as MA700 R&D continues.

Aging of its H-6 bomber could lead to product cycle gap before new products could contribute to

revenues and profits.

Catalyst

Potential announcement of further delay of COMAC’s C919 delivery dates where AVIC Aircraft is a key

component supplier, around or after its first flight in 2015. Such delays are common in new aircraft

developments by foreign manufacturers, e.g. Boeing 787, Airbus A380.

Potential cost overruns at its MA700 turboprop development process, commonly seen in new aircraft

developments by foreign manufacturers.

Valuation

We lower our 2015E-17E EPS by 9%-23% on limited cost-plus pricing improvement year to-date on its bomber

and transporter products. We also introduce our 2018E EPS of Rmb0.35. Our new 12-month target price of

Rmb17.80 (up from Rmb12.50) incorporates: (1) a 2016E P/B of 3.9X vs. 2016E-17E ROE of 4.7% (roll forward from

2.7X 2015E P/B vs. 2015E-16E ROE of 4.6%), derived using our A-share Aerospace & Defense sector regression

line, and (2) the removal of a 25% M&A discount previously applied as we believe M&A potential is still possible

given AVIC's ongoing fighter restructuring.

Key risks

Earlier-than-expected deliveries of heavy transporter or new variant of the fighter bomber JH-7; stronger-than-

expected turboprop sales.

Growth

Returns *

Multiple


Multiple

Returns *

Growth

Investment Profile

Low High





AVIC Aircraft (000768.SZ)


Key data Current

Price (Rmb) 35.15




12/14 12/15E 12/16E 12/17E

EPS (Rmb) 0.13 0.15 0.19 0.25

EPS growth (%) 0.3 12.9 24.0 32.7

EPS (diluted) (Rmb) 0.13 0.15 0.19 0.25


P/E (X) 89.4 NM NM 142.7

P/B (X) 2.6 7.8 7.7 7.6

EV/EBITDA (X) 30.3 77.5 65.9 54.9

Dividend yield (%) 0.8 0.3 0.4 0.5

ROE (%) 3.0 3.3 4.1 5.4

CROCI (%) 8.0 6.3 6.8 7.3

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

10

15

20

25

30

35

40

45

50



AVIC Aircraft (L) Shenzhen A Index (R)


Absolute 9.8 32.2 235.1

Rel. to Shenzhen A Index 15.4 (5.2) 72.0




AVIC Aircraft: Summary financials




SG&A (1,451.1) (1,632.0) (1,972.2) (2,276.8) Inventory 13,500.2 17,095.2 16,971.4 22,162.8



EBITDA 1,115.6 1,237.8 1,471.2 1,812.0 Net PP&E 5,727.9 6,154.6 6,730.8 7,425.5


EBIT 607.1 680.2 864.3 1,145.6 Total investments 184.4 189.6 195.4 201.8





Pretax profits 480.6 542.5 672.0 885.1 Short-term debt 3,976.5 3,976.5 3,976.5 3,976.5



Long-term debt 202.8 202.8 1,202.8 3,202.8







EPS (basic, pre-except) (Rmb) 0.13 0.15 0.19 0.25 Minority interest 996.8 1,023.5 1,055.8 1,093.1



DPS (Rmb) 0.10 0.11 0.14 0.19


Free cash flow yield (%) (6.2) 0.0 (0.7) (2.2)



EBITDA growth (8.5) 11.0 18.9 23.2 ROE (%) 3.0 3.3 4.1 5.4

EBIT growth (18.7) 12.0 27.1 32.5 ROA (%) 1.1 1.1 1.3 1.5









D&A add-back 508.6 557.6 607.0 666.4 P/E (analyst) (X) 89.4 NM NM 142.7


Net (inc)/dec working capital (2,281.4) (66.9) (630.4) (2,135.3) EV/EBITDA (X) 30.3 77.5 65.9 54.9


Cash flow from operations (1,132.6) 909.5 495.9 (783.9) Dividend yield (%) 0.8 0.3 0.4 0.5

Capital expenditures (893.8) (953.6) (1,152.4) (1,330.4)



Others 12.0 0.0 0.0 0.0

Cash flow from investments (881.8) (953.6) (1,152.4) (1,330.4)


Inc/(dec) in debt (363.1) 0.0 1,000.0 2,000.0



Cash flow from financing (629.1) (265.4) 700.4 1,628.4

Total cash flow (2,643.5) (309.5) 43.8 (486.0) Note: Last actual year may include reported and estimated data.




