JP Morgan China 2010

Asia Pacific Equity Research 19 December 2009

China Insights & Strategy

Views from the Bund

China Equities Research Team

Frank LiAC

(852) 2800-8511 [email protected]

J.P. Morgan Securities (Asia Pacific) Limited

See page 153 for analyst certification and important disclosures, including non-US analyst disclosures. J.P. Morgan 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.

Relative index performance

Source: Bloomberg.

‘Views from the Bund’ is a monthly publication that gives clients a value-added view on China macro, strategy, and industry insights. • Key investment theme: In FY10, the China equity market may offer

good investment opportunities but also presents many uncertainties and risks. On one hand, we believe Chinese equities could stage a rally between now and 1Q10, driven by: 1) the government’s recent reiteration of its “proactive fiscal policy” and “relatively loose monetary policy” for 2010, which should help alleviate the market’s concerns about possible earlier-than-expected monetary tightening; 2) the upward earnings estimate revision momentum for MSCI China; 3) a marked sequential improvement in liquidity from Dec-09 to 1Q10; and 4) the expectation that Rmb will resume appreciation in FY10. On the other hand, we could start to see an increase in market volatility for MSCI China if and when the government starts to tighten its monetary policy (possibly in 2Q10). We could see de-rating pressure for sectors that are highly correlated with fixed-investment growth as we approach mid-2010, when the equity market is likely to start pricing in a potential sharp slowdown in fixed asset investment growth in 2011. Our major investment strategy lies in focusing on defensive growth stocks—stocks with good earnings visibility, low penetration rate, strong secular growth, and those that should be least affected by a potential tightening kicking in as of 2Q10 and a downshift in FAI growth in 2011.

• What is changing: We highlight our two key investment themes for FY10: 1) accumulating consumption–related stocks to benefit from China’s growth rebalance; and 2) identifying undervalued China companies, which are likely to report record high earnings in FY09, but are still trading at a decent discount to their highs in FY07, and are free from major multiple contraction pressure.

• Information: We continue to see short-term trading opportunities for media and airline stocks, and food inflation plays.

• China model portfolio adjustment: We stay positive on: A) China banks; B) the coal sector; and C) defensive growth names—internet, tissue and diapers, gas, selected consumer staples, and healthcare. We are negative on: A) property on tightening concerns; within the sector, we favor those with the most exposure to Tier 2-3 cities; B) telecoms; C) FAI–related plays, including downstream commodities, commercial vehicles and construction; and D) IPPs.

China: Top picks Reuters Mkt cap Avg. dly TOEPS Y/Y growth (%) P/E (x) P/BV (x) ROE (%) Div. yld (%)

Rec ticker (US$MM) (US$MM) 2009E 2010E 2009E 2010E 2009E 2009E 2009E China Citic Bank - H Share OW 0998.HK 42,410 39.9 13.6 52.4 14.7 9.6 2.1 15.2 1.7 China Construction Bank OW 0939.HK 198,050 236.7 14.2 30.1 12.8 9.8 2.6 21.3 3.5 China Gas Holdings Limited N 0384.HK 1,588 5.4 NM NA 25.6 NA 3.4 14.3 0.0 Sinopharm OW 1099.HK 8,032 NA 42.1 15.3 47.2 40.9 4.7 12.7 0.5 Sina Corp N SINA US 2,796 53.3 -24.2 29.5 45.7 35.3 3.5 8.7 0.0

Source: Bloomberg, J.P. Morgan estimates. Prices and valuations are as of December 16, 2009.

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Frank Li (852) 2800-8511 [email protected]

Table of Contents Macroeconomic views .............................................................3 Market strategy.......................................................................16 Autos .......................................................................................66 Consumer................................................................................84 Energy .....................................................................................93 Financials: Banks...................................................................99 Financials: Insurance...........................................................109 Healthcare .............................................................................128 Real estate ............................................................................130 Transportation ......................................................................136 Telecom.................................................................................138 Utilities and infrastructure...................................................142

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Macroeconomic views Upbeat economic momentum Latest economic indicators confirmed that the upbeat momentum in China’s economic activity carried on well into 4Q09. Along with the positive tone from latest manufacturing PMIs, industrial activity continued with the solid expansion in November, with industrial production rising at a faster-than-expected 19.2% oya (J.P. Morgan: 19.0%; consensus: 18.2%), compared with 16.1% in October. Seasonally adjusted, IP rose an impressive 1.7% m/m in November, adding to the 1.4% gain in October, with the sequential trend rising at 16.7% 3m/3m, saar.

The strong momentum in industrial activity continued along with a steady and broad-based recovery in exports. On the domestic front, the pace of fixed investment growth eased modestly in November, which may help to ease some of the concerns about the buildup of excess capacity in some industries, in our view. Meanwhile, data about retail sales, which had shown an impressive gain in recent months, were rather mixed in November, underscoring the leadership’s decision to renew support for Chinese consumers. Overall, the latest data flow and policy tone are consistent with our GDP outlook of a 9.5% rise next year.

Figure 1: China—Real IP growth

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Source: CEIC, J.P. Morgan Economics.

Overall tone on macro policy still growth-friendly China’s annual Central Economic Work Conference, which sets the overall tone of the macro policy for the coming year, ended this week. The tone for 2010 was largely in line with the Politburo statement released earlier, reiterating stability and continuity, and focusing on supporting domestic demand, particularly private consumption, going into next year. As expected, the description of “proactive fiscal policy” and an “appropriately accommodative monetary policy” stance were unchanged in the statement after the conference. Policymakers emphasized that the foundation of the current economic recovery is yet to fully firm up, and uncertainty over the global recovery going into next year lingers. On the domestic front, the labor market and employment conditions were highlighted as areas of policy concern.

Meanwhile, along with the steady recovery in GDP growth, the focus on macro policy going into 2010 will gradually turn to structural adjustment and rebalancing of the economy, the quality and sustainability of the recovery, and managing inflation expectations, in our view. In particular, in the fiscal policy, we expect public

Qian Wang (852) 2800-7009 [email protected]

Grace Ng (852) 2800-7002 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

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expenditure to focus on education, social security, economic housing, agriculture, and environmental protection, among other areas.

With regard to the fixed investment cycle, it is well recognized that public sector investment spending, especially infrastructure investment, has been the major force behind the economy’s impressive recovery this year. The conference highlighted that going into 2010 the macro policy should ensure an appropriate pace of growth in fixed investment, with the focus on completing ongoing investment projects, while closely monitoring the number of new ones.

On monetary policy, while the conference emphasized the continuity and stability of the policy stance, it also highlighted the importance of flexibility, suggesting that the pace of credit expansion should be managed and adjusted according to changes in the global and domestic economies. Also, credit support should be channeled to sectors with greater impact on employment, new strategic industries, and small- and medium-sized enterprises.ok.

We believe such adjustments in monetary conditions are already taking place. As we highlighted recently, the sequential trend growth rates in the M2 money supply and total bank loans have moderated notably. Meanwhile, the part of credit creation, which is more relevant for real economic activity, has remained largely supportive of growth. We believe such a fine-tuning of overall monetary and credit conditions is likely to continue well into next year.

Policy focus on domestic consumption The conference highlighted domestic demand, especially private consumption, as an important driver of economic growth next year. Particular focus was placed on improving the distribution of national income and enhancing the consumption capability of lower-income groups. The continuation of policies supportive of consumption, especially those promoting purchase of autos and household electronic appliances, was emphasized as well.

For the property sector, policymakers focused on the provision of housing and the fulfillment of genuine household demand for home purchases. The conference also highlighted the policy target of speeding up the urbanization process, with emphasis on encouraging the rural migrant population to settle in urbanized areas, especially in medium-sized and smaller cities.

For the export sector, the conference suggested that in fostering steady recovery in exports, it is important to encourage further upgrading of the value-added content of exports. Again, policy continuity and stability with regard to the export sector were stressed, along with the need for developed economies to consolidate the market and further explore exports market.

Overall, the general macro policy tone coming out of the Economic Work Conference was largely consistent with our view on the growth and macro policy outlook for 2010. Our forecast for 2009 full-year GDP growth stands at 8.6% with the 2010 GDP growth forecast at 9.5%. We expect the PBoC to begin raising benchmark policy rates moderately by mid-10 with a total of two 27bp hikes over the second half of next year. On the currency front, we expect the continuation of the gradual appreciation of the Rmb exchange rate to begin sometime in 2Q10 and expect Rmb/US$ to reach 6.5 by end-10.

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Figure 2: China—GDP and household income

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Source: CEIC and J.P. Morgan Economics.

Broad-based export recovery China’s November trade reports confirmed further steady recovery in trade activity. September exports declined modestly at 1.2%oya (J.P. Morgan: +2.0%; consensus: +1.4%), translating into a modest gain of 0.7% m/m, sa, but backed by the impressive gain of 3.1% m/m and 6.3%m/m in October and September, respectively. The sequential trend growth accelerated further, to rise at 46.9% 3m/3m, saar by November. Besides, the General Administration of Customs commented that, adjusting for the number of working days, exports declined marginally at 0.3%oya in November. Meanwhile, imports rose notably at 26.7%oya in November, translating into a gain of 2.4% m/m, sa, with the sequential trend rising at 38.1% 3m/3m, saar. November trade surplus was at US$ 19.1 billion, which was the lowest trade surplus registered since 2005. For the first 11 months of the year, trade surplus was at $179.6 billion, compared with $250.7 billion for the same period last year.

Overall, China’s November trade figures continued to show steady sequential improvement in exports. This was consistent with the notable recovery in the global manufacturing cycle and the steady upturn in aggregate final demand, in developed as well as developing markets. In addition, on the domestic front, on-the-ground evidence continues to suggest an upturn in export orders and rising demand for labor at coastal manufacturing regions. Looking ahead, we expect further steady recovery in China’s exports, in line with our global team’s expectation of sustained above-trend growth for the global economy through 2010.

• In further details, exports in the important category of mechanical and electrical products (59% of total exports) rose 3.3% m/m, sa in November, with the sequential trend rising at 34.3% 3m/3m, saar. Meanwhile, high-tech exports stayed flat in November, but that was due to the 7.9% m/m, sa jump in October, with the sequential trend rising at an 38.9% 3m/3m, saar. In addition, exports of low-end consumer goods stayed flat in November, with the sequential trend rising at 19.4% 3m/3m, saar. Further details suggest that exports of textile products (up 3.6% m/m, sa) increased in November, while exports of clothing (down1.3% m/m, sa), footwear (down 1.5%) and toys (down 6.0%) all weakened. Meanwhile, exports of steel products (in volume terms) surged again, rising at 12.0% m/m, sa in November, following the sharp rise in October (16.9% m/m, sa) and September(18.1% m/m, sa).

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• A breakdown by destinations shows a broad-based improvement in demand. Shipment to neighboring Asian markets, including ASEAN (+100.4% 3m/3m, saar by November), Taiwan (+152.7% 3m3/m, saar) and Korea (+65.1% 3m/3m, saar) rose strongly. For advanced markets, exports also increased steadily in recent months, including those to the US (+21.9% 3m/3m, saar by November), EU (+37.1% 3m/3m, saar) and Japan (+36.7% 3m/3m, saar), in line with the improving growth picture in these economies.

• On the import side, it appears that the solid import gain in November was largely driven by imports of mechanical and electrical products (up 7.8% m/m, sa, and 40.9% 3m/3m, saar). With regard to commodities, in volume terms, imports of crude oil fell 13.8% m/m, sa in November, to record 17.1 million tons (nsa). On the other hand, imports of refined oil products rose 4.1% m/m, sa in November, to reach 2.4 million tons (nsa). Meanwhile, sequential trends in the import of a number of major industrial metals are either showing a notable slow pace of gain, or outright decline, including imports of iron ore (+11.4% 3m/3m, saar by November), copper (-60.1% 3m/3m, saar) and aluminum (-85.9% 3m/3m, saar), reversing from the elevated pace of growth during 1H09.

Figure 3: China—Merchandise trade

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Figure 4: China—Exports of steel products and low-end consumer goods

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Figure 5: China—Exports of mechanical and electrical products

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Figure 6: China—Exports by region

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New loan creation is stabilizing China’s M2 money supply growth edged up again in November, to rise at 29.7% over-year-ago (J.P. Morgan and consensus: 29.0%), compared with the 29.4%oya growth in October. Seasonally-adjusted, the monthly rise in M2 moderated to 1.4% m/m, sa in November, with the sequential trend growth easing further from the elevated pace in 1H09, to rise at 19.0% 3m/3m, saar by November. New loan creation rose moderately in November, to Rmb294.8 billion, compared with Rmb253 billion in October. Notably, a breakdown of November new loan creation showed a continuous decline in bill financing. In addition, new loans to the corporate sector eased modestly in November, while new loans to the household sector rose in November, supported by solid mortgage loan demand.

Bank loans rose at 33.8%oya in November, compared with the 34.2%oya growth in October, with the sequential trend rising at 22.0% 3m/3m, saar. New loan creation was at Rmb294.8 billion (-38.2%oya) in November, compared with Rmb253 billion for October. For the first 11 months of the year, new loan creation was at Rmb9.21 trillion, compared with Rmb4.14 trillion during the same period in 2008.

A significant amount of bill discounting was matured in November, with total bill discounting falling by Rmb108.5 billion. Besides, short-term corporate loans also declined modestly by Rmb20.5 billion in November. On the other hand, new

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household loans increased in November, to reach Rmb237.7 billion (compared with Rmb157.6 billion in October), largely supported by the strong mortgage loan demand. Besides, medium-to-long term corporate loans eased modestly, to reach Rmb201.2 billion in November (compared with Rmb272.5 billion in October), which was consistent with the modest easing in fixed asset investment growth in November. Overall, new loan creation and net of short-term bill financing was at Rmb403 billion in November.

The central bank’s weekly open market operations suggest that Rmb299 billion was drained from the banking system in November, though the net amount of liquidity withdrawal has slowed lately. Along with PBoC’s steady withdrawal of excess liquidity through open market operations, the sequential trend growth rates in M2 money supply and total bank loans have been steadily moderating from the elevated pace in 1H09, rising 22.0% 3m/3m saar through November (chart below). Looking ahead, we believe that the central bank will continue to rely on open market operations to manage overall liquidity.

Figure 7: China—Money supply and loan growth

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Figure 8: China—New loan creation

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CPI inflation turns positive For consumer prices, November CPI inflation turned into the positive territory, rising at 0.6% oya, compared with the 0.5% decline in October. Seasonally-adjusted, headline CPI rose 0.5% m/m in November, compared with the 0.2% m/m rise in October. The rise in November headline CPI again reflects the rise in food prices, at

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3.2%oya, translating into a rise of 1.0% m/m, sa, with the particular impact of heavy snow on food prices during the month. Excluding the food component, non-food CPI continued to fall at 0.7% oya in November, compared with the 1.6% decline, translating into a modest gain of 0.2% m/m, sa. Overall, we expect headline CPI to rise at a moderate 3.0% in 2010.

In addition, PPI declined at 2.1% oya in November, compared with the 5.8% decline in October, translating into a rise of 1.0% m/m, sa. Among major PPI categories, the pace of %oya decline narrowed most notably for mining (-4.1%oya in November, compared with -16.3%oya in October) and industrial raw materials (-1.7%oya in November, compared with -8.3%oya in October). Meanwhile, the PPI for consumer goods fell modestly at 0.2%oya in November, compared with the fall of 1.4%oya in October.

Figure 9: China—Headline CPI, food prices and non-food CPI

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PMI indicates solid momentum in industrial activity China’s two separate manufacturing PMIs stayed at levels well above the expansionary threshold of 50 in November, indicating that the sequential expansion of industrial activity continued at a solid pace. The official NBS manufacturing PMI series remained unchanged at 55.2 in November, the highest level since April 2008. The Markit PMI rose 0.3% to 55.7 in November, registering the highest level since the survey started in April 2004.

Putting the two separate PMI series together suggests that the sequential trend in China’s manufacturing sector remains in a solid expansion phase, supported by steady and broad-based demand growth on the domestic front as well as improving external orders. In addition, the manufacturing order-to-inventory ratio remained at the highest level since April 2008, suggesting that with further steady recovery in final demand conditions, the solid growth in the manufacturing sector will continue.

• The output component rose again to 59.4 in November in the NBS series (from 59.3 in October), the highest level since April 2008. The further increase in the PMI output component was led by industries, including textiles, garment and footwear, transportation equipment, electric machinery and instruments, and tobacco processing, while the output component for sectors including petroleum processing and coking, beverage manufacturing, and paper making and printing eased in November.

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• Among forward-looking components, new orders edged down marginally by 0.1%, but still registered an elevated 58.4 level in November in the NBS series. On the domestic side, public spending growth will likely moderate as the government becomes more cautious about approving new investment projects amid concerns about overcapacity and inefficient spending, in our view. Meanwhile, the growth in private real estate investment continued with a significant rebound, and consumer spending showed a further solid expansion. On the external side, export order components picked up steadily to reach 57.5 in the Markit series in November (from 55.6 in October), the highest level since March 2005. Meanwhile, export orders component in the NBS series eased somewhat to 53.6 in November (from 54.5 in October).

• The inventory component rose modestly to 45.4 in November in the NBS series (from 43.4 in October). Together with the solid improvement in orders, the orders-to-inventory ratio has improved steadily in recent months. Though the ratio eased modestly to 1.29 in November (from 1.35 in October), it remained at around the highest level since April 2008.

• With regard to labor market conditions, the employment component of the NBS series declined to 51.1 in November (from 52.4 in October), the sixth consecutive month that the index stayed above the threshold of 50. The rebound in the export sector is crucial for the recovery in the labor market and the outlook on household consumption. In particular, as export orders recover steadily, manufacturing employers may increase hiring, especially for coastal export-intensive regions. Hence, the employment component in the Markit PMI series, which is generally seen as focusing more on private sector corporates, stayed elevated at 54.3.

• The PMI input price components rose again in November, after easing in September and October. For the NBS series, the input price component rose to 63.4 (from 56.9 in October), the highest level since July 2008, with a broad-based increase in input costs across most industries. Corporate input costs increased along with the gain in global crude oil and coal prices, while the heavy snow and natural gas shortage in the country in November put further pressure on input costs.

Figure 10: China—Manufacturing PMIs

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Figure 11: China—PMI export orders and merchandise exports

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Figure 12: China—Manufacturing PMIs’ input prices

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Information Rmb NEER and movement in major currencies In the People’s Bank of China’s 3Q monetary policy report, the central bank, as usual, stated that the exchange rate will be managed in a proactive, controlled and gradual manner, and “based on international capital flows and movements in major currencies”. The last phrase caught widespread market attention with regard to the potential for a major near-term move in Rmb. However, in our view, the central bank’s latest statement on Rmb should be read more as a forward-looking statement, rather than suggesting that the Rmb will in the near-term play catch-up with major developed and developing currencies’ rise against the US$ since early this year.

On a trade-weighted basis, through the ups and downs in the greenback over the past year, the Rmb NEER, as well as the NEER for other currencies which have seen a significant rally this year, such as A$ and Brazilian real, are all roughly back to the levels prior to the beginning of the financial crisis (chart below). Hence, while we expect a resumption of gradual appreciation in the Rmb exchange rate, in terms of timing, our view has always been that this will likely begin sometime in 2Q10, when the export sector resumes positive over-year-ago growth rates and as officials become convinced that the global recovery is on a sure footing. Our Dec-10 estimate for Rmb/US$ is 6.5.

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Figure 13: Comparison of nominal effective exchange rates

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Figure 14: China—Exports and real effective exchange rate

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Cyclical case for Rmb’s movement On a cyclical basis, it is interesting to compare the current macro backdrop with the situation in 2005, when the Rmb regime change took place. Back then, the Chinese economy was in the midst of a significant export boom. Figures from the National Bureau of Statistics suggest that, on an average, net exports contributed 2.4% to headline GDP growth during 2005-07 (chart below). Nonetheless, for the first nine months this year, net exports declined 3.6% from headline GDP growth. Not surprisingly, for policymakers, the export sector is still seen as the weaker link in the economy’s recovery at this juncture, in our view.

Going forward, our global team is looking for a moderate recovery in the US consumer demand (J.P. Morgan expects the US consumer spending to rise 2.0%y/y in 2010) and a sustained and synchronized expansion of the global economy through 2010. Hence, we expect net external trade to show a moderate positive contribution to China’s headline growth next year, which would support the resumption of a gradual appreciation of Rmb. Timing-wise, it will more likely begin sometime in 2Q10, when exports turn decisively positive (in %oya terms), and as officials become convinced that the global recovery is on a sure footing, in our view.

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Figure 15: China—contribution to headline GDP growth

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Figure 16: US retail sales and China’s exports to the US

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Current account adjustment Structurally, as the US economy gradually adjusts its over-consumption (under-saving) growth pattern, there have been early signs of the long-awaited global rebalancing, with adjustments in the respective current account deficit/surplus for the US and China (chart below). As exports declined due to weak external demand since late last year, China’s import demand had held up better, especially with the investment boom under fiscal stimulus leading to a notable adjustment in China’s trade balances. For the first time in five years, China’s current account surplus declined (by 30%yoy) in 1H09. With such notable changes already taking place in external balances for both the US and China, we believe fundamentals would argue for the resumption of some gradual appreciation of the Rmb/US$ exchange rate to support further steady and smooth adjustments.

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Figure 17: China and US current account balances

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Capital inflows back in the limelight With regard to the central bank’s reference to “international capital flows” in its latest currency policy statement, we believe the indication is that once the gradual Rmb appreciation trend resumes, capital inflows would likely become one of the major macro policy concerns next year. There have recently been growing signs of renewed domestic expectation about Rmb appreciation, with a notable rise in onshore forex loans and slowing in forex deposit growth (chart below), as Chinese corporates and households look to reduce their net forex asset exposure.

Hence, concerns about capital inflows would likely constrain the extent of the rise in China’s policy rates (we look for two 27bp hikes in benchmark rates next year), especially considering that the China-US interest rate differential is already at the highest level since 2004 (chart below), and as the US Fed is expected to hold policy rate close to zero through the course of next year.

Figure 18: China’s forex deposits and loans and Rmb deposits in Hong Kong

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Non-consensus call Market concerns about policy tightening is overdone Financial market investors have been concerned about policy tightening in Asia, including China, as the economic activity continues with steady recovery, with growing concerns about an asset bubble. In this regard, latest statement from China’s top leadership is in tune with our view that authorities will be cautious regarding an

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“exit strategy,” even as the real economy continues to show a solid recovery, especially as policymakers are not yet convinced that the global recovery is on a sure footing. At a meeting with senior European officials recently, Premier Wen commented that a premature “exit” from macro policy stimulus could risk derailing the global economic recovery. Authorities’ latest decision to extend a series of consumption-related stimulus measures, including those for auto and home electrical appliances, into next year, while at the same time to re-impose the 5.5% tax on transaction of residential properties which have been held for less than five years, in order to curb property speculation, highlights the authorities’ latest approach to continue supporting domestic consumption, while fine-tuning sectoral policies to contain asset inflation.

We believe China’s fiscal spending plans have largely been laid out through 4Q10 and are unlikely to be reversed. On monetary policy, the PBoC is likely to move in stages, relying on open market operations to withdraw excess liquidity, combined with sector-specific actions such as a partial withdrawal of the stimulus provided to real estate late last year to reduce the risk of an asset bubble and inflation. Overall, going into 2010, if the new loan target comes in at Rmb7-8 trillion, and if the M2 growth target comes in at about 17% (compared with our forecast of a nominal GDP growth of 12.2%), we believe monetary conditions should remain largely supportive of the economy’s recovery. We expect the PBoC to begin raising policy rates moderately by mid-10, with a total of two 27bp hikes over the second-half of next year. On the currency front, we expect a resumption of the gradual appreciation of the Rmb exchange rate beginning sometime in 2Q10, looking for the Rmb/US$ rate to reach 6.5 by end-10.

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Market strategy From beta to alpha: Searching for hidden value in China equities (Extracted from the note, “China Strategy: From beta to alpha: Searching for hidden value in China equities,” published on 18 December 2009. Please see the original note for pricing dates.) • The China equity market may offer good investment opportunities but also

present many uncertainties and risks in FY10: On one hand, we believe Chinese equities could stage a rally between now and 1Q10, driven by: (1) the government’s recent reiteration of its “proactive fiscal policy” and “relatively loose monetary policy” for 2010, which should help alleviate the market’s concerns about a possible earlier-than-expected monetary tightening; (2) the upward earnings estimate revision momentum for MSCI China; (3) a marked sequential improvement in liquidity from Dec-09 to 1Q10; and (4) the expectation that Rmb will resume appreciation in FY10. On the other hand, we could start to see an increase in market volatility for MSCI China, if and when the government starts to tighten its monetary policy (possibly in 2Q10). We could see de-rating pressure for sectors that are highly correlated with fixed-investment growth as we approach mid-2010, when the equity market is likely to start pricing in a potential sharp slowdown in fixed asset investment growth in 2011.

• Entering an alpha year in FY10: Our major investment strategy lies in focusing on defensive growth stocks—stocks with good earnings visibility, low penetration rate, strong secular growth, and those that should be least affected by a potential tightening kicking in as of 2Q10 and a downshift in FAI growth in 2011. We highlight our two key investment themes for FY10: (1) accumulating consumption-related stocks to benefit from China’s growth rebalance; and (2) identifying undervalued China companies, which are likely to report record-high earnings in FY09, but are still trading at a decent discount to their highs in FY07, and are free from major multiple contraction pressure.

• Sector views: We stay positive on: (A) China banks, as we believe the recent correction on fund-raising concerns creates a good opportunity to accumulate bank shares; (B) the coal sector; and (C) defensive growth names—internet, tissue and diapers, gas, selected consumer staples, and healthcare. We continue to see short-term trading opportunities for media and airline stocks, and food inflation plays. We are negative on: (A) property—on tightening concerns; within the sector, we favor those with the most exposure to tier 2-3 cities; (B) telecoms; (C) FAI-related plays, including downstream commodities, commercial vehicles and construction; and (D) IPPs.

Table 1: China: Top five picks

Reuters Mkt cap Avg. dly TOEPS Y/Y growth (%) P/E (x) P/BV (x) ROE (%) Div. yld (%) Rec ticker (US$MM) (US$MM) 2009E 2010E 2009E 2010E 2009E 2009E 2009E China Citic Bank - H Share OW 0998.HK 42,410 39.9 13.6 52.4 14.7 9.6 2.1 15.2 1.7 China Construction Bank OW 0939.HK 198,050 236.7 14.2 30.1 12.8 9.8 2.6 21.3 3.5 China Gas Holdings Limited N 0384.HK 1,588 5.4 NM NA 25.6 NA 3.4 14.3 0.0 Sinopharm OW 1099.HK 8,032 NA 42.1 15.3 47.2 40.9 4.7 12.7 0.5 Sina Corp N SINA US 2,796 53.3 -24.2 29.5 45.7 35.3 3.5 8.7 0.0

Source: Bloomberg, J.P. Morgan estimates. Prices and valuations are as of December 16, 2009.

Figure 19: Relative index performance

Frank LiAC (852) 2800-8511 [email protected]

Peng Chen (852) 2800-8507 [email protected]

Lan Deng (852) 2800-8520 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

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Source: Bloomberg.

Investment summary After the one-directional bull market for most of 2009, the China equity market may offer good investment opportunities as well as present many uncertainties and risks in FY10. The rationale for our view is summarized below:

On one hand, we believe Chinese equities may stage a rally between now and 1Q10, driven by:

1. The government’s recent reiteration of its “proactive fiscal policy” and “relatively loose monetary policy” for 2010 in China’s Central Economic Work Conference; this should help alleviate the market’s concerns about a possible earlier-than-expected monetary tightening.

2. An upward earnings estimate revision momentum for the MSCI China in FY10, in view of an acceleration in the economic recovery and improving industrial profit growth outlook for FY10; we note the consensus’ FY10 MSCI-China EPS forecast has been lifted by 20% since June 2009.

3. A marked sequential improvement in liquidity from December 2009 to 1Q10, with the estimated monthly new loans rising from around Rmb250 billion for December 2009 to above Rmb800 billion for January 2010.

4. The expectation that Rmb will resume appreciation in FY10, given an export recovery and the rising inflationary pressure.

On the other hand, we could start to see an increase in market volatility for the MSCI China, if and when the government starts to tighten its monetary policy (possibly in 2Q10). Meanwhile, we could see de-rating pressures for sectors that are highly correlated with fixed-investment growth as we approach the middle of 2010. By then, the equity market should start pricing in the potential sharp slowdown in fixed asset investment growth in 2011, as the two-year (FY09E and FY10E) economic stimulus policies fade away.

Key investment themes and sector views While FY09 has proven to be a “recovery trade” year, with high-beta and bombed-out stocks generating the most return, we could enter an alpha year for FY10. Our major investment strategy lies in focusing on defensive growth stocks—stocks with good earnings visibility, low penetration rate, strong secular growth, and those that

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should be least affected by a potential tightening kicking in as of 2Q10 and a potential downshift in FAI growth in 2011.

We highlight two key investment themes for FY10: (1) accumulating consumption-related stocks to benefit from China’s growth rebalance: from an investment and export-driven economy to a domestic consumption driven economy; and (2) identifying undervalued China stocks, which are likely to report record-high earnings in FY09, but are still trading at a decent discount to their highs in FY07 and are free from major multiple contraction pressure.

With regard to the sector allocation, we maintain our overweight stance on:

• China banks, as we believe the recent correction on fund-raising concerns creates a good opportunity to accumulate bank shares, because: (1) the prospective fund-raising by China banks are meant not to repair their balance sheets, but to fund their growth; (2) we believe many China banks may choose to use rights issue rather than issuing additional new shares to raise money, which would cause minimum dilution for the existing shareholders, sharply reducing the amount of money to be raised from the secondary market investors. The government-owned investment entities hold the lion’s share of the major China banks, and are expected to come up with most of the fund-raising; and (3) their 1Q10 results are expected to surprise on the upside.

• Coal names, because (1) coal prices have started to rally, with Qinghuangdao coal prices up 30% as of the end of August 2009; (2) the supply-side discipline on the consolidation of small coal mines; and (3) the transportation bottleneck at the Daqing railway line.

• Defensive growth names – companies that are positioned in sectors with low penetration rate and strong secular growth, and companies with good earnings quality--internet, tissue and diapers, gas, selected consumer staples, and healthcare.

Meanwhile, we continue to see short-term trading opportunities for media and airline stocks, as well as food inflation plays. • Media as a late cycle recovery play and with stronger earnings growth in FY10

than FY09.

• Airlines stand to benefit from (1) the rising cargo and passenger traffic on domestic and international routes on the back of the strong economic recovery and (2) Rmb resuming appreciation as of 2Q10.

• Food inflation plays on continued rising food prices.

We have an underweight stance: A) Property on tightening concerns. Within the property sector, we favor those companies with the most exposure to tier 2-3 cities, which stand to benefit from the government’s prospective relaxation of the control over the so-called “Hukou” system in medium and small cities, as per China’s Central Economic Work Conference, and those with exposure to commercial property space. B) Telecom due to the sector’s lackluster 2G subscriber growth in China and that the 3G business has yet to take off in China. C) FAI-related plays,

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including downstream commodities (cement and aluminum), commercial vehicles and construction, which could be negatively affected by the downshift in China’s fixed asset investment growth in FY11, with the fading away of China’s economic stimulus program, which largely focuses on FY09 and FY10; and (D) IPPs, which are suffering from the rising market-based coal cost and the government-regulated power tariff.

Figure 20: Price movements in basis points (as of December 14, 2009)

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Source: Bloomberg. Figure 21: MSCI China P/E

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long term av g PE=15.8x (since y ear 2000)

Current=16.7x

x

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+1 std dev = 20.5x

Source: Bloomberg and J. P. Morgan. Figure 22: MSCI China P/BV

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0

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x

-1 std dev = 1.5x

+1 std dev = 2.9x

+2 std dev = 3.7x

-2 std dev = 0.8x

Source: Bloomberg and J. P. Morgan.

Figure 23: 2009 YTD MSCI-China price performance by sector

204%

146%

109%

97%

96%

85%

74%

70%

68%

48%

45%

-5%

-5%

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IT

CONS DISCR

CONS STAPLES

REAL ESTATE

DIV FIN

MATERIALS

INSURANCE

ENERGY

BANKS

HEALTHCARE

INDUSTRIALS

Telecom

UTILITIES

Source: Bloomberg.

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Favorable macro conditions from now until 1Q10E We believe there is still 22%% upside for the MSCI China, with our end-FY10 MSCI China index target of 78. We believe the sweet spot will fall in 1Q10, boosted by the positive factors detailed below:

(1) The government has reiterated its “proactive fiscal policy” and “relatively loose monetary policy” for 2010 in the Central Economic Work Conference China’s Central Economic Work Conference, concluded on December 7, 2009, noted that the central government will maintain its “proactive fiscal policy” and “relatively loose monetary policy” to ensure stable and rapid economic growth in FY10.

Among others, the government is still concerned about (a) the sustainability of the world economic recovery; (b) the domestic employment conditions. Meanwhile, inflation does not appear to be the government’s top concern for the moment, even though the report does mention about the management of inflationary expectations.

The overall monetary policy stance is in line with our base-line scenario that the central government is unlikely to make major adjustments to the monetary policy in the near team. In our view, the central bank will not begin raising benchmark policy rates until mid-2010, when inflation pressure finally builds up (around 3-4%oya) and export recovery is on a more solid footing (with the headline growth rate returning to around 20%oya).

We believe this is positive for China’s stock market as it helps alleviate the market’s concerns about possible earlier-than-expected tightening measures, thus creating a favorable environment for the stock market from now to 1Q10.

Figure 24: China—Benchmark interest rates

123456789

% per annum

2005 2006 2007 2008

1-year working capital lending rate

1-year time deposit rate

J.P. Morgan forecasts

20092004 2010

Source: CEIC, J.P. Morgan estimates.

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(2) The upward earnings estimate revision should continue in FY10, in view of an acceleration in the economic recovery and improving corporate profit growth outlook for FY10 China’s strong economic recovery seen this year likely to continue into 2010 After a remarkable turnaround in 2009, we expect China’s strong economic growth momentum to continue in 2010, with the major source of growth coming from a broad-based improvement in private consumption, and further strengthening in private housing investment, and a solid recovery in exports.

Now that we have more pillars for the underlying economic strength, we expect China’s 2010 GDP growth to accelerate to 9.5%oya, after an estimated 8.5% growth in 2009. Based on our forecasts, the three components—consumption, investment and net trade—are expected to contribute 4.6ppt, 4.7ppt and 0.2ppt, respectively, to the headline GDP growth in 2010. Notably, we expect the net trade’s contribution to GDP to swing from -2.6ppt in 2009 to +0.2ppt in 2010.

Table 2: China’s GDP composition 2008 2009E 2010E Real GDP, % change 9.0 8.6 9.5 Consumption¹ 4.2 4.4 4.6 Investment¹ 4.6 6.8 4.7 Net trade¹ 0.2 -2.6 0.2 Source: J.P. Morgan Economics. Note 1: Contribution to growth of GDP.

Figure 25: China—Real GDP and industrial production

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%q/q, saar, both scales

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JPM forecast

Source: CEIC, J.P. Morgan.

A broad-based pickup in private consumption: we believe increasing confidence in the economic recovery, improving labor markets, rising wage growth, and further government supportive policy will continue to support household spending. The rebound in the export sector is crucial to the recovery in labor markets and household consumption.

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Figure 26: China—Retail sales value and urban income

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%oy a %oy a, 6mma

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Urban income

2006 2008 2009200720052003 Source: CEIC, J.P. Morgan.

A solid expansion in private housing investment as well as other private sector investment: Following strong sales and low investment growth earlier this year, inventory in the property market remains low, paving the way for rising private housing investment going ahead. We also look for a gradual stabilization in export-related investment, following the sharp declines earlier this year.

Figure 27: China—Fixed asset investment

-100

102030405060

%oy a

Real (adjusted by PPI)Nominal

2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: CEIC, J.P. Morgan.

Figure 28: FAI growth breakdown by industry

0%

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Total Mining Non-ferrousmetal

Electronics Infrastructure Real estate

3Q08 4Q08 1Q09 3Q09 Oct-Nov 09 Series6%, Y/Y


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Figure 29: Real estate investment growth and floor space started

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%oy a Real estate FAI

Floor space started


A decent recovery in exports: We continue to expect solid gains in exports, in line with the recovery in G-3 domestic demand and the marked upturn in the global manufacturing cycle. As our global team is looking for sustained above-trend growth into 2010, this should further support exports, with headline export growth rate returning to around 20%oya around mid next year.

Figure 30: China—Merchandise trade: Sequential trend

-80-60-40-20

020406080%3m/3m, saar

2002 2003 2004 2005

Exports Imports

2006 2007 2008 2009


Risks to the economic outlook for FY10 are on the upside In view of the more solid-than-expected domestic demand and earlier-than-expected export recovery as reflected in recent macro releases, the Street has been actively revising up its 2010 economic growth forecasts for China since mid-2009.

Consensus is now looking for 9.6%Y/Y FY10 GDP growth for China, compared to the forecast of 8.4% made in June 2009. (Source: Consensus Economics Inc.) Similarly, we have also raised our FY10 GDP growth forecast to 9.5% Y/Y, from our 8.5% forecast published in June, to capture the expected larger contributions from private consumption, private housing investment and export.

Table 3: J.P. Morgan and consensus GDP growth forecasts Forecasts made in June 09 Current forecasts J.P. Morgan forecast 8.5% 9.5% Consensus estimates 8.4% 9.6%

Source: Consensus Economics Inc, J.P. Morgan estimates.

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Even so, the latest developments in stimulus-related investment as well as export activities suggest that there is still room for further upward revisions to the consensus estimates and our economic growth outlook for FY10:

• As the government is undershooting its fiscal allocation in 2009, the money left for fiscal spending in 2010 could exceed the previously planned amount. Of the Rmb4 trillion stimulus package, Rmb1.18 trillion comes from the central government. It is further distributed into a few phases: Rmb120 billion for 4Q08; Rmb480 billion for 2009, and Rmb580 billion for 2010. Following the progress so far suggests that the total spending from the central government may only amount to Rmb360 billion in 2009. Hence, there could be as much as Rmb700 billion left to be spent in 2010, which could result in higher public investments for 2010 than we currently expect.