Hongdu Aviation: Extremely demanding valuation vs. peers; maintain Sell


We maintain our Sell on Hongdu Aviation on the back of its overly demanding valuation, >170X 2015E P/E versus

other A-share defense peers at c.85X, which we believe is driven by overoptimistic market expectations on

M&A/trainer orders/military asset injections. Meanwhile, we see limited scope for further M&A as assets at its

Hongdu parent are actually loss-making, hence are unlikely to be accretive to earnings in the event of an

injection. While the market appears to be pricing in the potential for Hongdu Aircraft to participate in future

revived fighter jet asset restructuring (evident from the stock’s demanding valuations of >180X 2016E P/E vs. peers

at c.70X), we view this participation as uncertain and the risk-reward for Hongdu Aviation as unfavorable.

Catalyst

Further competing trainer jet orders (e.g. Super Tucano, T-50, M-346 or Yak-130) secured by peers in

African/Latin American countries, Hongdu’s key target regions. Hongdu lost to Embraer’s Super Tucano in

Ghana’s trainer jet procurement in December 2014.

Any confirmation of AVIC’s fighter jet restructuring, if without the involvement of Hongdu Aviation as a

consolidating platform.

Valuation

We lift our 2015E earnings by 25% on earlier-than-expected domestic orders of L-15, and revise our 2016E/17E

earnings by -16%/+6% after updating delivery assumptions for its L-15 and K-8 trainer jets. We also introduce our

2018E EPS of Rmb0.41. Our new 12-month target price of Rmb22.90 (up from Rmb17.40) incorporates: (1) a 2016E

P/B of 3.2X vs. 2016E-17E ROE of 4.4% (roll forward from 2.6X 2015E P/B vs. 2015E-16E ROE of 3.2%), derived using

our A-share Aerospace & Defense sector regression line, and (2) a 15% M&A discount (unchanged) to account for

unprofitable unlisted assets at parent Hongdu Group that could be injected into the company long-term.

Key risks

Larger-than-expected or earlier-than-expected domestic trainer orders, asset injections that are outside the scope of

its immediate Hongdu group.

Growth

Returns *

Multiple


Multiple

Returns *

Growth

Investment Profile

Low High





Hongdu Aviation (600316.SS)


Key data Current

Price (Rmb) 29.21




12/14 12/15E 12/16E 12/17E

EPS (Rmb) 0.14 0.16 0.26 0.38

EPS growth (%) 8.6 18.1 58.4 46.8

EPS (diluted) (Rmb) 0.14 0.16 0.26 0.38


P/E (X) 147.5 NM 113.4 77.3

P/B (X) 3.0 4.2 4.0 3.8

EV/EBITDA (X) 142.9 94.5 60.7 47.9

Dividend yield (%) 0.0 0.0 0.1 0.1

ROE (%) 2.0 2.3 3.6 5.1

CROCI (%) 1.1 3.6 4.9 6.4

2,000

2,500

3,000

3,500

4,000

4,500

5,000

5,500

6,000

15

20

25

30

35

40

45

50

55



Hongdu Aviation (L) Shanghai SE A Share Index (R)


Absolute (20.6) (7.9) 73.0

Rel. to Shanghai SE A Share Index (3.5) (17.1) (1.3)




Hongdu Aviation: Summary financials


Total revenue 3,450.7 3,723.6 4,049.1 4,510.2 Cash & equivalents 582.0 247.3 1,345.4 1,372.9


SG&A (180.0) (194.2) (211.2) (212.7) Inventory 2,293.3 1,934.0 1,460.0 1,612.1



EBITDA 103.8 228.1 336.9 426.7 Net PP&E 2,622.9 2,729.3 2,848.5 2,986.7


EBIT 23.7 143.3 248.7 334.5 Total investments 749.6 754.6 759.6 764.6





Pretax profits 118.6 139.3 219.7 321.7 Short-term debt 830.7 830.7 830.7 830.7



Long-term debt 0.0 0.0 0.0 0.0










DPS (Rmb) 0.01 0.01 0.02 0.03


Free cash flow yield (%) (8.6) (1.6) 5.3 0.2




EBIT growth 2.5 504.0 73.5 34.5 ROA (%) 1.2 1.4 2.2 3.2





EBIT margin 0.7 3.8 6.1 7.4 Net debt/equity (%) 5.0 11.6 (9.9) (9.9)