• On the export front, we are currently looking for a gradual recovery in 2010. However, a stronger-than-expected global consumer demand recovery, as implied by the elevated orders/inventory ratio of our global PMI and the notable moderation in job contraction in the US November non-farm payroll, could lay the foundation for upside surprises for China’s exports in coming quarters. Indeed, the return of export orders, as suggested by the steady pick-up in the export orders components of China’s PMI in recent months, pointed to a sooner-than-expected coming-back in external demand.

Figure 31: China—PMI export orders and merchandise exports

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2007 2008 2009


Industrial profits on the rise As the company earnings cycle in general follows the economic cycle, the sustained economic recovery since early this year leads to a notable turnaround in corporate China’s earnings conditions. The recent data on China’s industrial profits indeed supports this argument:

Industrial profits in 22 key provinces and municipalities across China declined 3.4% Y/Y in the first ten months of this year, compared to -9.1% in the first nine months of this year. In October alone, industrial profits amounted to Rmb232.2 billion for the 22 key provinces and municipalities, rising 65.2% Y/Y, marking October the third consecutive month with Y/Y growth rate staying above 60%. It is worth noting that the historical monthly average for industrial profits for the whole country is Rmb300 billion, translating into a monthly average of Rmb235 billion for 22 provinces. Hence, industrial profits have largely returned to the trend level as of October 2009.

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The improvement in industrial profit growth was broad-based across major industrial sectors. Of the total 39 sectors, 34 have seen either a rising Y/Y growth or a narrowing Y/Y decline in their profits for January-October 2009, compared to only 14 sectors in the 2Q09. Among all, the best performers include chemical fiber, rubber and transportation equipment, which all registered higher Y/Y growth rate for 10M09 than 9M09. On the other hand, steel, non-ferrous metals and electric and telecom products still recorded Y/Y decline in 10M09, although the rate of decline moderated in 10M09 versus 9M09.

Figure 32: Industrial profits in 22 provinces and municipalities across China on the rise

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Industrial Enterprises' rev enue grow th (LHS) Industrial Enterprises' profit grow th (RHS)

Source: Wind, J.P. Morgan estimates.

Figure 33: Industrial profit growth by industry in 22 provinces and municipalities across China

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Steel Nonferrous Metals Electronic Chemical Fiber Rubber TransportationEquipment

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Source: Wind, J.P. Morgan estimates.

Upward earnings estimate revision could continue in FY10 In light of the improved economic and industrial profit growth outlook as highlighted above, we have observed a consistent upward estimate revision trend for the MSCI-China’s EPS forecast since mid-2009, with consensus’ FY10 EPS turning notably higher in recent months. Consensus has raised the MSCI China FY10 EPS forecast by 20% since June 09.

Even so, we believe there is still room for further upward earnings estimate revisions, as consensus’ FY10 EPS estimate is still well below the level seen prior to the fallout from the Lehman Brothers bankruptcy.

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Figure 34: Continued upward revisions in consensus earning estimates (EPS in Rmb)

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Lehman Brothers went bankrupt in Sep08

Source: Bloomberg and J. P. Morgan.

(3) A marked sequential improvement in liquidity from December 2009 to 1Q10 Early each year, commercial banks in China always have the incentive to front-load loans under approved quarterly loan quota to maximize their annual interest income. Historically, 1Q loans have tended to account for around 30-45% of the full year’s new loans. Indeed, new Rmb loans lent out in the first quarter by all Chinese banks accounted for 39.1%, 27.1% and 45.8% of the total new loans created in 2007, 2008 and 2009 (assuming that total new loans would reach about Rmb10 trillion this year), respectively.

Unless there is any sudden structural change in the lending business in China, this front-loading pattern will be repeated in 2010, in our view. We forecast average monthly new lending in the system for 1Q10 to be above Rmb800 billion (we expect new loan creation in 1Q10 to account for roughly 35% of the estimated total new lending in FY10, based on the seasonal pattern), compared to a monthly average lending of Rmb420 billion in 3Q09 and an estimated Rmb250 billion for December 2009.

Table 4: Chinese commercial banks have incentives to front-load new lending early each year Monthly new Rmb loans (in billions)

2007 2008 2009 Jan 567.6 803.6 1620.0 Feb 413.8 243.4 1070.0 Mar 441.7 283.4 1890.0 Apr 422.0 463.9 591.8 May 247.3 318.5 664.5 Jun 451.5 332.4 1530.4 Jul 231.4 381.8 335.9 Aug 302.9 271.5 410.4 Sep 283.5 374.5 516.7 Oct 136.1 181.9 253.0 Nov 87.4 476.9 294.8 Dec 48.5 771.8 Source: CEIC, J.P. Morgan.

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Table 5: New loan creation and total loan growth forecasts (Rmb loans only) 2008A 2009E 2010E Loan outstanding at the end of the year (Rmb in trillions) 30.3 40.3 47.3 Annual new loan creation (Rmb in trillions) 4.9 10.0 7.0 Total loan growth (% Y/Y) 18.7 33.0 17.4


Naturally, the expected rise in newly created bank loan in early 2010 should warrant a more favorable liquidity condition than in 4Q09. This, in turn, should help boost China’s equity market in 1Q10. There seems to be some correlation between China’s stock market performance and the change in monthly new loan creation, as shown in figures below.

Figure 35: MSCI China’s performance and the change in monthly new loan creation

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New loan (Rmb bn) MSCI China index 's 1m performance follow ing loan data releases

Source: CEIC, Bloomberg.

Figure 36: A-share performance and the change in monthly new loan creation

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New loan (Rmb bn) SHCOMP index 's 1m performance follow ing loan data releases

Source: CEIC, Bloomberg.

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(4) Rmb will likely resume appreciation in FY10, given an export recovery and the rising inflationary pressure Figure 37: J.P. Morgan and consensus Rmb forecasts

6.0

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Sep 04 Dec 05 Feb 07 Apr 08 Jul 09 Sep 10

ForwardConsensus

J.P. Morgan

J.P. Morgan forecast:end Dec 09: 6.75end Mar 10: 6.70end Jun 10: 6.65

Source: Bloomberg, J.P. Morgan estimates.

While we expect the Rmb to be stable for the rest of the year to reflect Chinese authorities’ attempt to support the export-related jobs, we believe the government will resume Rmb appreciation in FY10 (J.P. Morgan forecasts Rmb/US will reach 6.5 by end-10), as:

(1) The gradual recovery of exports should reduce the government’s concern about Rmb appreciation on export-related jobs. Notably, the sequential trend growth for China’s exports has come out of the negative territory entering 2H09 and hovered above 40% 3m/3m, saar in November 2009.


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2002 2003 2004 2005

Exports

2006 2007 2008 2009


(2) Inflationary pressure is building up, making Rmb appreciation a powerful tool to counter inflation for the medium term. The rising food inflation since mid-09, and the recent hike in gasoline and diesel, electricity, and water prices, as well as the widely anticipated price liberalization for gas and power, all suggest that rising inflationary pressure is emerging.

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Figure 39: Consumer price inflation

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Consumer price inflation%oy a

JPM forecast


Figure 40: Rmb NEER, REER and CPI inflation

9095

100105110115120

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index , 2000=100, +=appreciation

CNY NEER, REER and CPI inflation%oy a

2003 2004 2005 2006 2007 2008

Headline CPI inflationNEER REER

headline inflation will emerge mid next year; RMB appreciation a crucial tool to temper this pressure


Figure 41: CPI—Food prices—Sequential trend growth

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10203040

2003 2004 2005 2006 2007 2008 2009

%3m/3m, saar


Rmb appreciation is positive for Chinese equities Overall, in our view, Rmb appreciation is positive for Chinese equities as it enhances the attractiveness of Rmb assets, especially for foreign investors, who hold foreign

31



currencies. Meanwhile, the expectation of faster Rmb appreciation could draw more liquidity inflows into China, which could provide an additional impetus to asset prices in China.

Potential winners and losers from the resumption of Rmb appreciation in 2010 (A) Sector-wise, beneficiaries include: (1) Steel, paper and refinery names, which import their raw materials abroad using US$ but sell their products domestically in Rmb; (2) airlines and IPPs, which have massive foreign debt and future capex denominated in US$; and (3) internet companies, which record their revenue in Rmb but purchase foreign equipments in US$.

Steel The resumption of Rmb appreciation would have a positive impact on the China steel sector in general.

The Rmb appreciation will reduce purchasing costs of imported materials, especially iron ore, which account for around 30% of total steel production cost. China imported 566 million tons of iron ore from January to November FY09, with a total value of US$44,785 million. A 1% appreciation in Rmb will thus have a large impact on the cost of steel products.

The negative impact on steel exports is largely offset by the cost-saving on imported materials, as China’s steel net exports plunged 88% Y/Y to only 5.11 million tons from January to November 2009, accounting for less than 1% of China’s total crude steel production. We don’t expect steel exports to recover until 2011. As a result, we believe the Rmb appreciation’s impacts on steel exports should be limited. In our calculation, every 1% Rmb appreciation will boost Angang’s and Maanshan’s FY10 earnings estimates by 4.1% and 12.2%, respectively.

Table 6: Earnings sensitivity on steel names 2010E EPS impact - 1% Rmb appreciation Company name Ticker (BBG) Total (Rmb) Incl: recurring Non-recurring Angang Steel 347 HK 4.1% 4.1% n/a. Maanshan Iron and Steel 323 HK 12.2% 12.2% n/a.

Source: J.P. Morgan estimates.

Paper The paper industry would be a big winner from currency appreciation because nearly all of the sales are denominated in Renminbi and the majority of its costs (importing pulp and recovered paper) and capital expenditures is in US dollars.

Within this sub-sector, we believe Nine Dragons Paper has a further advantage in that it has a significant amount of US$-denominated debts as well as an aggressive expansion plan which requires purchasing imported equipment denominated in foreign currencies.

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Airlines A stronger Rmb will be positive for Chinese airlines:

Airlines’ U.S. dollar-denominated costs—mainly international fuel, aircraft lease rental expenses, some maintenance and airport-related charges—exceed their US$ revenue. In addition, they will also book foreign exchange translation gains due to their large US$ debt as well as their future aircraft capex, which will predominately be in US$.

Table 7: Rmb appreciation impact on airline sector

2010E EPS impact - 1% Rmb appreciation Company Excluding FX Gains/Losses Including FX Gains/Losses Air China 3% 11% China Southern 4% 142%


IPPs The potential impact of Rmb appreciation will be from two fronts: (1) one-off gain on the depreciation of foreign currency debts; and (2) cheaper coal costs from overseas markets (e.g. Newcastle).

(1) Our calculations suggest that 1% Rmb appreciation will lead to a potential 0.5-5.1% one-off gain on 2010E earnings for Huaneng/Datang/CRP/Huadian. (2) Given that imported coal only accounts for a very small portion of total coal consumed (<5%), we believe the earnings impact will be minimal.

Table 8: Rmb appreciation impact on Chinese IPPs

EPS impact - 1% Rmb appreciation Company name Ticker (bbg) Total (Rmb) Incl: recurring Non-recurring China IPPs Huaneng 5.1% 0.0% 5.1% Datang 0.8% 0.0% 0.8% CR Power 1.3% 0.0% 1.3% Huadian 0.5% 0.0% 0.5%


Internet We expect U.S.-listed Chinese internet shares to benefit from the potential Rmb appreciation versus the US dollar.

We believe the sector will see higher US$-based earnings, mainly through direct translation gains, as well as slight margin improvements. Hence, should the average Rmb-US$ exchange rate rise by 5% in 2010, as we currently expect, we could see 5% earnings accretion in the sector.

Margins improvements mainly come from lower capex in Rmb terms (computer-related capex is typically linked to US$), and lower games licensing upfront payment (for games licensed overseas, upfront payment is typically signed in US$).

Many of the Chinese internet companies have positive cash sitting in their bank accounts generated from operations and majority of the cash is in Rmb. Hence, some companies could see translation gains.

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In the sector, we like Baidu, Sohu and NetEase.

(B) Sectors that will be negatively affected by Rmb appreciation are mainly export-related sectors, such as shipping and container manufacturers, as Rmb appreciation could hurt China’s export volumes, hence the top-line, which will not be completely offset by higher import volumes given the trade imbalance.

Shipping A stronger Rmb will be negative for shipping companies.

The negative impact on shipping companies’ predominantly US$-denominated revenue is largely offset by their largely US$-denominated costs (mainly bunker fuel, charter expenses), leaving the net EPS impact fairly negligible.

That said, a bigger downside risk is that Rmb appreciation/revaluation could hurt Chinese export volumes which will not be completely offset by higher import volumes given the trade imbalance. Every 1% reduction in container volume could increase CSCL’s and China Cosco’s FY10E losses by 5% and 4%, respectively, on a full-year basis.

Infrastructure contractors and power equipment producers For Chinese infrastructure contractors and power equipment producers, the potential impact on Rmb appreciation could come from: (1) one-off gains/losses on the depreciation of foreign-currency debts/bank deposits; and (2) overseas business (FX-denominated construction revenue but Rmb-denominated costs).

(1) Our calculations suggest that 1% Rmb appreciation will lead to a potential 1.1% FX gain to a 2.2% one-off FX loss on 2010E earnings. (2) Our calculations suggest that 1% Rmb appreciation will lead to a potential 0.2-1.0% recurring FX loss. Net-net, a 1% Rmb appreciation will result in a potential 0.4% gain to 3.2% loss on their 2010E EPS.

Table 9: Rmb appreciation impact on China infrastructure contractors and power equipment producers

EPS impact - 1% Rmb appreciation Company name Ticker (bbg) Total (Rmb) Incl: recurring Non-recurring China Infrastructure contractors CRCC -3.2% -1.0% -2.2% CRGL -0.4% -0.6% 0.2% CCCC 0.1% -1.0% 1.1% China Power Equipment Producers Shanghai Electric -0.9% -0.9% 0.1% DF Electric -0.5% -0.5% 0.0% Harbin Power 0.4% -0.6% 1.0% China High Speed -0.1% -0.2% 0.1%


(C) For other sectors, such as banks, consumer staple/discretionary, telecom and autos, whose earnings, assets and liabilities are largely denominated in Rmb terms, the impact of Rmb appreciation should be rather limited if not neutral, in our view.

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Banks Banks are not a major beneficiary of Rmb appreciation, even though indirectly banks indeed benefit from Rmb appreciation, especially from overseas investors who hold foreign currencies and are buying Rmb assets. For domestic investors who already hold Rmb on hands, however, an appreciation means very modestly negative (almost immaterial) impact on banks.

Table 10: Rmb appreciation impact on banking sector

2010E EPS impact - 1% Rmb appreciation Others (overseas earnings/FX

position) Company

name Ticker (BBG)

Total (Rmb)

Incl: recurring Non-recurring

Net FX position Overseas earnings

BOC 3988 HK -0.4% -0.4% US$7B US$2.9B ICBC 1398 HK -0.1% -0.1% US$2B US$1.0B CCB 939 HK -0.1% -0.1% US$1.6B US$630MM BoComm 3328 HK -0.2% -0.2% US$1.5B US$240MM Source: J.P. Morgan estimates.

• For most banks in the sector, earnings, assets and liabilities are predominantly in renminbi, so does equity. Hence, overall this is good for foreign investors who currently hold foreign currencies. Indirectly, more liquidity inflows into China would be positive for asset prices, which are good for banks overall, at least in the near term, although the risk of bubbling asset prices is worth monitoring or guarding against.

• In Rmb terms, however, most H-share banks will experience very modest and immaterial impact from translation loss on their non-structural net FX opening position (i.e., the FX-denominated assets minus FX-denominated liabilities). Some banks may also have some foreign-currency/overseas earnings from their overseas operations, which are also subject to translation loss.

• However, since 2007 most banks, including BOC, have controlled their net FX position to a relatively low level; so that translation losses have been largely immaterial since 2007. As given in the table above, due to legacy issue, only BOC still has a large net FX position. However, even in BOC’s case, every 5% Rmb appreciation affects earnings by only 2% at the maximum in Rmb terms.

• It is also important to realize that the FX position is changing on an ongoing basis, and thus our analysis can only be done on a relatively static basis. The actual impact could be even less than what is shown here.

Relatively speaking, BOC will see slightly more negative impact. But even in this case, the impact should be very modest and could be more than offset by potential upside surprise in overseas impairment write-back.

Autos The impact on autos—Neutral.

On one hand, producers will benefit from the US$-denominated cost, even though the impact will be very limited due to the high localization rate for most listed

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vehicles except for Brilliance China, whose BMW JV only has a 40% localization rate.

Potential winner: DongFeng Motor – DongFeng’s exports account for less than 1% of its total sales income, which, we expect, to have a very limited impact on its bottom line. However, DongFeng will benefit from the Rmb appreciation as about 20% of its costs are denominated in US$.

Potential losers: Great Wall Motor, Sinotruk, Weichai and Qingling – as exports account for 7% of Great Wall Motor’s sales, 8% of Sinotruk’s sales, 8% of Weichai’s sales and 3% of Qingling’s sales. None of these companies have US$-denominated costs to hedge the negative impact of Rmb appreciation on their sales income.

On the other hand, medium and high-end auto producers will be subject to increased competition from imports. With the Rmb appreciating, imported vehicles’ purchasing cost will be lower, thus increasing the pricing pressure for medium- and high-end vehicles. Hence, Denway, which gets a large part of its earnings from its upper-medium Accord models, and Brilliance China, which could record around 60% of its FY10 earnings from BMW cars, will be negatively affected. In comparison, around 55% of DFM’s cars sold are small cars, which will be less affected, in our view.

Telecoms As all three operators have all revenues, costs and capex denominated in Rmb terms, there would be very little effect on these items if Rmb appreciates.

China Unicom has 6% of its total debt denominated in US$ terms with an Rmb value of Rmb511 million. If Rmb rises to 6.5 versus US$ by the end of 2010, interest-saving would be roughly Rmb1.5 million/year, which is immaterial compared to its operating profits. China Mobile’s and China Telecom’s debt, borrowed from state-owned banks, is therefore all in Rmb terms.

In summary, we see CU as the greatest beneficiary among Chinese telcos of Rmb appreciation because of its US$ debt, but even so, the impact would be very minor.

Table 11: The impact of Rmb appreciation on debt, revenue, costs and capex for China telcos

Debt

CM All of CM’s debt is denominated in Rmb, so no impact CT All of CT’s debt is denominated in Rmb, so no impact

CU CU has 6% of total debt denominated in US$ with current value of Rmb511MM. A 6% appreciation of the currency will see this marked-to-market debt value falling from Rmb511 million to Rmb480 million (around Rmb30MM)

It may also result in small interest savings of roughly Rmb1.5 million a year which would be immaterial Revenues, costs and capex CM Almost all of CM’s revenues, costs and capex are denominated in Rmb. Some international interconnect settlement costs in US$ but this is immaterial CT Almost all of CT’s revenues, costs and capex are denominated in Rmb. Some international interconnect settlement costs in US$ but this is immaterial CU Almost all of CU’s revenues, costs and capex are denominated in Rmb. Some international interconnect settlement costs in US$, but this is immaterial Source: J.P. Morgan estimates.

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China’s Central Economic Work Conference and policy outlook for 2010 China’s most important annual official economic conference—the Central Economic Work Conference—was held from December 5 to December 7, in which the central government set the overall tone of its macro policy for 2010.

The key messages conveyed from the conference include: (1) maintaining the “proactive fiscal policy” and “relatively loose monetary policy” to ensure stable and rapid economic growth in FY10; (2) switching its growth mode to achieve quality and sustainable growth, balanced regional development, and energy conservation; (3) focusing on boosting domestic consumption, by promoting urbanization and improving national income distribution

In our view, we believe the key policy tone is largely conducive to China’s stock market, with consumer sector and banks being the major potential beneficiaries. However, the growth mode adjustment could be negative for FAI related plays.

(1) The government to maintain the “proactive fiscal policy” and “relatively loose monetary policy” As discussed earlier, the relatively accommodative monetary conditions should be intact in early next year, creating a favorable environment for the stock market from now to 1Q10. (For more details, please refer to the section, Favorable macro conditions from now to 1Q10, on page 7). That said, we could see volatility and de-rating pressure kicking in 2H next year for sectors such as commodities (aluminum, steel and cement), infrastructure and machinery, commercial vehicles and construction, which are highly correlated with fixed-asset investment growth and could be negatively affected by the onset of the monetary tightening kicking in as of mid-2010.

(2) The government to change its growth mode to achieve quality and sustainable growth, with the focus being placed on boosting domestic consumption This is consistent with the government’s long-held policy orientation that China should change its economic growth mode from an investment and export-driven economy to a domestic consumption-driven economy. Looking ahead, we expect more stimulative measures from the government to boost private consumption. Hence, we believe this official commitment is very positive to consumption-related stocks. (For more detailed discussion, please see the section, OW domestic private consumption-related stocks, on page 26).

(3) The government to promote urbanization process In order to boost domestic consumption, the central government also highlighted the policy target to speed up the urbanization process, with the emphasis on encouraging rural migrant population to settle in urbanized areas, especially in medium and smaller cities. Notably, the conference noted that China could relax the control over the so-called “Hukou” system, i.e., the residential card system in medium and small cities and towns, to loosen the household registry policies in medium and smaller cities.

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In our view, the policy initiative should be very positive to boost domestic consumption as more farmers come to the urbanized areas to earn more money and spend more money. We note that this is the first time that the central government officially proposes the relaxation on the “Hukou” system in medium and small cities and towns on a national level.

That said, we notice that the government has realized the problems of the congestion, and the high property prices in big cities. Hence, it does not want to lift the “Hukou” system in big cities to worsen such problems.

In fact, the conference suggested that China should use public spending to build more economic housing for low income households. Indeed, Premier Wen recently noted that China’s housing policy should now be devoted to building economic housing, to inhibiting the speculative investments in the property market, and to supporting residents’ real demand for first home purchase and housing upgrades.

However, the supply of economic housing so far this year has come well below the original plan. As a result, the economic housing project has failed to play an active role in cooling down the red hot property market in China. Hence, the government policy for the property market in 2010 should focus on: (1) inhibiting the speculative demand; (2) accelerating the supply of economic housing in the market; and (3) supporting the real residential housing demand.

(4) The government to encourage energy conservation and emission cuts The Central Economic Work Conference set the tone of policy endorsement for encouraging energy conservation and emission cuts. Besides, the latest official announcement that China would cut its carbon dioxide emissions per unit of GDP in 2020 by 40-45% from the 2005 level , plus the recently released subsidy to buyers of new energy cars, all show the government’s commitments to this policy direction.

Hence, we believe relevant companies in alternative energy and emission cut-related industries should find near-term catalysts on the back of these favorable policy announcements. For the longer term, an inevitable shift of China to a more environmental-friendly and energy efficient development model bodes well for the secular growth for these sectors.

(5) The government may be backing away from the policy of leveraging on the fixed asset investment to boost China's economic growth. While the government-led infrastructure investment has been the major force in bringing about a “V-shaped” economic recovery this year, the work conference noted that China should aim at an appropriate growth rate for fixed asset investment, given the existing capacity overhang in many industries.

Against this backdrop, the government will carefully review any new investment projects, although it will warrant properly completion of the on-going investment projects.

In our view, going forward, China’s public spending is expected to focus more on social benefits, such as social security, education, environment protection, economic housing, rather than on the infrastructure projects, which consume a large amount of aluminum, steel, cement, trucks.

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With the fading away of the current economic stimulus package, we believe China’s FAI will slow from 33% Y/Y in 2009 to only 18% Y/Y in 2011. If we strip out the pricing effect (using PPI as a proxy), the real FAI growth in 2011 would slow more notably to only 15% Y/Y in FY11, from 38.6% in FY09, given that J.P. Morgan expects negative PPI of -5.6% Y/Y in 2009 but positive PPI of 3% Y/Y in 2011.

Hence, we believe this policy signal of relying less on FAI growth should be negative for China’s fixed asset investment-related sectors such as downstream commodities (aluminum, steel, and cement), trucks, engineer machinery.

Table 12: J.P. Morgan FAI and PPI forecasts 2009E 2010E 2011E Nominal FAI growth 33% 25% 18% PPI -5.6% 3.2% 3% Real FAI growth 38.6% 21.8% 15%


Figure 42: China—Fixed asset investment and growth

0.0

5.0

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35.0

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 20110

5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

30,000,000

Fix ed asset inv estment Grow th rate

%oy a RMB mn

Source: CEIC, J.P. Morgan..

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Key investment themes While FY09 has proven to be a “recovery trade” year with high-beta and bombed-out stocks generating the most return, we could enter an alpha year in FY10, for which our major investment strategy lies in focusing on defensive growth stocks—stocks with good earnings visibility; low penetration rate; strong secular growth; and those that should be least affected by a potential tightening kicking in as of 2Q10 and a potential downshift in FAI growth in 2011.

We believe two key investment themes for FY10 should be: (1) accumulating consumption-related stocks to benefit from China’s growth rebalance: from an investment and export-driven economy to a domestic consumption-driven economy; and (2) identifying the under-valued China companies, which are expected to report record-high earnings in FY09, but are still trading at a decent discount to their highs in FY07 and are immune from major multiple contraction pressure.

Positive on domestic private consumption-related stocks We believe domestic consumption should see strong growth in FY10, supported by a series of positive factors, which include: (1) more stimulative measures from the government to boost private consumption in 2010; (2) decent household disposable income growth to enable a rapidly increasing private consumption; (3) accelerating progress in urbanization; and (4) improving consumer sentiment.

These tailwinds, in our view, should further bolster the earnings visibility of domestic consumption-related companies, such as auto, home appliance, domestic retailers, and hence pave the way for a broad-based rally for these names in FY10

(1) More stimulative measures from the government likely to boost private consumption in 2010 Exports and investments used to be the driving forces for China’s economy. However, the rapidly changing economic environment has made the Chinese authorities understand that they cannot solely rely on export or fixed-investment to achieve 8-9% growth for the medium term, as: (1) export is becoming a less powerful engine of China’s growth, given the ongoing, sharp balance-sheet adjustments in the developed economy after the most severe recession in half a century; and (2) over-stimulating investments is infeasible, as this will result in over-capacity in many industries.

Hence, boosting domestic consumption, which only accounts for 35% of China’s GDP composition, has clearly become the good choice for China. While China has flagged the importance of this transition, it is only until the outbreak of the economic crisis that China finally realized the urgency of this switch and started to come out supportive measures to boost domestic consumption.

Notably, for the first time, the Central Economic Work Conference, concluded on December 7, noted that the government should place boosting domestic consumption as its top agenda for the next year. Hence, we believe the government will mostly come up with more supportive measures to boost private consumption in coming months.

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Figure 43: China GDP composition (as % of nominal GDP)

0%

20%

40%

60%

80%

100%

2002 2003 2004 2005 2006 2007 2008Priv ate consumption Gov ernment consumption Inv estment & change in inv entories Net ex ports

Source: CEIC. In fact, China has clarified its stimulative policies on auto, property and home appliance recently; the implications are summarized below: 1) Auto News: (1) China to renew the preferential vehicle purchase tax for cars with an engine size of 1.6 liters and below in FY10, but will lift it to 7.5%; (2) China to maintain the policy to provide financial subsidy to help farmers upgrade from three-wheeled and/or low-speed agricultural vehicles to light trucks and minivans; (3) China to maintain the policy to provide financial subsidy to encourage people to scrap old vehicles for new ones in 2010 and increase the subsidy from Rmb5,000 to Rmb18,000 per vehicle; (4) China to expand the number of cities to promote new energy vehicles from 17 to 20 and choose five pilot cities in which the government will provide financial subsidy to the buyers of new energy cars.

Implications: Mildly negative for China autos, because: (1) the renewal of preferential policies is largely within our and the market expectations; (2) the government fails to expand the scope of vehicles to receive the preferential tax to those with an engine of 2.0 liters and below; (2) the market had expected the 5% preferential tax to be maintained rather than lifted to 7.5%.

(2) Property: News: China to withdraw a preferential policy for the property sector introduced late last year: China will impose a transaction tax (5.5%) on houses sold within five years of holding period, virtually terminating the temporary incentive started since December 2008, which give a tax free bracket for houses held for more than two years.

Implications: Mildly negative for Property developers. (1) The withdrawal of the preferential policy suggests that the government is fine-tuning its accommodative policy stance on the property sector, implemented late last year. Premier Wen recently noted that the policy focus for FY10 in property market should be (a) inhibiting the speculative demand; (b) accelerating the supply of economic housing in the market; and (c) supporting the real residential housing consumption. (2) We note that this is not the first time the government starts to adjust its accommodative stance. Under the guidance from the authorities, banks in several cities have already

41



started to tighten the mortgage policies and cancel the preferential lending for the 2nd home purchase since a few weeks ago.

(3) Home appliance: News: (1) China to renew the national subsidy program for rural households to buy electric appliances, with the subsidy remaining at 13% of the selling price, and lift the cap of the maxim purchase price of the appliances. (2) China to renew the home appliance replacement program after its expiry in May 2010, and further extend the pilot regions from a total of 9 provinces under the current program.

Implications: Positive for home appliance producers. Now that these stimulus programs have been successful in lifting the sales of home appliance so far this year—sales of household electric and video appliances rose 47% Y/Y in the first ten months of 2009—a renewal and expansion of the existing supportive policies will likely continue to unleash rural households’ demand for such home appliance and boost the volume growth for home appliance producers.

Table 13: China—The stimulative measures introduced this year and their impact on respective sectors Sector Policy Impact Home appliances

The rural home appliance promotion campaign was implemented nationwide in February 2009. Starting in May, more products, including energy-efficient air conditioners, were in the subsidy list. Export tax rebates were raised for most household appliances in June. The home appliance trade-in program was carried out on a trial basis starting from August.

This policy has driven a strong growth in the sale of Household Electric & Video Appliance. For instance, the sales of Household Electric & Video Appliance rose 47% Y/Y in the first ten months of 2009.

Automobiles (1) Reduction in vehicle purchase tax from 10% to 5% for cars with an engine size of 1.6 liters or below from January 20 to December 31, 2009.

This policy has driven a strong growth in the sale of passenger vehicles with an engine size of 1.6 liters or below. For instance, the sale of PVs with an engine size of 1.6 liters or below rose 63% Y/Y in the first ten months of 2009. On the other hand, the sale of PVs with an engine size of above 1.6 liters increased only 15% Y/Y in the same period.

(2) Providing a financial subsidy totaling Rmb5 billion to help farmers upgrade from three-wheel and/or low-speed agricultural vehicles to light trucks and mini vans.

This policy has driven a strong growth in China’s mini van sales and mini truck sales. For instance, minivans’ sales volume grew 77% Y/Y and mini trucks’ sales volume rose 80% Y/Y in the first ten months of 2009.

(3) Providing a financial subsidy totaling Rmb5 billion to scrap old vehicles for new ones.

This has helped boost vehicle sale in FY09 through encouraging the consumers to scrap the old vehicles before their assessed usage life before replacing such old vehicles with new ones. The policy is expected to add 1MM vehicle replacement demand.

Real estate (1) In October 2008, the Ministry of Finance released a circular to lower the property deed tax rate from 1.5% to 1% for <90sqm homes, eliminate land VAT and stamp duty on second-hand home sales, lower the mortgage rates to 70% of benchmark lending rates for owner-occupied homes, and reduce the minimum down payment ratio to 20%

Primary sales volume in the eight major cities we track increased 90% Y/Y in the first ten months of year 2009.

(2) In November 2008, the Ministry of Housing and Urban-Rural Development proposed to invest Rmb900B in low-rent housing for 7.47MM urban low-income families in three years: home leasing for 2.87MM and financial subsidies for the rest 4.6MM. In addition, 4MM units of affordable housing will be built in China in the next three years; houses in danger of collapse will be renovated for employees from state-owned forestry/coal/agricultural organizations, approximately 2.2MM units.

(3) In December 2008, the State Council decided that second-hand home sales are exempt from the business tax (or face a reduced business tax rate) if the home has been held for two years by the original owner, down from five years in the past. In addition, the government would promote financial/credit support to property developers and encourage M&As.

(4) Effective May 25, 2009, the minimum equity capital requirement was changed to 20% for policy/ordinary housing projects and 30% for other property development projects.

Source: Ministry of Finance, State council, J.P. Morgan.

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We expect more stimulative measures to boost private consumption We expect more new policies initiatives to be released next year to speed up the unleashing of private consumption. For example, the government will accelerate the development of the consumer finance sector to help domestic consumption, in our view. We believe China’s consumer finance is currently in its early development stage and hence has substantial growth potential. For instance, in FY08, only 8% of people who buy cars used auto loans, versus 85% in the US, thus leaving the door open for the government to come up with new auto financing regulations that will make it easier and cheaper for consumers to get auto loans from banks and auto financing companies.

Figure 44: China—Auto loan as a percentage of total consumer loans

0%

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10%

15%

20%

2000 2001 2002 2003 2004 2005 2006 2007 2008

0

1,000

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3,000

4,000

Consumer Loan (Rmb bn, RHS) Auto Purchasing loan as % of consumer loan ( LHS)

Source: CEIC, J.P. Morgan estimates. Table 14: Percentage of car sales financed by auto credit in different countries/regions 2008 China 8% India 70% EU 80% Germany 71% Italy 87% France 78% UK 87% Spain 89% US 85% LatAm 60% Source: CEIC, J.P. Morgan estimates. Meanwhile, pilot personal income tax-deferred pension insurance is likely to be introduced in Shanghai soon, with an intention to speed up insurance coverage in China to reduce the need for precautionary saving and hence support consumption.

Besides, we expect the government to increase public spending on healthcare to provide a better safety net to China’s households, as healthcare expenditure is just less than 5% of GDP in China, compared to over 10% for most developed nations. In fact, in the final draft of healthcare reform approved early this year, the government has planned to expand the medical insurance network to cover 90% of the population and increase the annual subsidy for each person covered by the system to Rmb120 by 2011. We expect a total investment of Rmb850 billion to be spent on carrying out this reform.

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Table 15: More supportive measures likely to be released next year to boost domestic consumption in China Types Policies Auto The government will likely accelerate the development of the consumer finance sector to help domestic consumption, in our view. We

believe China's consumer finance is currently in its early development stage and hence has significant growth potential. For instance, in FY08, only 8% of people who bought cars used auto loans, thus leaving the door open for the government to come up with new auto financing regulations that will make it easier and cheaper for consumers to get auto loans from banks and auto financing companies.

Insurance Pilot personal income tax-deferred pension insurance is likely to be introduced in Shanghai soon, with an intention to speed up insurance coverage in China to reduce the need for precautionary saving and thus support consumption.

Healthcare We expect the government to increase public spending on healthcare to provide a better safety net of China’s households, as healthcare expenditure is just less than 5% of GDP in China, compared to over 10% for most developed nations.


(2) Decent household disposable income growth should lead to a rapidly increasing private consumption We believe a decent rise on household’s real disposable income, which equals to increasing purchasing power, always lays the foundation for a notable gain in private consumption. In our view, this is happening in China at this moment: household income growth has stayed solid since late last year, benefiting from the substantial fiscal stimulus, the recovery in export business, and the acceleration in domestic demand.

In particular, YTD real urban household disposable income rose 10.4%oya, outpacing YTD real GDP growth of 7.7%oya. Meanwhile, YTD real rural household cash income also outpaced YTD real GDP growth, rising 9.5%oya. The improving household purchasing power undoubtedly leads to rising domestic consumption this year.

Figure 45: China—Urban household’s real disposable income growth versus real GDP growth

0

3

6

9

12

15

18

2003 2004 2005 2006 2007 2008 2009

%oya

Real GDP growth

Real disposable income of urban household


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Figure 46: China: Rural household’s real cash income growth versus real GDP growth

-202468

1012141618202224

2005 2006 2007 2008 2009

%oya

Real GDP growth

Real cash income of rural household

Source: CEIC, J.P. Morgan estimates. We believe the upward trend in both urban and rural household income growth should continue next year, given the improving labor market conditions, buoyant asset market performance, favorable macro policies improving national income distribution (such as lifting the personal income tax threshold).

In particular, rural household could benefit more from rising agriculture prices and improved infrastructure in rural areas than urban households. And that is largely why we see real rural household income rising at a faster pace than urban household income as of 3Q09. (10.3%oya versus 9.6%oya)

Figure 47: China—Number of employees is on the rise since 1Q09

Source: CEIC and J. P. Morgan. Figure 48: China—Average wage growth bottoming out

10121416182022

2002 2003 2004 2005 2006 2007 2008 2009

%oy a

Source: CEIC and J. P. Morgan.

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Figure 49: China—Asset prices

1100

2100

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-2

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index , 19 Dec 1990=100

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2007

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Source: CEIC and J. P. Morgan. Table 16: China—Personal income tax reform Effective date Adjustments 1994-1-1 The threshold of personal income tax was revised up to Rmb800 from Rmb400. 2006-1-1 The threshold of personal income tax was revised up to Rmb1,600 from Rmb800. 2008-3-1 The threshold of personal income tax was revised up to Rmb2,000 from Rmb1,600. Source: J. P. Morgan. (3) Accelerating progress in urbanization With urbanization ratio still below 50%, China has significant potential to facilitate further urbanization to boost domestic consumption. It is against this backdrop that the central government highlighted in the Central Economic Work Conference that China would encourage rural migrant population to settle in urbanized areas, especially in medium and smaller cities. The conference noted China could relax the control over the so-called “Hukou” system, i.e., the residential card system in medium and small cities and towns, to facilitate their migration.

Figure 50: China’s urbanization process

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Urban population (person mm) (RHS) Urban population as percentage of total population (LHS)


In our view, the policy initiative should be very positive to boost domestic consumption as granting farmers and migrant workers full resident status would

46



enable them to enjoy the same public services and social welfare as the urbanites did, thus reducing their precautionary savings and unleash their pent-up demand for consumer goods. Indeed, farmers and migrant workers nowadays have a higher propensity to consume than most urban residents given the need to upgrade their living standard.