D&A add-back 80.1 84.7 88.2 92.3 P/E (analyst) (X) 147.5 NM 113.4 77.3


Net (inc)/dec working capital (453.0) (340.2) 1,038.3 (95.0) EV/EBITDA (X) 142.9 94.5 60.7 47.9

Other operating cash flow (128.7) (5.0) (5.0) (5.0) EV/GCI (X) 2.5 3.3 3.6 3.4

Cash flow from operations (400.6) (141.3) 1,309.0 266.4 Dividend yield (%) 0.0 0.0 0.1 0.1




Others 94.5 0.0 0.0 0.0



Inc/(dec) in debt 622.0 0.0 0.0 0.0




Total cash flow (592.1) (334.7) 1,098.0 27.5 Note: Last actual year may include reported and estimated data.




Appendices



Appendix 1: China’s 10 key state-owned defense groups

Exhibit 46: AVIC is one of the 10 key state-owned military manufacturing groups in China China 10 Central Military Groups and their key listed company subsidiaries

Source: Company data.

Aviation Industry Corporation of China (AVIC)

State-owned Assets Supervision and Administration Commissionof the State Council (SASAC)

China Shipbuilding Industry Corporation (CSIC)

China National Nuclear Corporation (CNNC)

China Aerospace Science and Technology Corporation

(CASC)

China Aerospace Science & Industry Corp (CASIC)

China State Shipbuilding Corporation (CSSC)

China Electronics Technology Group Corporation (CETC)

China Energine International Hldgs

(1185.HK)

China Aerospace International Holdings

(0031.HK)

APT Satellite Holdings(1045.HK)

China Spacesat (600118.SS)

China Aerospace Times Electronics

(600879.SS)

Shaanxi Aero-space Power Hi-Tech (600343.SS)

Shanghai Aero Auto Electromechanical

(600151.SS)

NavInfo Co.(002405.SZ)

Aerospace Communications Hldgs

(600677.SS)

Beijing Aerospace Changfeng

(600855.SS)

Aerosun Corporation(600501.SS)

AISINOCO(600271.SS)

Aerospace Hi-Tech Holding

(000901.SZ)

Guizhou Space Appliance

(002025.SZ)

China Shipbuilding Industry

(601989.SS)

CSSC Offshore & Marine Engineering Group

(600685.SS/0317.HK)

China State Shipbuilding Co.

(600150.SS)

CSSC Steel Structure Engineering Co.

(600072.SS)

CNNC International Limited

(2302.HK)

SUFA Technology Industry

(000777.SZ)

China Nuclear Engineering Group Co. (CNEG)

No Listco

Anhui Sun-Create Electronics

(600990.SS)

Shanghai East-China Computer

(600850.SS)

Glarun Technology(600562.SS)

Taiji Computer Corporation(002368.SZ)

Westone Information Industry

(002268.SZ)

Hangzhou Hikvision Digital Techgy (002415.SZ)

Gci Science & Technology(002544.SZ)

China North Industries Group Corporation (CNGC)

North Navigation Control Technolgy

(600435.SS)

North Electro-Optic (600184.SS)

Inner Mongolia North Hauler Joint Stock

(600262.SS)

Baotou Beifang Chuangye

(600967.SS)

Liaoning Huajin Tongda Chemicals

(000059.SZ)

Sichuan Nitrocell (002246.SZ)

Norinco International(000065.SZ)

China South Industries Group Corporation (CSGC)

Zhongyuan Special Steel

(002423.SZ)

Yunnan Xiyi Industrial (002265.SZ)

Changan Minsheng APLL Logistics

(1292.HK)

China Jialing Industrial (600877.SS)

Baoding Tianwei Baobian Electric

(600550.SS)

Hunan Tyen Machinery (600698.SS)

Harbin Dongan Auto Engine

(600178.SS)

Chongqing Jianshe Motorcycle

(200054.SS)

Chengdu Tianxing Instrument & Meter

(000710.SZ)

Chongqing Changan Automobile (000625.SZ)

Lida Optical & Electronic(002189.SZ)

Jiangling Motors Corporation(000550.SZ)

AviChina(Buy, 2357.HK)