Figure 51: Rural and urban households’ propensity to consume

0.500.550.600.650.700.750.800.850.90

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009YTDUrban household propensity to consume Rural household propensity to consume

Source: CEIC and J. P. Morgan. We note that the plan targets mid/small-sized cities and small towns rather than large cities. This policy adjustment makes it a more effective initiative to boost private consumption as farmers/migrant workers could have better affordability when migrating to mid/small-sized cities and small towns than to large cities. The disposable income gap between households in rural areas and tier 4-6 cities is the narrowest in the rural/city comparison. (see the figure below)

Figure 52: Disposable income per capita for rural areas and tier 1-6 cities.

05000

1000015000200002500030000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

tier 1 tier 2 tier 3 tier 4-6 rural areas

Source: CEIC, IDC and J. P. Morgan. Meanwhile, the different life styles between cities and rural areas will cause farmers and migrant workers to consume more when they move into cities and towns. For example, the penetration rates for different home appliances in rural areas are well below those in urban cities, which, to some extent, reflect less dependence on home appliances in rural areas. This leaves great potentials for a sharp increase in home appliance consumption, especially when rural households settle in urban cities and get themselves accustomed to the urban life style.

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Figure 53: Home appliance penetration rates in urban and rural areas (unit per 100 households)

020406080

100120140

Air-condition Refrigeratory Washing machine Color TV

Urban Rural Source: CEIC and J. P. Morgan.

(4) Improving consumer sentiment The sequential improvement in headline retail sales, with its sequential trend growth rising to 18.8% 3m/3m, saar in November 2009, has certainly helped shore up consumer sentiment in China, as this reading is generally taken as a sign post for the strength of domestic private consumption. Moreover, solid household income growth, improved job market conditions, as well as a buoyant stock market, all help hold up the consumer confidence well so far this year.

These favorable factors should be intact in 2010, based on our underlying scenario of continued sequential improvement in domestic demand and gradual recovery on the export front. Hence, improving consumer sentiment could lead to further gains in private consumption.

Figure 54: China—Consumer confidence and expectations index

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Source: CEIC and J. P. Morgan. Figure 55: China—PBoC diffusion index of urban resident confidence

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Identifying under-valued China companies The notable V-shaped recovery in China since late 2008 has significantly shot up earnings for companies that are highly leveraged to the strong economic recovery. Some of them are even expected to report record-high earnings this year, with their consensus FY09E EPS exceeding their previous high in FY07.

Normally, the record-high EPS should sharply drive up their share prices. A number of stocks with higher earnings in FY09 than FY07 indeed are trading above their highs in 2007. We note that the companies in this group are mostly from auto, consumer staple and healthcare sectors, which are all among the best performers YTD.

Table 17: Companies with record-high share price and earnings in FY09E

Price performance (%) FY09E FY09E EPS higher than Ticker Stock names since 30 Oct 2007 EPS FY07 EPS by % Sector 1211 HK BYD CO LTD-H 266% 1.5 84% Technology Hardware 700 HK TENCENT HOLDINGS LTD 128% 3.2 250% Internet 1044 HK HENGAN INTL GROUP CO LTD 98% 1.7 81% Consumer Staples 606 HK CHINA AGRI-INDUSTRIES HLDGS 80% 0.6 76% Consumer Staples 322 HK TINGYI (CAYMAN ISLN) HLDG CO 72% 0.5 99% Consumer Staples 763 HK ZTE CORP-H 68% 1.5 111% Technology Hardware 1068 HK CHINA YURUN FOOD GROUP LTD 63% 0.9 49% Consumer Staples 8199 HK SHANDONG WEIGAO GP MEDICAL-H 52% 0.7 116% Health Care 489 HK DONGFENG MOTOR GRP CO LTD-H 48% 0.8 71% Auto 168 HK TSINGTAO BREWERY CO LTD-H 46% 1.1 151% Consumer Staples 2338 HK WEICHAI POWER CO LTD-H 34% 4.5 156% Industrials 682 HK CHAODA MODERN AGRICULTURE 21% 1.3 71% Consumer Staples 336 HK HUABAO INTERNATIONAL HOLDING 10% 0.4 55% Materials 1109 HK CHINA RESOURCES LAND LTD 8% 0.7 70% Real Estate 392 HK BEIJING ENTERPRISES HLDGS 7% 2.2 27% Industrials 998 HK CHINA CITIC BANK - H 6% 0.4 83% Banks 658 HK CHINA HIGH SPEED TRANSMISSIO 3% 0.7 150% Industrials 688 HK CHINA OVERSEAS LAND & INVEST 2% 0.8 42% Real Estate 363 HK SHANGHAI INDUSTRIAL HLDG LTD 1% 2.6 32% Industrials Source: Bloomberg, J.P. Morgan estimates. Priced as of 16 December 2009. Past performance is not indicative of future results.

That said, certain companies are still trading below the highs in 2007 even though they are likely to report record-high earnings this year.

We believe the above discrepancy could be due to two reasons: (1) this is due to the de-rating kicking in for companies that have seen worsening fundamentals since 2007; and (2) the equity market has not fully factored in the rising profitability for companies that possess solid fundamentals and are benefiting from the strong recovery.

Apparently, companies in the latter group could provide potential share price appreciation for investors looking for under-valued companies. As such, we believe it is a very valuable exercise to generate a list for this kind of under-valued companies in the China universe.

Identifying undervalued companies in the China universe We take a two-step process here. First, we screen potential candidates using three inputs: (1) MSCI-China components under J.P. Morgan coverage; (2) companies that

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are expected to report higher EPS in FY09 than in FY07; and (3) companies are trading at a discount to the share price as of 30 October 2007. Hence, we get a shortlist of 19 MSCI-China components matching these criteria.

We then review these companies one-by-one, in order to remove the names with large de-rating pressure as a result of their weak fundamentals. Among these, we believe companies in industrials, materials, utilities and real estate sectors would likely face more headwinds going ahead as their earnings visibility could be hurt by the likely monetary tightening kicking in as of 2Q10 and a potential downshift in FAI growth in 2011.

After taking out these names, we find 15 companies under our coverage fit into the category (shown in Table 18). Most of them are from China banks, sport wear, coal and retailing sectors. Among these, we believe banks and coal names may offer good investment value. (For more detailed discussion, please see “Sector recommendations.”)

While China’s sportswear sector in overall are being de-rated on the concern of a slowdown in their growth rate, we still like the leaders within this sector, such as China Dongxiang. We believe that China Dongxiang already offers good value at the current level, as it is likely to see rising growth momentum in FY10.

Table 18: Stock screen for undervalued China companies

Price performance (%) FY09E FY09E EPS higher than

Relatively free from

Ticker Stock names since 30th Oct 2007 EPS FY07 EPS by % Sector de-rating pressure 2331 HK LI NING CO LTD -8% 1.0 109% Sports Wear Yes 1398 HK IND & COMM BK OF CHINA - H -13% 0.4 77% Banks Yes 3818 HK CHINA DONGXIANG GROUP CO* -11% 0.3 76% Sports Wear Yes 939 HK CHINA CONSTRUCTION BANK-H -22% 0.5 68% Banks Yes 1088 HK CHINA SHENHUA ENERGY CO - H -23% 1.9 63% Energy Yes 3328 HK BANK OF COMMUNICATIONS CO-H -37% 0.7 57% Banks Yes 3988 HK BANK OF CHINA LTD - H -13% 0.4 56% Banks Yes 3368 HK PARKSON RETAIL GROUP LTD -19% 0.4 55% Retailing Yes 1800 HK CHINA COMMUNICATIONS CONST-H -68% 0.6 34% Industrials No 1898 HK CHINA COAL ENERGY CO - H -46% 0.7 31% Energy Yes 836 HK CHINA RESOURCES POWER HOLDIN -46% 1.1 31% Utilities No 914 HK ANHUI CONCH CEMENT CO LTD-H -34% 2.3 31% Materials No 3968 HK CHINA MERCHANTS BANK - H -32% 1.1 30% Banks Yes 1880 HK BELLE INTERNATIONAL HOLDINGS -20% 0.3 27% Retailing Yes 2319 HK CHINA MENGNIU DAIRY CO -17% 0.9 27% Consumer Staples Yes 177 HK JIANGSU EXPRESS CO LTD-H -22% 0.4 27% Transportation Yes 386 HK CHINA PETROLEUM & CHEMICAL-H -42% 0.8 17% Energy Yes 203 HK DENWAY MOTORS LIMITED -10% 0.3 13% Auto Yes 3383 HK AGILE PROPERTY HOLDINGS LTD -33% 0.6 12% Real Estate No Source: Bloomberg, J.P. Morgan estimates. * Note: China Dongxiang Group’s share price reached its record high in January, 04, 2008 at HK$6.26. Hence, we use this price in the price performance calculation. Priced as of 16 December 2009. Past performance is not indicative of future results.

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Sector views Table 19: Sector weighting matrix

Earnings

visibility FY10 Penetration

rate Secular growth

Affected by tightening

Affected by the FAI slowdown in FY11 Affected by Inflation

OW 1, Banks High Medium Medium Medium Medium Medium 2, Coal names Medium N/A High Low Medium High (positively affected) 3, Defensive growth names (1) Internet High Low High Low Low Low (2) Gas High Low High Low Low Low (3) Tissue and diaper High Low High Low Low Low (4) Selected consumer staples (5) Healthcare High Low High Low Low Low 4, Media High Medium Medium Low Low Low 5, Food inflation plays High Medium High Low Low High (positively affected) UW 1, Property Low Medium Medium High High Low 2, Telecom Low Medium Low Medium Medium Medium 3, FAI-related plays Low N/A Low High High Medium 4, IPP Low Medium Medium Medium Medium High (negatively affected) Source: J.P. Morgan estimates.

We are positive on the following sectors: (1) Banks: The correction on fund-raising concerns has created a good opportunity to accumulate bank shares We believe the recent correction on fund-raising concerns has created a good opportunity to accumulate bank shares, because:

(1) The prospective fund-raising by China banks are meant not to repair their balance-sheet, but to fund their growth.

(2) We believe many China banks may choose to use rights issue rather than issuing additional new shares to raise money, which would cause minimum dilution for the existing shareholders, sharply reducing the amount of money to be raised from the secondary market investors. The government-owned entities hold the lion’s share of the major China banks, and are likely to come up with most of the fund-raising.

(4) Banks’ 1Q10 results are likely to surprise on the upside, given the benign asset quality outlook and the potential NIM expansion.

Within the banking sector, we favor China Citic Bank, a growth play with the strongest estimated earnings and ROE momentum; and CCB, which we believe has attractive valuations on a P/E basis and strong dividend yield support.

(2) Coal names: A beneficiary of the recent coal price increase We stay positive on the coal sector, which is benefiting from the recent increase in coal prices.

Indeed, recent sector statistics show that coal prices have started to rally, with Qinghuangdao coal prices up 30% as of the end of August 2009.

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Figure 56:China Qinghuangdao coal prices vs. NEWC prices

Source: cctd.com and globalcoal.com. Looking ahead, the sharp rebound in electricity usage, supported by continued recovery in industrial and manufacturing activities alongside the gradual recovery in exports business, is translating into solid coal products demand.

Moreover, the supply-side discipline on the consolidation of small coal mines, as well as the transportation bottleneck at the Daqing railway line, should help drive coal prices to rise further in coming month, in our view.

Figure 57: China: Real industrial production and electric power usage

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Figure 58: Domestic coal inventory level (Number of days for right hand axis, ‘000 tones for left hand axis)

Source: SERC, J.P. Morgan. (3) Defensive growth names We stay positive on defensive growth names—companies that are positioned in sectors with low penetration rate and strong secular growth, and that will likely be least affected by a potential tightening in 2Q10 and a downshift in FAI growth in 2011.

In our view, internet, gas, tissue and diaper companies, selected consumer staples, and healthcare fulfill these defensive features well and offer a good risk-reward profile for the investors.

(A) Internet, tissue and diaper and gas names As discussed in our September 2009 research note, Where to find the next ten-baggers, we screened out three sectors—internet, tissue/diaper and gas, which all have a much lower penetration rate than that in developed economies, thus positioning themselves well for long-term secular growth.

Hence, we believe the leading companies in these sectors, with a low penetration rate and strong secular growth, will offer investors good value in FY2010.

Table 20: China—Sectors that still have low penetration rates

2006 2007 2008 US Internet sector (users per capita0 10.3% 15.9% 22.4% 75.0% Tissue sector (KG per capita) 2.5 2.7 2.95 23+ Natural gas sector (% of population) 6.3% 7.7% N/A 60%+

Source: CEIC, J.P. Morgan. (B) Selected consumer staples As shown in Figure 40, historically, consumer staple companies have been able to post strong earnings growth, while at the same time highly defensive in nature, outperforming the overall market in several market downturns.

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Figure 59:China—Consumer staple names’ earnings growth over the last few years

Source: IBES and J.P. Morgan estimates.

Figure 60: Consumer staples have outperformed the MSCI China in the market downturns (basis points = 30 Dec 2005)

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Source: Bloomberg and J.P. Morgan.

Hence, select staple names, with company-specific strength, could still deliver good earnings next year, and therefore provide good value for investors.

(C) Healthcare We believe leading healthcare stocks should benefit from the government’s increasing public spending on this sector, given China’s current low spending per capita on healthcare and the urgency for China to provide a better safety net to Chinese households.

We note that the current spending per capita on healthcare is approximately US$92 per year in 2006, according to the World Health Organization, or just 1.5% of that of the US. As a percentage of per capital GDP, the total healthcare spending in China is about 5% or roughly a third of the proportion in the US.

Such an underdeveloped healthcare system reflects the necessity for the government to increase its spending to foster greater access to healthcare by the population so as to boost domestic consumption. It is against this backdrop that the government decided to unveil the long-awaited healthcare reform in February this year. In the final draft of healthcare reform, the government has planned to expand the medical

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insurance network to cover 90% of the population and increase the annual subsidy for each person covered by the system to Rmb120 by 2011. A total investment of Rmb850 billion is expected to be spent on carrying out this reform.

Therefore, we believe the investment in new healthcare facilities will continue to be strong even after other stimulus related spending on infrastructure starts to fade away in FY11. Moreover, given that healthcare is one of the few industries in China with no excess capacity, very little demand for resources, and can employ a large number of skilled workers, we could see strong secular growth for this sector in the long term.

Our top pick in this sector is Sinopharm due to its simple growth story, comprising strong pharmaceutical sales growth in China and market share gains by the largest operator.

Table 21: Low per capita healthcare spending and higher growth rates

Source: World Health Organization. (4) We continue to see short-term trading opportunities for media and airline stocks and food inflation plays (A) Media As a late-cycle recovery play, media sector is likely to post robust earnings growth in FY10, the second year of the ongoing economic recovery, after suffering severe loss in FY09, the first year of the recovery. Consensus is looking for much higher earnings growth from China’s leading advertising companies in FY10 than FY09. This should provide an impetus for their share prices to move higher in the near term, as the market is actively seeking companies with visible earnings.

Table 22: Revenue growth in China’s advertising market lagging China’s real GDP growth

Source: Bloomberg. Note Vsionchina was listed on 5 December 2007. (B) Airlines We see trading opportunities for China’s airline sector, which stands to benefit from: (1) the rising cargo and passenger traffic on domestic and international routes on the back of the strong economic recovery; and (2) Rmb resuming appreciation in 2Q FY10.

Ticker Name Price movement since

30 Oct 2007

2009E earnings

growth

2010E earnings

growth FMCN US EQUITY FOCUS MEDIA HOLDING-ADR -72% -66% 54% SINA US EQUITY SINA CORP -20% -29% 34% VISN US EQUITY VISIONCHINA MEDIA INC-ADR na -35% 39%

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(C) Food inflation plays Food inflation plays have performed well since early September. For example, China Yurun has risen more than 50% since 7 September, outperforming the MSCI China by 44% for the period.

Even after such a notable run-up, we believe this trade should continue to perform well in the near term, given the potential further rise in food prices in coming months.

Figure 61: CPI food prices

-226

1014182226

2003 2004 2005 2006 2007 2008 2009

%oy aCPI food prices

Source: CEIC, J.P. Morgan estimates. We are negative on the following sectors: 1) Property We are negative on this sector due to concerns about tightening.

While a broad-based monetary tightening is unlikely until 2H10, property sector-specific tightening measures could be pushed forward ahead of that time, given the recent adjustment to the policy tone in the sector.

Indeed, the latest withdrawal of the preferential policy implemented late last year suggests that the government is fine-tuning its accommodative policy stance on the property sector.

Notably, Premier Wen recently noted that the policy focus for FY10 in property market should be: (a) inhibiting the speculative demand; (b) accelerating the supply of economic housing in the market; and (c) supporting the real residential housing demand.

Within the property sector, we favor those companies with the most exposure to tier 2-3 cities, which stand to benefit from the government’s prospective relaxation of the control over the so-called “Hukou” system in medium and small cities, as per China’s Central Economic Work Conference, and those with exposure to commercial property space.

2) FAI-related plays While the strong earnings recovery momentum seen this year for FAI-related companies, including downstream commodities (cement and aluminum), commercial vehicles and construction, may be carried over to early next year, we recommend that

56



investors capitalize on the potential share price strength on the back of the likely strong results to trim their exposure to these sectors.

This is because these companies could be negatively affected by two headwinds: (1) the likely monetary tightening kicking in as of 2Q10, and (2) the potential downshift in FAI growth in 2011.

Historical performance show their share prices seem to be correlated more closely with China’s monetary and fixed investment cycles than their respective quarterly earnings results.

Figure 62: FAI-related stocks performance and M2 growth (with 3-6 months leading)

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% %, m/m, sa

Source: Bloomberg and CEIC. Figure 63: FAI-related stocks performance and FAI growth (with 3-6 months leading)

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% % Y/Y

Source: Bloomberg and CEIC. 3) Telecoms We stay cautious on this sector due to the lackluster 2G subscriber growth in China and that the 3G business has yet to take off in China.

4) IPPs We believe IPPs are suffering from the rising market-based coal cost and the government-regulated power tariff, which should weigh on the sector’s performance in FY10.

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MSCI China performance overview Over the past month, the MSCI China index fell 4.4% to 64.25 points. Despite the recent pullback, MSCI China has still risen 57% YTD. At the sector level, only three sectors—consumer staples (+10%), consumer discretionary (+6%), and IT (+1%)—gained over the past month. Of the eight sectors that fell in the past month, utilities was the biggest loser, falling 9% over the past month.

On the earnings front, consensus continues to revise up its 2010 earnings estimates, which validates a trajectory toward our 2010 EPS forecast of HK$4.6, implying around 21.8% earnings growth. Currently, MSCI China trades at 17x 2009E P/E and 13.9x 2010E P/E.

Table 23: Valuation for Indices and sectors Price MSCI P/E (x) EPS growth P/BV (x) Dividend yield 16-12-09 weighting 2009E 2010E 2009E 2010E 2009E 2010E 2009E 2010E

MSCI China 64.25 17.0x 13.9x 14.68% 21.86% 2.4x 2.2x 2% 3% H-share 12,691 16.2x 12.9x 23% 25% 2.4x 2.1x 3% 3% 3% Sector (MSCI China): Consumer Discretionary 280 5% 22.8x 19.5x 17% 17% 3.4x 3.0x 1% 2% Consumer Staples 1,262 5% 21.4x 18.1x 54% 18% 4.3x 3.6x 1% 2% Energy 657 18% 14.4x 11.8x -1% 23% 2.2x 2.0x 3% 3% Financials 518 38% 16.2x 13.1x 23% 23% 2.6x 2.3x 2% 3% Health Care 141 0% 38.2x 28.6x 28% 33% 8.2x 6.6x 1% 1% Industrials 170 8% 23.8x 17.0x 36% 40% 1.8x 1.7x 2% 2% Information Technology 105 6% 41.8x 29.1x 61% 44% 7.1x 5.8x 1% 1% Materials 1,121 6% 27.1x 15.7x 45% 72% 2.4x 2.1x 1% 2% Telecommunication Services 113 13% 12.2x 12.0x -7% 2% 1.9x 1.8x 4% 4% Utilities 375 1% 12.8x 11.7x 817% 10% 1.4x 1.3x 3% 3%

Source: Bloomberg, J.P. Morgan estimates. Note: Updated as of December 16, 2009.

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Figure 64: One-month price movement

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Figure 65: Sector contribution to one-month MSCI China point change

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Figure 66: 2009 YTD price movement

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As shown in figures above, we look at sectors which had the highest impact on moving the market since January 1, 2009. We observe that cyclicals (IT, consumer

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discretionary, consumer staples, materials, energy and financials) have outperformed the MSCI China, while defensive sectors (utilities, healthcare, industrials and telecom) have underperformed the index YTD. Sector-wise, the top contributor was the financials sector, which contributed 10 points to the 23.4 points gain YTD, while utilities and telecom dragged down the index by 0.1 and 0.5 points, respectively.

Figure 68: Top 20 YTD performers in MSCI China universe

594%

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GEELY AUTOMOBILE HOLDINGS LT

BYD CO LTD-H

DONGFENG MOTOR GRP CO LTD-H

WEICHAI POWER CO LTD-H

CNPC HONG KONG LIMITED

FUSHAN INTERNATIONAL ENERGY

HIDILI INDUSTRY INTL DEVELOP

INNER MONGOLIA YITAI COAL-B

ALIBABA.COM LTD

JIANGXI COPPER COMPANY LTD-H

TENCENT HOLDINGS LTD

CHINA DONGXIANG GROUP CO

YANZHOU COAL MINING CO-H

BELLE INTERNATIONAL HOLDINGS

GOME ELECTRICAL APPLIANCES

SHIMAO PROPERTY HOLDINGS LTD

AGILE PROPERTY HOLDINGS LTD

ZTE CORP-H

CHINA MENGNIU DAIRY CO

CHINA AGRI-INDUSTRIES HLDGS

Sources: Bloomberg, J.P. Morgan estimates. Note: Updated as of Dec 16, 2009

Figure 69: Bottom 20 YTD performers in MSCI China universe

28%

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CHINA SOUTH LOCOMOTIVE - H

COSCO PACIFIC LIMITED

BEIJING CAPITAL INTL AIRPO-H

JIANGSU EXPRESS CO LTD-H

SOHO CHINA LTD

SINOFERT HOLDINGS LTD

CHINA TELECOM CORP LTD-H

CHINA RAILWAY GROUP LTD - H

SHANGHAI ELECTRIC GRP CO L-H

CHINA UNICOM HONG KONG LTD

HARBIN POWER EQUIPMENT CO-H

GUANGSHEN RAILWAY CO LTD-H

CHINA ZHONGWANG HOLDINGS LTD

CHINA RESOURCES POWER HOLDIN

CHINA MOBILE LTD

CHINA RAILWAY CONSTRUCTIO-H

DATANG INTL POWER GEN CO-H

CHINA COMMUNICATIONS SERVI-H

HUANENG POWER INTL INC-H

CHINA COMMUNICATIONS CONST-H


YTD, FY09 best performers are mainly concentrated in consumption-related sectors, such as autos, property, bank, IT, and materials. In the MSCI China universe, 71 stocks out of 109 have outperformed the MSCI China index.

Model portfolio adjustments As of December 16, 2009, China model Portfolio posted a YTD gain of 75.73%, while the MSCI China rose 57% in the same period. Since the inception on 31 December 2004, our CMP has outperformed the MSCI China by 94.7%.

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Figure 70: J.P. Morgan China Portfolio vs. MSCI China since inception of J.P. Morgan China %

50100150200250300350400450500

Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09

JPM China Portfolio

MSCI China

Sources: Bloomberg, J.P. Morgan estimates. Note: Updated as of Dec 16, 2009. Past performance is not indicative of future results.

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Table 24: China Model Portfolio performance Weightings % Performance YTD Performance from add in date Add in Ticker Benchmark J.P. Morgan YTD vs. MSCI China % Abs % vs. MSCI China % Date Price (LC)

Consumer Discretionary 5.34 1.50 146.34 89.08 31-Dec-04 Li Ning Co Ltd 2331 HK 0.44 1.50 121.90 64.64 67.81 27.80 30-Apr-09 16.00 Consumer Staples 4.43 7.50 106.80 49.54 31-Dec-04 China Mengniu Dairy Co. Ltd. 2319 HK 0.68 1.50 166.37 109.11 21.49 18.15 30-Jun-08 22.10 China Yurun Food 1068 HK 0.49 2.00 123.38 66.12 103.50 63.77 30-Sep-08 10.00 Hengan International Group Ltd 1044 HK 0.86 2.00 128.92 71.66 28.81 20.48 4-Sep-09 44.25 Tsingtao Brewery 168 HK 0.29 2.00 147.53 90.27 29.40 28.51 15-Oct-09 30.95 Energy 17.59 22.00 72.03 14.77 31-Dec-04 CNOOC 883 HK 4.81 6.00 65.75 8.49 112.39 -11.48 21-Sep-05 5.65 Sinopec Corp 386 HK 2.41 2.50 43.50 -13.76 110.31 -43.54 31-Dec-04 3.20 China Shenhua Energy 1088 HK 2.78 5.50 134.15 76.89 328.28 209.97 10-Aug-05 8.97 Yanzhou Coal Mining - H 1171 HK 0.74 2.00 195.61 138.35 40.40 39.51 15-Oct-09 11.98 PetroChina 857 HK 4.45 4.00 38.44 -18.82 126.51 -27.35 31-Dec-04 4.15 China Coal Energy 1898 HK 1.10 2.00 127.55 70.29 0.00 0.00 16-Dec-09 14.04 Financials 38.01 37.50 67.17 9.91 31-Dec-04 China Life Insurance 2628 HK 6.46 4.00 64.54 7.28 645.19 491.34 31-Dec-04 5.20 China Overseas Land 688 HK 1.55 1.00 57.33 0.07 834.95 681.10 31-Dec-04 1.81 Ping An Insurance 'H' 2318 HK 1.97 1.00 82.80 25.54 419.63 269.92 14-Feb-05 13.19 ICBC - H 1398 HK 6.45 6.00 54.41 -2.85 46.85 26.04 30-Apr-07 4.29 China Merchants Bank - H 3968 HK 1.56 1.50 81.96 24.70 58.55 35.71 29-Dec-06 12.68 China Construction Bank 939 HK 6.61 8.00 54.35 -2.91 33.85 11.00 29-Dec-06 4.90 Bank of China -H 3988 HK 5.24 6.50 93.40 36.14 93.40 18.57 26-Feb-09 2.12 PICC Property & Casualty Co.Ltd 2328 HK 0.38 5.00 65.55 8.29 0.00 0.00 16-Dec-09 6.92 China Citic Bank 998 HK 0.72 1.50 144.15 86.89 0.00 0.00 16-Dec-09 6.47 Greentown China Holdings 3900 HK 0.17 3.00 296.91 239.65 0.00 0.00 16-Dec-09 12.86 Health care 0.00 3.00 31-Dec-04 Sinopharm 1099 HK 0.00 3.00 0.00 -57.26 0.00 0.00 16-Dec-09 27.40 Industrials 8.42 2.50 43.45 -13.81 31-Dec-04 China Cosco Holdings, Ltd. 1919 HK 0.51 1.50 73.84 16.58 30.50 9.69 30-Apr-07 7.18 China Southern Airlines 1055 HK 0.00 1.00 100.00 42.74 0.00 0.00 16-Dec-09 2.58 Information Technology 6.03 12.00 216.67 159.41 31-Dec-04 ZTE 'H" 763 HK 0.27 1.50 173.45 116.19 104.78 131.31 27-Sep-07 20.85 Netease NTES US 0.00 3.00 70.27 13.01 -11.50 -19.83 4-Sep-09 42.52 Alibaba.com Limited 1688 HK 0.51 3.00 224.01 166.75 -12.23 -20.56 4-Sep-09 20.60 Baidu.com BIDU US 0.00 2.50 226.46 169.20 24.18 15.85 4-Sep-09 343.27 Sina Corp SINA US 0.00 2.00 98.70 41.44 17.77 16.87 15-Oct-09 39.06 Materials 6.14 2.00 85.28 28.02 31-Dec-04 Maanshan Iron and Steel - H 323 HK 0.23 2.00 112.68 55.42 15.78 14.88 15-Oct-09 5.07 Telecommunication Services 12.20 7.50 -4.93 -62.19 31-Dec-04 China Mobile (HK) 941 HK 9.67 5.00 -7.91 -65.17 190.55 42.39 2-Mar-05 24.66 China Telecom Corp 728 HK 1.02 1.00 13.84 -43.42 -44.33 -31.32 25-Jan-08 5.91 China Unicom - H 762 HK 1.35 1.50 9.25 -48.01 -10.88 -33.73 29-Dec-06 11.40 Utilities 1.63 3.00 -4.66 -61.92 31-Dec-04 China Resources Power Holdings 836 HK 0.54 1.00 1.55 -55.71 -30.43 -17.42 25-Jan-08 21.36 Xinao Gas 2688 HK 0.32 2.00 134.27 77.01 54.35 46.03 4-Sep-09 12.40 China Gas Holdings Limited 384 HK 0.00 1.50 221.93 164.67 0.00 0.00 16-Dec-09 3.67 MSCI Total 99.79 100.00 57.26 0.00 154.00 0.00 31-Dec-04 Source: Bloomberg and J.P. Morgan. Updated as of December 16, 2009. Past performance is not indicative of future results.

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CMP adjustments We adjusted our banking exposure in our China Model Portfolio by taking profit on Shanghai Pudong Development Bank, Shenzhen Development Bank and Bank of Communications, and reduced the weighting of BOC to 6.5% from 8%. We added Citic bank with a weight of 1.5%. Our banking analyst initiated coverage on Citic Bank with a Dec-10 PT of HK$8.6, which implies 2.4x FY10E P/B and 12.7x FY10E P/E.

China’s property sector suffered a sharp correction on the government’s new measures to inhibit investment demand and to increase the supply of economy housing. While we continue to maintain our underweight stance on the sector, we believe many mid-cap property names with good exposure to Tier 2 and Tier 3 cities already offer very good value. We believe the government’s new policy of relaxing control over the residential card system in middle and small cities are positive for property developers with exposure to Tier 2 and Tier 3 cities, and that the government has reiterated its support for the residents’ genuine demand for the property sector. Hence, we add Greentown into our model portfolio with a weight of 3%. We like Greentown, given the strong sales pipeline ahead. The company has Rmb80 billion worth of properties available for sale in FY10. The company can achieve contract sales of Rmb40 billion-Rmb64 billion based on 50%-80% sales rate. Together with the sales of Rmb45 billion to be delivered in FY10-12, this would render support to its strong earnings growth from FY11 onwards. Greentown has also exposure to Hangzhou and most other second/third-tier cities in Yangtze River Delta as well as selected Bohai Rim cities.

We continue to reduce the weight in the downstream commodities by taking out Anhui Conch (-0.5%).

With the proceeds, we added to our weighting in the coal sector by 2% as we believe coal names should be benefiting from the current coal price hike. We add China Coal to CMP with a weight of 2%.

We continue to like gas sector with low penetration rate and strong secular growth. Hence, we add China Gas with a weight of 1.5%.

We continue to reduce our exposure to telecom and utilities. We reduce the weight in both China Telecom and China Resource Power to 1% from 1.5% and 3%, respectively.

We reduce our exposure to consumer sector by taking profit on Parkson (-1%) and Huabao (-1.5%) and reduce the weight of Yurun by 2.5% to 2%.

We take some profit on ZTE by cutting its weight to 1.5% from 3%, due to ZTE’s less attractive valuations after its strong YTD price performance of 173%. Meanwhile, we add China Southern Airline to our CMP with a weight of 1%. We believe this company should benefit from 1) the rising cargo and passenger traffic on domestic routes on the back of a strong economic recovery, and (2) Rmb resuming appreciation as of 2Q10.

Our pharmaceutical analyst, Leon Chik initiated coverage on China’s healthcare sector. We like the sector because we believe that healthcare will benefit from the government’s increasing public spending on this sector, given China’s current low spending per capita on healthcare and the urgency for China to provide a better safety net to Chinese households. Hence, we add Sinopharm into our model portfolio with a

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weight of 3%. We like this name because its simple growth story, comprising strong pharmaceutical sales growth in China and market share gains by the largest operator. We also believe there is upside risk to the consensus forecast for the name.

Lastly, we add PICC to our portfolio with a weight of 5% because: (1) we expect its core property insurance business to be lifted by the auto boom in China; (2) we believe there is a possibility that its parent company might inject the life insurance business into the listed vehicle.

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CMP return-risk profile To provide an all around picture of our CMP return-risk profile and justification of the monthly adjustment for investors, we introduce the following four ex-post (historical) measures: • Return profile: Active return—Monthly portfolio return minus benchmark return.

• Risk profile: Active risk—Volatility/risk we undertake correspondingly.

• Integrated performance measure: Information ratio—A classical tool for measuring the active return of an investment manager divided by the amount of risk the manager takes relative to a benchmark.

• Micro performance attribution: Pure sector allocation return—To measure the impact on performance attributed only to the sector-weighting decisions.

1. Within sector selection return: To calculate the impact on performance attributed only to security selection decisions.

2. Allocation/selection interaction return: Involving the joint effect of assigning weights to both sectors and individual securities.

We primarily focus on the first two measures.

The following table manifests the positive performance changes after adjusting our model portfolio. The annualized information ratio has increased to 5.5 from 0.4, with the annualized excess return increasing to 20.5% from 2.16%, and the active risk falling to 3.73% from 5.62%. This implies that the new CMP is equipped with higher return and lower risk.

Table 25: CMP return-risk checker Performance checker CMP before adjustment CMP after adjustment Annualized active return 2.16% 20.53% Annualized active risk 5.62% 3.73% Information ratio 0.38 5.50 Pure sector allocation return 0.90% 0.37% Within-sector stock selection return 3.04% 3.13% Sources: Bloomberg, J.P. Morgan estimates. Note: Updated as of Dec 16, 2009.

In order to get a deeper insight into our CMP performance, we also conduct a micro performance attribution analysis. We categorize the active return into three parts: (1) pure sector allocation; (2) allocation-selection interaction; and (3) within-sector stock selection. The active returns contributed by pure sector allocation and by within-sector stock selection over the last month, were 0.9% and 3.04%, respectively. This breakdown indicates that the slight outperformance last month was mainly due to the better portfolio components.

Besides ex-post measures, we can also forecast the new CMP return in an ex-ante (prospective) way. By applying our analysts’ June-10/Dec-10 price targets to our CMP components, we forecast our Dec-09 CMP monthly return of 0.6%.That

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Table 26: J.P. Morgan China model portfolio Change (%) MSCI JPM Dev. PER PER DY ROE Ticker Price Rating 4

Wk Ytd Weight Weight (%) 2009 2010 2009 2009

Consumer Discretionary 280 6.5 146.3 5.3 1.5 -3.8 22.0 19.0 1.7 19.2 Li Ning Co Ltd 2331 HK 26.9 N 8.5 121.9 0.4 1.5 1.1 31.1 27.1 1.9 43.2 Consumer Staples 1262 6.9 106.8 4.4 7.5 3.1 18.8 15.9 1.5 20.4 China Mengniu Dairy Co. Ltd.