AVIC Helicopter(Buy, 600038.SS)

Hongdu Aviation(Sell, 600316.SS)

AVIC Avionics(Buy, 600372.SS)

AVIC Aviation Engine(Neutral, 600893.HK)

Sichuan Chengfa Aero Science &Technology

(600391.SS)

AVIC Heavy Machinery (600765.SS)

AVIC Aircraft(Sell, 000768.SZ)

AVIC Sanxin(002163.SZ)

AVIC Real Estate Holding

(000043.SZ)

Fiyta Holdings (000026.SZ)

TONTEC Technology (600862.SS)

China Aviation Optical-Electrical Tech (002179.SZ)

AVIC Electromechanical(002013.SZ)

ZH Electronic Measuring Instruments (300114.SZ)

AVIC Aero Engine Controls

(000738.SZ)

Guihang Automotive Components(600523.SS)

Sichuan Chengfei Integration

(002190.SZ)

Zhonghang Heibao (600760.SS)

Tianma Microelectronics (000050.SZ)

Rainbow Department Store

(002419.SZ)

AVIC International Holdings

(0161.HK)

AVIC International Holding HK (0232.HK)

China 10 Central Military Groups Listed companies under each groupWith defense related assets

Aerospace Ship building Nuclear Electronics Land-based weapons



Appendix 2: Who does what in China and in US/Europe Aerospace & Defense?

Exhibit 47: AVIC Helicopter, Hongdu and AVIC Aircraft are key prime contractors/system integrators alongside the unlisted Shenyang Aircraft Corporation and

Chengdu Aircraft Corporation Key firms in China and US/Europe Defense and Civil Aero


Tier 3 components

Tier 2 suppliers

Systems/ components

Tier 1 suppliers/

System Integrators

China

Prime Contractors/

System Integrators

ChinaChengdu Aircraft Group & Shenyang Aircraft Group (not yet listed) – fighter jets

AVIC Aircraft (000768.SZ)– bombers, transporters

AVIC Helicopter (600038.SS) – helicopters

Hongdu Aviation (600316.SS) – trainer jets L-15, K-8

COMAC (not listed) – C919, ARJ21

AVIC Aircraft (000768.SZ) – Modern Ark (MA) turboprops

AVIC Helicopter (600038.SS) – AC series Helicopters, general aviation

Hongdu Aviation / AVIC General Aviation (not listed) – general aviation

AVIC Aircraft (000768.SZ) – C919, ARJ21, MA series

GE, Honeywell, Parker Hannifin, Rockwell Collins, Goodrich, Hamilton Sundstrand forming ring-fenced JVs with subsidiaries of AVIC Avionics Systems / AVIC Electro-mechanical Systems – C919

Lieherr JV with AVIC Landing Gears (subsidiary of AVIC Aircraft)

JONHON Optronics (002179.SZ) – C919 connectors

AVIC Aircraft/AVIC Helicopter /Hongdu/AVIC Aviation Engine –sub-contracting for Airbus, Boeing, AgustaWestland, Eurocopter, Sikorsky, Rolls-Royce

AVIC Aviation Engine (600893.SS) – fighter engines, including WS-9 and WS-10

AVIC Avionics (600372.SS) – flight control, power systems, APU, environment control, lighting etc.

Chengfa Science & Technology (600391.ss) –aero engine components and control systems

AVIC Aero-Engine Controls (000738.SZ) – aero engine control systems

Avic Electro-Mechanical Systems (002013.SZ) –Electro-mechanical parts and systems

JONHON Optronics (002179.SZ) – connectors

US/Europe US/EuropeDefense

Lockheed Martin – aircraft

Boeing – aircraft

BAE Systems – aircraft

Finmeccanica – aircraft

EADS – aircraft, helicopters

Many US companies

Rolls Royce, GE Aviation, Pratt & Whitney – enginesThales – defense electronicsFinmeccanica – defense electronicsMany US companies

Cobham – antenna, mechanical equipment

Meggitt – target systems etc.

Ultra Electronics – sundry defense electronics

Many US companies

Civil Aero

Boeing – US

EADS – Airbus

Many US companies –regional and business jets, helicopters

Rolls Royce, GE Aviation, Pratt & Whitney – engines

Safran – engines, wheels, brakes, landing gears

Thales – avionics

Meggitt – engine monitoring, fire control, wheels, brakes

MTU – engine modules

Zodiac – utilities



Appendix 3: China defense budget reform policies

Exhibit 48: We expect China’s defense reform to lead to more effective usage of the defense budget, benefiting equipment

procurement and modernization China defense spending reform key ideas

Source: Xinhua.net.