2319 HK 26.9 OW 13.3 166.4 0.7 1.5 0.8 32.9 28.8 0.0 20.6

China Yurun Food 1068 HK 20.4 OW 10.6 123.4 0.5 2.0 1.5 21.5 18.9 1.2 23.7 Hengan International Group Ltd

1044 HK 57.0 N -1.3 128.9 0.9 2.0 1.1 32.5 29.7 1.9 27.3

Tsingtao Brewery 168 HK 40.1 N 4.0 147.5 0.3 2.0 1.7 41.4 36.1 1.2 20.1 Energy 657 -3.7 72.0 17.6 22.0 4.4 15.6 13.2 3.0 15.6 CNOOC 883 HK 12.0 N -5.8 65.7 4.8 6.0 1.2 18.6 15.4 3.6 17.3 Sinopec Corp 386 HK 6.7 OW -2.3 43.5 2.4 2.5 0.1 9.1 8.8 2.8 18.2 China Shenhua Energy 1088 HK 38.4 N -3.0 134.1 2.8 5.5 2.7 23.4 22.0 1.5 20.9 Yanzhou Coal Mining - H 1171 HK 16.8 N 9.2 195.6 0.7 2.0 1.3 15.5 15.8 1.7 18.3 PetroChina 857 HK 9.4 UW -7.1 38.4 4.4 4.0 -0.4 15.4 13.9 2.9 13.6 China Coal Energy 1898 HK 14.0 OW 2.2 127.6 1.1 2.0 0.9 17.7 17.2 1.7 16.6 Financials 515 -7.5 67.2 38.0 37.5 -0.5 16.5 12.8 3.1 17.5 China Life Insurance 2628 HK 38.8 OW -0.8 64.5 6.5 4.0 -2.5 40.6 35.3 0.8 13.4 China Overseas Land 688 HK 17.0 OW -0.8 57.3 1.6 1.0 -0.6 22.8 17.5 0.9 16.2 Ping An Insurance 'H' 2318 HK 68.6 N -5.8 82.8 2.0 1.0 -1.0 49.0 36.7 0.4 11.1 ICBC - H 1398 HK 6.3 OW -

10.3 54.4 6.5 6.0 -0.5 16.1 12.4 3.1 20.4

China Merchants Bank - H 3968 HK 20.1 N -7.6 82.0 1.6 1.5 -0.1 22.3 17.4 0.6 17.4 China Construction Bank 939 HK 6.6 OW -

10.6 54.4 6.6 8.0 1.4 14.5 11.1 3.1 21.3

Bank of China -H 3988 HK 4.1 OW -15.1

93.4 5.2 6.5 1.3 12.6 8.9 4.0 16.9

PICC Property & Casualty Co.Ltd

2328 HK 6.9 UW 16.3 65.6 0.4 5.0 4.6 NM 64.6 0.0 -1.1

China Citic Bank 998 HK 6.5 OW -6.6 144.2 0.7 1.5 0.8 16.6 10.9 1.5 15.2 Greentown China Holdings 3900 HK 12.9 N 9.0 296.9 0.2 3.0 2.8 15.9 12.9 0.0 14.5 Health care 0.0 3.0 3.0 NA NA NA NA Sinopharm 1099 HK 27.4 OW 9.4 0.0 0.0 3.0 3.0 53.5 46.4 0.4 12.7 Industrials 169 -5.2 43.4 8.4 2.5 -5.9 21.5 16.7 1.7 9.5 China Cosco Holdings, Ltd. 1919 HK 9.4 N -

16.3 73.8 0.5 1.5 1.0 NM 47.3 0.0 -6.3

China Southern Airlines 1055 HK 2.6 N -4.1 100.0 0.0 1.0 1.0 34.0 84.3 0.0 6.9 Information Technology 104 4.1 216.7 6.0 12.0 6.0 41.6 28.9 0.7 19.7 ZTE 'H" 763 HK 43 N -8.1 173.4 0.3 1.5 1.2 30.1 24.1 0.7 16.5 Netease NTES US 38 OW -7.5 70.3 0.0 3.0 3.0 18.4 12.7 0.0 27.7 Alibaba.com Limited 1688 HK 18 N -6.9 224.0 0.5 3.0 2.5 87.6 51.8 0.0 20.2 Baidu.com BIDU US 426 OW -2.0 226.5 0.0 2.5 2.5 69.5 46.6 0.0 37.1 Sina Corp SINA US 46 N 1.2 98.7 0.0 2.0 2.0 45.5 35.1 0.0 8.7 Materials 1121 -1.3 85.3 6.1 2.0 -4.1 27.2 16.5 1.6 12.9 Maanshan Iron and Steel - H

323 HK 5.9 OW 9.9 112.7 0.2 2.0 1.8 NM 62.8 0.3 1.4

Telecommunication Services 113 -6.1 -4.9 12.2 7.5 -4.7 12.4 12.5 3.6 13.5 China Mobile (HK) 941 HK 71.7 N -5.9 -7.9 9.7 5.0 -4.7 12.6 12.7 3.4 22.7 China Telecom Corp 728 HK 3.3 N -8.4 13.8 1.0 1.0 0.0 19.7 18.0 2.3 6.1 China Unicom - H 762 HK 10.2 UW -5.0 9.2 1.4 1.5 0.1 26.5 38.3 1.7 4.4 Utilities 374 -8.8 -4.7 1.6 3.0 1.4 15.5 12.3 2.6 10.8 China Resources Power Holdings

836 HK 15 N -7.6 1.6 0.5 1.0 0.5 14.6 11.7 2.2 14.1

Xinao Gas 2688 HK 19 OW 0.7 134.3 0.3 2.0 1.7 24.5 19.7 1.0 13.9 China Gas Holdings Limited 384 HK 4 N 5.5 221.9 0.0 1.5 1.5 118.0 25.6 0.0 3.3 MSCI Total 64 -4.3 57.3 100 100 0 17.2 14.1 2.7 15.3 Source: Bloomberg and J.P. Morgan estimates. Updated as of December 16, 2009.

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Autos (Extracted from the note, “Auto WIN: Regional auto industry highlights", published on 4 December 2009; please see the original note for pricing dates)

What is changing Change 1: We raised our FY10 auto sales forecast We raised our FY10 auto sales forecast by 12% to 15.13 million (please see the table below). Among these, we expect China’s passenger vehicle sales to rise 15% Y/Y to 11.56 million, and commercial vehicle sales to increase 8% Y/Y to 3.58 million.

Table 27: J.P. Morgan forecasts for China auto sales Sales unit ('000) 2004 2005 2006 2007 2008 2009E 2010E 2011E Sedan 2,242 2,787 3,829 4,727 5,047 7,231 8,225 9,076 MPV 109 156 191 226 197 234 269 299 SUV 163 196 238 357 448 637 765 879 Minivan 757 831 918 988 1,064 1,947 2,297 2,573 Total PV 3,271 3,970 5,176 6,298 6,756 10,049 11,556 12,827 (Y/Y % change) 21% 30% 22% 7% 49% 15% 11% Bus 183 179 191 247 253 340 357 382 Truck 1,121 1,163 1,317 1,516 1,641 2,173 2,390 2,558 Trailer 99 57 93 178 194 214 235 251 Van chassis 91 91 98 102 88 92 95 98 Truck chassis 307 298 341 450 450 485 500 515 Total CV 1,801 1,788 2,040 2,494 2,625 3,304 3,577 3,804 (Y/Y % change) -0.7% 14.1% 22.3% 5.2% 25.9% 8.3% 6.3% Total vehicles 5,072 5,758 7,216 8,792 9,381 13,353 15,133 16,631 (Y/Y % change) 17.2% 13.5% 25.3% 21.8% 6.7% 42.3% 13.3% 9.9% Source: CAAM and J.P. Morgan estimates.

Impact We revised up our China vehicle sales forecasts for FY10 based on the following factors:

1) Chinese government’s commitment to transform China’s economic growth mode from an investment and export- driven economy to a consumption-driven economy China’s Politburo, the top decision-making body in China, held a conference on November 27, 2009 to set the tone for the Central Economic Work Conference to be held in mid-December, 2010. The Politburo noted at the conclusion of the conference that China would maintain its proactive fiscal and relatively loose monetary policies. Also, the Politburo highlighted the importance of promoting the development of consumption and private investment as a key driver of sustainable economic growth.

Meanwhile, Zhu Hong, the spokesperson of China’s Industrial and Information Ministry recently stated that China would consider renewing the policies that have been introduced this year to boost automobile consumption.

Hence, we expect the Chinese government to renew its preferential policies introduced this year to boost vehicle consumption.

In fact, we believe the government may well expand the scope of the vehicles that will receive the preferential vehicle purchase for FY10 to boost car consumption.

Frank LiAC (852) 2800-8511 [email protected]

Jin Luo (852) 2800-8516 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

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Among others, we expect the vehicles with an engine size of 1.8 liters and below to enjoy the 5% preferential vehicle purchase tax (versus the normal 10% tax rate). Currently, only vehicles with an engine size of 1.6 liters and below qualify for a 5% preferential vehicle purchase tax.

In addition, Chinese auto producers are lobbying for the removal of the vehicle purchase tax for vehicles with an engine size of 1.4 liters or below.

Table 28: The impact of preferential policies introduced in FY09 to boost vehicle sales Policies Impact (1) Reduction in vehicle purchase tax from 10% to 5% for cars with an engine This policy has driven a strong growth in the sale of passenger vehicles size of 1.6 liters or below from January 20 to December 31, 2009 with an engine size of 1.6 liters or below. For instance, the sale of PVs with an engine size of 1.6 liters or below rose 63% Y/Y in the first ten months of 2009. On the other hand, the sale of PVs with an engine size of above 1.6 liters increased only 15% Y/Y in the same period. (2) Providing a financial subsidy totaling Rmb5 billion to help farmers upgrade from three-wheel and/or low-speed agricultural vehicles to light trucks and mini vans

This policy has driven a strong growth in China’s mini van sales and mini truck sales. For instance, minivans’ sales volume grew 77% Y/Y and mini trucks’ sales volume rose 80% Y/Y in the first ten months of 2009

(3) Providing a financial subsidy totaling Rmb5 billion to scrap old vehicles for new ones.

This has helped boost vehicle sale in FY09 through encouraging the consumers to scrap the old vehicles before their assessed usage life before replacing such old vehicles with new ones. The policy is expected to add 1 million vehicle replacement demand.

Source: J.P. Morgan.

2) Additional new policies to be released next year to boost auto consumption: Against the backdrop of promoting consumption as a key economic driver, we expect the government to come up with two new policies to boost auto consumption. First, we expect the release of new auto financing regulations that will make it easier and cheaper for consumers to get auto loans from banks and auto financing companies. In FY08, only 8% of the consumers who bought cars opted for auto loans. Second, we expect the government to release new regulations for boosting the development of the “new energy vehicles.” The Chinese government earlier set a target to increase China’s electric car possession from an estimated 100,000 units by 2012 to 4 million by 2020.

3) The current third auto boom is driven by the breakout of disposable income in China’s tier-three cities. At the beginning of this year, we forecast that China’s third auto boom would be unleashed by the breakout of demand in China’s tier-three cities in FY10 when the household average disposable income is forecast to reach Rmb40,199, when discounted with China’s CPI figures. This is similar to the level of tier-two cities’ disposable income in FY06, and tier-one cities’ disposable income in FY03, which fueled China’s previous two auto booms. China’s third auto boom kicked off in FY09, i.e., one year ahead of our forecast, helped by a slew of government policies to boost auto consumption.

With the strong economic recovery, we expect China urban residents' disposable income growth to remain robust in FY10, helping to set the stage for robust car demand.

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Figure 71: China urban residents’ per capita disposable income growth (quarterly)

5%

8%

11%

14%

17%

Mar/08

May/08

Jul/08

Sep/08

Nov/08

Jan/09

Mar/09

May/09

Jul/09

Sep/09

1-tier 2-tier 3-tier

Source: CEIC.

Figure 72: China urban residents’ per capita disposable income growth (yearly)

5%7%9%

11%13%15%17%

2003 2004 2005 2006 2007 2008

1-tier 2-tier 3-tier

Source: CEIC.

We see the above upward revision in China’s vehicle sales forecast as a positive for China’s auto sector, and see upside risks to the sector's 4Q09E and 1Q10E results, given the huge operating leverage of the sector.

On the other hand, we have identified the following key investment risks for China autos:

1) The impact of negative wealth effect to rise from the possible volatilities in China’s stock and property markets on China’s vehicles sales in FY10. With the acceleration in China’s economic growth, we expect the Chinese government to resort to tightening measures, such as window guidance for the banks to slow down the lending as of 2Q FY10, raising the banks’ required reserve ratio, and possibly cracking down on the high-end property sector in 2Q FY10, which could result in volatilities in China’s stock and property markets. This, in turn, could hurt car sales in FY10.

2) Valuations of China’s auto stocks look reasonable to us but not very attractive after the strong performance this year.

3) The strong car sales growth this year could be partly attributable to the advanced purchase by some consumers, who thought that the preferential tax policies might not be renewed next year;

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4) The supply of new paper. We believe a number of auto companies may capitalize on the current cyclical upturn in China’s auto market to raise money in the secondary market. We could see the existing listed auto companies raising money to expand capacity and/or to do M&A activities. In addition, a number of unlisted auto companies may also seek to do IPOs next year.

In conclusion, we now switch from a positive stance at the beginning of the year to a neutral stance on China auto sector following the strong performance this year, and recommend investors focus on those names that have company-specific strengths or positive share price drivers. Among others, we like DongFeng Motor, a leading company in China’s auto sector with a track record of expanding market share and growing core earnings in both the upturn and the downturn of the cycle. Unlike Denway, which is a red chip (i.e., Chinese company incorporated in Hong Kong), DongFeng Motor is an H-share company (i.e., Chinese company incorporated in China and governed by Chinese laws). DongFeng’s H-share status means that it is much easier for the company to go for the listing in the domestic A-share market, where stocks typically trade at a much higher multiple than that in the H share market. It should help the sentiment of DongFeng Motor if the company decides to do the A share listing.

Change 2: The impact of Rmb appreciation on China autos U.S. President Obama’s visit to China in November 2009 re-ignited market speculation on Rmb appreciation—an imminent one-off Rmb revaluation, expansion of the daily trading band, or at least a resumption of Rmb appreciation in the very near term—after Rmb staying largely stable since mid-09.

The recent notable downward movement of the one-year Rmb NDF suggests heightened expectations of Rmb appreciation over the past month.

Figure 73: Rmb/US$ one-year non-deliverable forward (NDF) outright rate

6.46.56.66.76.86.9

77.17.2

1/1/

2009

2/1/

2009

3/1/

2009

4/1/

2009

5/1/

2009

6/1/

2009

7/1/

2009

8/1/

2009

9/1/

2009

10/1

/200

9

11/1

/200

9

Source: Bloomberg.

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Figure 74: J.P. Morgan and consensus Rmb forecasts

6.0

6.4

6.8

7.2

7.6

8.0

8.4

Sep 04 Dec 05 Feb 07 Apr 08 Jul 09 Sep 10

ForwardConsensus

J.P. Morgan

J.P. Morgan forecast:end Dec 09: 6.75end Mar 10: 6.70end Jun 10: 6.65

Source: Bloomberg, J.P. Morgan estimates.

While Rmb was largely stable versus U.S.$ in 2H09, we expect Rmb shall resume appreciation in FY10 (J.P. Morgan’s economics team forecasts Rmb/US$ will reach 6.5 by end-10) due to: 1) The ongoing recovery of exports should reduce the government’s concern over Rmb appreciation on export-related jobs. Notably, the sequential trend growth for China’s exports has come out of the negative territory entering 2H09 and currently hovers around 20% 3m/3m, saar.


-80-60-40-20

020406080%3m/3m, saar

2002 2003 2004 2005

Exports Imports

2006 2007 2008 2009


2) Inflationary pressure is building up, making Rmb appreciation a powerful tool to counter inflation for the medium term. The rising food inflation since mid-09, and the recent hike in gasoline and diesel prices, as well as the widely anticipated price liberalization for gas, water and power, all suggest that rising inflationary pressure is emerging.

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Figure 76: Consumer price inflation

-3-113579

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

%oy a


Figure 77: Rmb NEER, REER and CPI inflation

9095

100105110115120

-20246810

index , 2000=100, +=appreciation

CNY NEER, REER and CPI inflation%oy a

2003 2004 2005 2006 2007 2008

Headline CPI inflationNEER REER

headline inflation will emerge mid next year; RMB appreciation a crucial tool to temper this pressure


Figure 78: CPI—Food prices: Sequential trend growth

-100

10203040

2003 2004 2005 2006 2007 2008 2009

%3m/3m, saar


Impact: Neutral on China’s auto sector We hold that Rmb appreciation is largely neutral on China’s auto sector.

On one hand, Chinese auto producers will benefit from their US$-denominated cost, although the impact should be limited due to the high localization rate for most listed

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vehicles, except for Brilliance China, whose BMW JV only has a 40% localization rate.

On the other hand, medium and high-end auto producers will be subject to increased competition from imports, in our view. Given an Rmb appreciation, imported vehicles’ purchasing cost will be lower, thus increasing the pricing pressure on medium- and high-end vehicles. Hence, Denway, which gets a large part of its earnings from its upper-medium Accord models, and Brilliance China, which could post around 60% of its FY10 earnings from BMW cars, will likely be negatively affected.

Winners: DongFeng Motor—DongFeng’s exports only account for less than 1% of its total sales income. This means that Rmb appreciation would have a very limited impact on its bottom line. On the other hand, DongFeng Motor should benefit from Rmb appreciation, as about 20% of its costs are denominated in US$.

Losers: Great Wall Motor, Sinotruk, Weichai and Qingling—as exports account for 7% of Great Wall Motor’s sales; 8% of Sinotruk’s sales; 8% of Weichai’s sales; and 3% of Qingling’s sales. None of these companies have US$-denominated costs to hedge the negative impact of Rmb appreciation on their sales income.

Change 3: Gasoline consumption growth lagging passenger vehicles’ sales growth

China sold 8,190,293 new passenger vehicles in the first 10 months of 2009, up 45% Y/Y. Among these, sales of gasoline-fired passenger vehicles recorded 8,127,388, up 45% Y/Y.

On other hand, China’s gasoline consumption rose only 8% Y/Y in the first 10 months of 2009, well below the sales growth of new passenger vehicles.

This has caused many China bears to cast doubt over the authenticity of the new vehicle sales in China. Some come up with the theory that maybe Chinese government has bought a lot of cars this year before having them stored at warehouses to boost the “nominal consumption”. We disagree with the above cynical view, and help to explain the discrepancy between the sales growth of passenger vehicles and that of gasoline consumption as follows

Impact 1) The change in sales mix toward cars with an engine size below 1.6 liters due to the vehicle purchase tax cut for cars with an engine size below 1.6 liters. The sales of cars with an engine size of 1.6 liters and below which qualify for the preferential 5% vehicle purchase tax accounted for 70% of total passenger vehicle sales in the first ten months of 2009.

On comparison, the sales of cars with an engine size below 1.6 liters accounted for 62% of total passenger vehicle sales in the same period of 2008.

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Figure 79: China autos—Sales of vehicles with an engine size below 1.6 liters as a % of total car sales

Source: CEIC.

2) Gasoline consumption is driven by the vehicle fleet size rather than by the new vehicle sales.

We believe it is reasonable to compare gasoline consumption growth with the car fleet size increase rather than the new car sales growth,

The gasoline consumption, among others, is driven by the fleet size growth ( the old fleet size plus the new vehicle sales minus the scrapped vehicles), and the average cars’ mileage change.

Based on the new car sales of 8,190,293 in the first 10 months of 2009 and assuming the average usage life of a passenger car be ten years, we estimate the total number of cars running on the road rose 20% Y/Y in the first ten months of 2009. This is apparently lower than the 45% sales growth of the new passenger vehicles during the same period.

Figure 80: China autos—Cars on road vs. gasoline consumption per car

Source: CEIC.

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3) Fuel cost hike encouraging people to reduce their car usage On November 10, 2009, China’s National Development and Reform Commission (NDRC) raised gasoline and diesel prices by Rmb480 per ton, After the adjustment, the benchmark gasoline and diesel retail prices will increase to Rmb7,100 per ton and Rmb6,360 per ton, respectively.

Table 29: China—Price change for gasoline and diesel year to date Gasoline price change Diesel price change (Rmb/ton) (Rmb/ton) 15-Jan-2009 -140 -160 25-Mar-2009 +290 +180 1-Jun-2009 +400 +400 30-Jun-2009 +600 +600 29-Jul-2009 -220 -220 2-Sep-2009 +300 +300 10-Nov-2010 +480 +480

Source: NDRC, J.P. Morgan.

Table 30: Retail price increase for gasoline and diesel in Shanghai as of November 10, 2009 Before price hike After price hike Change (Rmb/liter) (Rmb/liter) (Rmb/liter) 93# gasoline 5.9 6.61 0.71 97# gasoline 6.27 7.03 0.76 98# gasoline 6.85 7.61 0.76 0# diesel 5.64 6.5 0.86 Source: CEIC, J.P. Morgan.

We believe the continuous increase in fuel prices has caused people to reduce usage of cars. Instead of driving their cars on a daily, some people may choose to take public transportation modes such as the subway during the weekdays and to drive on weekends so as to save costs. This should bring down the average mileage of the vehicles.

By our estimates, the recent fuel price hike could increase the fuel bill of the owner of a small car (Fit), and an upper-medium-end car (Accord) by Rmb548 p.a. and Rmb1,186 p.a., respectively.