Exhibit 49: We only factor in a minor improvement in margins over the next three years China Aerospace & Defense: EBIT margin trends


Oct. 2014

For every budget item, an objective/contribution will be needed and tracked.

Budget and expense will be tracked closely. Actions will be taken should the objective of the expense deviate from the

original.

Defense Spending Reform

Expand from the pilot units to all units in the army; Optimize the construction of equipment, infrastructure, and budgeting system; Solve the

inefficiency in budget planningAccountability system

2020

Optimized management systemStandard protocol

Comprehensive monitoring

Budget origination restructuring

For the objectives that have not been effectively realized, responsible parties will be penalized.

Establish full accountability system for budget expense; Utilize mathematical model and expert

consultation to effectively build management database system for budget planning

2017

Hongdu’s average EBIT margin in the earlier decade (2002-2009) was at 9%

0%

3%

6%

9%

12%

15%

18%

2010 2011 2012 2013 2014 2015E 2016E 2017E

AVIC Avionics

JONHON

Hongdu

AviChina

Aviation Engine

AVIC Aircraft

Helicopter



Appendix 4: China’s helicopter fleet at a glance

Exhibit 50: China has fewer than 400 civil helicopters, vs. the US with >10,000

and the EU with >6,000 (broader Europe of >8,000) Global civil helicopter fleet (2014)

Exhibit 51: We see civil as a faster growth driver for China’s helicopter

demand long-term, as China has a sizable military helicopter fleet

Global military helicopter fleet (2015)

Source: FlightGlobal. Source: FlightGlobal.

Exhibit 52: AVIC now has a civil product line-up to compete with foreign

peers, it sees 20% OEM cost advantage and after-sales as key strengths AVIC Helicopter’s AC-series helicopter product line-up

Exhibit 53: We see significant growth potential for China’s civil helicopter

fleet, especially when compared to the US with 6,000 in 1980 and then

surpassing 10,000 in 2010 Civil helicopter fleet size progression in key countries

Notes: D – Development; T – Testing; P – Production. Source: Company data, Press reports (including Sina), Goldman Sachs Global Investment Research.

Source: FAA, CAAC, Transport Canada, CAA New Zealand, South African CAA, BAZL, CAA UK, ANAC Brazil.

0

50,000

100,000

150,000

200,000

250,000

US Canada Germany Brazil UK Australia SouthAfrica

NewZealand

China Switzerland

2.1

0.80.5

2.31.6 2.0

0.7

1.81.9

2.2

-

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

0

1,000

2,000

3,000

4,000

5,000

6,000

USA Russia China Japan SouthKorea

France India Germany Italy UK

Attack helicopter (LHS) Utility Helicopter (LHS)

Training helicopter (LHS) Helicopters vs. fix wing combat aircrafts (RHS)

Avg: 1.6

0

500

1,000

1,500

2,000

2,500

3,000

1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013

Australia Brazil Canada New ZealandSouth Africa Switzerland United Kingdom China



Disclosure Appendix

Reg AC

I, Ronald Keung, CFA, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify

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Disclosures

Coverage group(s) of stocks by primary analyst(s)

Ronald Keung, CFA: Asia Pacific Airlines, Asia Pacific Shipping, China Transportation.

Asia Pacific Airlines: Beijing Capital Intl Airport, Cathay Pacific, Shanghai Int'l Airport, Singapore Airlines.

Asia Pacific Shipping: China COSCO Holdings (A), China COSCO Holdings (H), China Int'l Marine Containers (A), China Int'l Marine Containers (H), China Shipping Container Lines (A), China Shipping

Container Lines (H), China Shipping Development (A), China Shipping Development (H), Evergreen Marine, Hanjin Shipping, Neptune Orient Lines, Orient Overseas Intl, Pacific Basin Shipping, Wan

Hai Lines, Yang Ming Marine.

China Transportation: AVIC Aircraft, AVIC Aviation Engine Corp., AVIC Avionics, AVIC Helicopter Co., AviChina, Daqin Railway, Guangshen Railway (A), Guangshen Railway (H), Hongdu Aviation.

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