Table 31: China autos—Impact of fuel price hike on the recurrent usage cost of car owners Fuel consumption Gasoline

(97#) Expense rise on per

liter gasoline Monthly mileage

Annual expense before fuel price

hike

Annual expense after fuel price hike

Recurrent usage cost

increase

(Rmb/liter) (Rmb/liter) (kms) (Rmb) (Rmb) (Rmb) Accord 13 liter/100 km 7.03 0.76 1,000 9,781 10,967 1,186

Parking expense 9,600 9,600 0 Maintenance expense 1,800 1,800 0 Insurance 6,000 6,000 0 Total 27,181 28,367 1,186

Fit 6 liter/100 km 7.03 0.76 1,000 4,514 5,062 548 Parking expense 9,600 9,600 0 Maintenance expense 1,040 1,040 0 Insurance 4,000 4,000 0 Total 19,154 19,702 548


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Change 4: China to expand the scope of vehicles that qualify for the preferential vehicle purchase tax? On November 28, 2009, Shanghai Securities News reported that China’s National Development and Reform Commission and the Ministry of Finance had recently reached an agreement to renew the preferential policies that were introduced this year to boost car consumption, and that the government would consider expanding the scope of vehicles that qualify for the 5% preferential vehicle purchase tax (versus China’s normal vehicle purchase tax of 10%).

The report has brought about a strong rally for China auto stocks, with Denway up 21% and DongFeng up 10% since November 30, 2009, respectively.

Earlier this year, on November 17, FY09, Mr. Zhu Hong, the spokesperson for China’s Industrial and Information Ministry, the direct governing authority of China’s automotive industry, noted that China would consider renewing the preferential policies introduced this year to boost car consumption.

Impact We believe the positive impact should be very limited if the scope of preferential vehicle purchase tax is only expanded to vehicles with an engine size of 1.8 liters and below (versus the current scope of vehicles with an engine size of 1.6 liters and below).

This is because:

1) The positive impact of the preferential vehicle purchase tax on China autos should be through the boost in sales of the vehicles that receive the preferential vehicle purchase tax. The vehicle purchase tax cut, which is charged at the consumer level, will not directly affect the auto producers’ profitability.

On contrast, the change of the consumption tax, which is charged at the producer level, will directly affect the auto producers’ profitability.

2) The medium-end cars (with an engine size of between 1.6 liters and 1.8 liters) sell well in China even without the help of preferential vehicle purchase tax. Hence, the marginal impact of applying the preferential vehicle purchase tax for this category is rather limited, in our view.

3) The profitability of the medium-end cars and of low-end cars is well below that of the upper-medium and high-end cars. For instance, Denway’s 50%-owned Guangzhou Honda derived 84% of its 1H09 profit from its Accord and Odyssey models, which are all fitted with engines of 2.0 liters and above. The low-end Fit model and medium-end City model together accounted for 43% of its 1H09 sales mix, but only 16% of its 1H09 profit.

Hence, the marginal impact of extending the preferential vehicle purchase tax to include vehicles with an engine of 1.8 liters on Denway should be very limited. Denway sold 7,158 City models with an engine size of 1.8 liters, and 42,389 City models with an engine size of 1.5 liters in 1H09, accounting for 4% and 26% of its 1H09 total vehicle sales, respectively.

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Assuming the sales of its City model with an engine size of 1.8 liters would rise by 20% in response to the possible change in vehicle purchase tax to extend the preferential vehicle purchase tax to vehicles with an engine size of 1.8 liters and below, we could see only 1% upward revision in our FY10 earnings forecast for Denway.

China autos should get a boost in profit only if China extends the scope of preferential vehicle purchase tax to the upper-medium-end segment, i.e., vehicles with an engine size of 2.0 liters to 3.0 liters.

We take Denway as an example: Accord with an engine size of 2.4 liters accounted for 36% of Denway’s total Accord sales. We believe the likelihood of expanding the scope of vehicles to receive preferential vehicle purchase tax to vehicles with an engine size of 2.4 liters and below is small, as it conflicts with the government’s aim of promoting fuel efficiency.

At most, we expect the government to expand the scope of vehicles that will receive preferential vehicle purchase tax to vehicles with an engine size of 2.0 liters and below. Under this scenario, Denway’s Accord model fitted with a 2.0 liter engine, will benefit from the revised policy, in our view. Denway’s Accord model with 2.0 liter engine sold 51,108 units in 1H09, accounting for 31% of its 1H09 total sales and around 42% of its 1H09 profit.

Assuming the sales of its Accord model with 2.0 engines and City model with 1.8 engines be given a 20% boost as a result of the possible extension of the preferential vehicle purchase tax to vehicles with an engine size of 2.0 liters and below, we could see a 7% upward revision in our FY10 earnings forecast for Denway

Table 32: J.P. Morgan forecasts: Vehicles with different engine sizes as a percentage of total vehicle sales of major auto producers in China in FY10E

Denway DongFeng Great Wall Brilliance China

Cars with an engine size of 1.6 liters and below 41% 50% 57% 53%

Cars with an engine size between 1.6 liters and 1.8 liters (1.8 liters included) 3% 9% 0% 9.7%

Cars with an engine size between 1.8 liters and 2.0 liters (2.0 liters included) 32% 12% 0% 0.6%

Cars with an engine size above 2.0 liters 24% 29% 43% 36.8%


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Table 33: Impact on the FY10E earnings of major auto producers in China under two scenarios: 1) 20% rise in sales of vehicles with an engine size between 1.6 liters and 1.8 liters; 2) 20% rise in sales of vehicles with an engine size between 1.8 liters and 2.0 liters

Denway DongFeng Motor

Great Wall Motor

Brilliance China

Scenarios 1: 20% rise in sales of vehicles with an engine size between 1.6 liters and 1.8 liters (1.8 liters included)

0.5% 3% n.a. n.a.

Scenarios 2 20% rise in sales of vehicles with an engine size between 1.8 liters and 2.0 liters (both 1.8 liters and 2.0 liters included)

7% 5% n.a. n.a.

Source: J.P. Morgan estimates. Note: 21We expect Brilliance China to dispose of its Zhonghua sedan business in FY10. Thus, Brilliance China will not have models with engine sizes of 1.8 liters and 2.0 liters. Scenarios 1 is based on the assumption that the vehicles with an engine size of 1.6 liter of 1.8 liters to 2.0 liters get a 20% growth in sales on the adoption of the assumed lower vehicle purchase tax.

Information Information 1: BMW JV expanding capacity in China Brilliance China and BMW recently announced a plan to spend Rmb5 billion to expand the capacity of their JV. According to the plan, the BMW JV will expand the capacity of its first plant from 40,000 units currently to 75,000 units by the end of FY10 before further expanding it to 100,000 units. Meanwhile, the JV plans to build its second plant with an initial capacity of 100,000 units, which will further increase to 300,000 units. Hence, the BMW JV will eventually have a total capacity of 400,000 units in China. In addition, the JV will also build an engine plant in China for its BMW JV to help reduce the production cost of BMW cars in China. BMW also confirmed Brilliance China as its sole and exclusive partner in China.

Impact: Positive for Brilliance China We see the news as a positive for Brilliance China, which has emerged as a Chinese auto company with strong growth potential in China after its recent restructuring. After the sale of its loss-making Zhonghua sedan business to its parent company, Brilliance China’s business is now mainly comprised of its minivan business, which has the largest market share in China, and the 49.5%-owned BMW JV. Following its efforts in the past few years to increase the localization content to above 40%, and reducing the purchase cost of auto parts , Brilliance China’s BMW JV has entered the “harvest time”, in our view. We expect the profit contribution from its BMW JV to double H/H to over Rmb210 million in 2H09.

We expect the BMW JV to sell 42,000 units in FY09, which will likely rise to 50,000 units in FY10. We expect the profit contribution from its BMW JV to rise from Rmb317 million in FY09 to Rmb514 million in FY11, driven by robust demand and gradual improvement in its margins due to expanded economy of scale and reduced production cost. In comparison, Brilliance China’s management has set a more aggressive target of doubling the profit contribution from its BMW JV from FY09 to FY11.

Information 2: China’s vehicle export was still weak in October After a slight M/M rebound in September 2009, China’s vehicle exports fell again in October 2009, reflecting the weak overseas demand.

China exported 28,859 vehicles in October 2009, down 5.26% M/M and 26.86% Y/Y. For the first 10 months, China exported 248,600 vehicles, down 54.5% Y/Y. Among these, China exported 106,935 passenger vehicles, down 65.38% Y/Y, and 141,665 commercial vehicles, down 40.46% Y/Y. China’s top three auto exporters

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this year are: Chery, Great Wall Motor, and Guangzhou Auto, which exported 31,899, 26,346, and 23,336 vehicles in the first 10 months of this year, respectively.

Impact: Negative for China’s auto exporters We see the news as a negative for China’s auto exporters such as Great Wall Motor. Great Wall Motor exported 25,000 vehicles in the first 10 months of this year, down 48% Y/Y. In 2009, we expect Great Wall Motor to export only 30,000 vehicles, representing only 16% of its total forecast sale for FY09.

Non-consensus calls Qingling Motors Co: Sacrificing margins for sales (UW, 1122.HK, HK$2.26, PT: HK$1.95) (Extracted from the note, “Qingling Motors Co: Sacrificing margins for sales," published on 13 November 2009; please see the original note for pricing dates)

• We expect Qingling’s sales volume to rise 22% to 43,000 in FY09: We expect 22% Y/Y growth in Qingling’s FY09E sales volume, to be driven by: a) rising demand for commercial vehicles in China due to China’s robust fixed asset investment growth; and b) the hefty 20% price cut for its light trucks fitted with 100 horse power engines in the beginning of 2009.

• Gross margin under pressure: Qingling Motors seems to have adopted a strategy of boosting vehicle sales through competitive sales price reductions, i.e. sacrificing gross margins for sales volume growth. It cut selling prices by 20% for its pick-up trucks in FY08, and that of its light trucks fitted with 100 horse power engines in FY09 to boost sales, bringing down its gross margin from 17.8% in FY07 to 17.2% in FY08, and around 15.3% in FY09. Going forward, we believe it is likely to cut selling prices of its light trucks fitted with 600 horse power engines, which will further erode its gross margins.

• We maintain UW: We cut our FY09 earnings estimates by 4% to Rmb252 million, to factor in the lower gross margin assumption. Unless it undertakes a restructuring to shed its low-return businesses of heavy trucks and medium trucks to focus on the light truck sector, and/or return excess cash to shareholders, we continue to see Qingling as a valuation trap. We maintain our Underweight rating given: 1) its gross margin could continue to be under pressure from rising competition in China’s truck sector; 2) poor capital management and a diversified product strategy; and 3) its low ROE of 4% in FY10E. Given the improved demand outlook for commercial vehicles on the back of the rising economic growth in China, we raised our Jun-10 price target from HK$1 to HK$1.95, which is based on 0.6x FY10E P/B, or 20% above its average 0.5x P/B since January 2002, when the company increased its shares outstanding by 22% to 2,482 million through the conversion of its CBs and option exercise by its parent. Key risks to our price target are: 1) stiffer–than-expected pricing pressure; 2) higher-than-expected steel cost hike; and 3) the possible failure of its new products to be accepted by the Chinese market.

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FY09 sales volume to go up 22% Y/Y We expect Qingling’s sales volume to rise 22% to 43,000 in FY09, of which light trucks and pick-up trucks could account for 38,000, medium-sized trucks at 3,500, and heavy trucks at 1,000.

Among other things, our FY09 sales growth estimate of 22% Y/Y for Qingling Motor is due to:

1) The rising demand for commercial vehicles in China due to robust fixed asset investment growth and the Chinese government’s policy of providing Rmb5 billion financial subsidy to help farmers upgrade from three-wheeled and/or low-speed agricultural vehicles to light trucks and mini vans.

In the first 10 months of this year, China’s light truck sales have risen 20% Y/Y to 1,264,685.

Figure 81: China’s fixed asset investment growth

Source: SSB, J.P. Morgan.

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Figure 82: Monthly sales of China’s light trucks in 2008 and 2009

0

20000

40000

60000

80000

100000

120000

140000

160000

180000

1 2 3 4 5 6 7 8 9 10 11 12

2008 2009

Source: CAAM.

2) The hefty 20% price cut for its 100 horse power light trucks in the beginning of 2009.

The 100 horsepower light trucks normally account for one-third of its total sales volume.

According to management, Qingling recorded vehicle sales of 36,000 in the first 10 months of 2009. Qingling will need to sell 3,500 vehicles a month in both November and December to meet our FY09 sales volume estimate of 43,000.

Gross margin on a downward trend As mentioned above, Qingling Motors seems to have adopted a strategy of boosting vehicle sales through competitive sales price reductions, i.e., sacrificing gross margins for sales volume growth.

For example, the company cut the selling prices of its pick-up trucks by 20% in the beginning of FY08 in an effort to maintain its market share under increasing competition from other pick-up truck producers such as Great Wall Motor and Jiangling Motors, which tend to produce pick-up trucks with a better price performance ratio in China.

Entering FY09, Qingling Motors cut sales prices of its light trucks fitted with 100 horse power engines, which normally account for one-third of its total sales volume, by 20% in an effort to boost sales.

Going forward, we expect Qingling Motors to cut selling prices of its 600 horsepower light trucks if it wants to maintain its current small market share of around 2% in China’s light truck market.

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Hence, we expect Qingling’s gross margin to continue to come under continued price cut pressure due to increasing competition.

In fact, Qingling’s gross margin has already declined from 17.8% in FY07 to 17.2% in FY08, which, we expect, to drop further to 15.3% and 15% in FY09 and FY10, respectively.

Table 34: Qingling Motors’ gross margins from FY07 to FY10E FY07 FY08 FY09E FY10E Gross margins 17.8% 17.2% 15.3% 15%

Source: Company data, J.P. Morgan estimates.

The export-oriented Isuzu JV is not expected to become a major earnings driver in the foreseeable future Qingling Motors has a 50:50 JV with Isuzu, which started operations in November FY07.

The JV, with a registered capital of Rmb680 million and an investment of Rmb1.5 billion, is devoted to the production of engines for supply to Qingling and Isuzu and other customers in China. According to its development plan, the engine JV should boost its annual capacity from 100,000 units to 175,000 units by 2012.

Many investors have significant expectations on the JV to become a major earnings driver for the company on expectation of strong export orders from Isuzu group.

In fact, its engine JV with Isuzu had contributed a profit of only Rmb9 million in FY08.

The JV is expected to sell around 45,000 engines in FY09, which are mainly sold to Qingling itself rather than exported to Isuzu’s other overseas operations. Given the financial crisis, the export market remains rather weak.

Contrary to public belief, we do not expect the JV to become a major earnings driver for the company in the foreseeable future, given the weak export market.

The sale of medium and heavy trucks below expectation Management now expects its medium-sized trucks, which were launched in July 2008, to fetch sales volume of 3,500 in 2009, versus its original sales target of 4,000. Medium-sized trucks are expected to be priced at Rmb120,000 per unit, versus its domestic peers’ sales price of around Rmb80,000.

We do not expect its medium-sized trucks to become a major earnings driver for the company, given its limited sales volume.

Meanwhile, its heavy truck sales continue to disappoint, with FY09 sales volume expected to be flat at around 1,000. On comparison, its domestic competitors such as Sinotruk and DongFeng Motor have started to see a sharp jump in heavy truck sales due to rising fixed asset investment growth. We believe the weak sales of Qingling’s heavy trucks are largely due to its high sales prices. While Qingling’s heavy trucks

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are sold at prices between Rmb350,000 and over Rmb400,000, Sinotruk’s heavy trucks are priced around Rmb230,000 per unit.

Earnings estimate revision and PT hike We cut our FY09 earnings estimates by 4% to Rmb252 million, to mainly factor in our lower gross margin assumptions.

Going forward, we expect Qingling’s net profit to rise 13% Y/Y in FY10 before rising 7% Y/Y in FY11.

Earnings-based valuation At HK$2.26, Qingling’s stock is trading at 19.6x FY09E P/E, down to 17.3x in FY10E, which still puts Qingling among the most expensive names in China’s auto space.

Asset-based valuation Meanwhile, on an asset basis, it is very cheap. A price of HK$2.26 puts it at 0.7x FY09E P/B, declining to 0.684x in FY10E.

We maintain our Underweight rating on Qingling, given:

1) Its gross margin could continue to be under pressure from rising competition in China’s truck sector.

2) Poor capital management which is reflected in:

a) Diversified product strategy:

The company is a marginal player in a niche market, with a share of around 2% in China’s light truck sector.

Instead of focusing on one sector, such as the light truck sector, Qingling Motors has adopted a diversified product strategy, i.e. producing light trucks, multi-purpose vehicles, heavy trucks and pick-up trucks at the same time. We believe such a poor capital management has made it difficult for the company to gain a competitive advantage for its products.

For example, its heavy truck business, which accounts for 45% of its fixed assets, is generating a very small investment return, given: i) its high selling price—heavy trucks, which are based on Isuzu technology, are sold at prices between Rmb350,000 and over Rmb400,000, versus Rmb230,0000 for Sinotruk’s heavy trucks; b) its small scale—Qingling’s market share in China’s heavy truck market is less than 1%.

b) Despite its strong balance with a net cash per share of Rmb1.69 by end-FY08, the company is expected to return cash to shareholders, given its diversified product strategy that entails continued investments in new areas of low investment returns.

3) Low ROE of 3.6% and 4% expected in FY09 and FY10, respectively.

Qingling’s stock is trading at a prospective P/B band of between 0.2x and 0.8x since January 2002, with an average P/B ratio of 0.5x.

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Figure 83: Qingling Motors’ prospective P/B band

0.0

0.1

0.2

0.3

0.4

0.5

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Dec-01

Dec-02

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+2 standard dev iation

+1 standard dev iation

av erage

-1 standard dev iation

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As shown Figure 83, Qingling is noSure.Now already trading at the high end of its historical prospective P/B band since January 2002 when the company increased its shares outstanding by 22% to 2,482 million through the conversion of its CBs and option exercise by its parent.

Our Jun-10 price target of HK$1.95 is based on 0.6x FY10E P/B, 20% above its average 0.5x P/B since January 2002.

To put it in a nutshell, we believe, in the short-term, its share price may be boosted by the abundant liquidity in the current capital market. Some investors may overlook its problems of poor capital management, low investment return of only 4.1% in FY10E, and poor liquidity, and decide to focus on is cheap asset-based valuation as an excuse to drive up its share prices.

However, unless the company can undertake a restructuring to shed its low-return businesses of heavy trucks and medium trucks to focus on the light truck sector, and/or return excess cash to shareholders, we continue to see the stock to be in a valuation trap and refrain from upgrading the stock.

Our key concerns on the stock include : 1) its poor capital management; 2) its business could be negatively impacted by the expected slowdown in China’s fixed asset investment growth in FY11; and 3) the expected further erosion in its gross margins.

We will revisit our view if the company drastically boosts its ROE through measures such as giving cash back to shareholders and sharply increases its operating margin through effective cost control.

Risks to our price target are: 1) more intense-than-expected pricing pressure; 2) higher-than-expected steel cost hike; and 3) the possible failure of its new products to be accepted by the Chinese market.

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Consumer Huabao International Holdings Limited: New business prospects (This note was originally published on 4 December 2009; please see the original note for pricing dates)

• 1HFY10 net profit in line with expectations; Revenue was 5% lower; operating profit 2% higher than expectations. Results did not beat consensus as in prior periods owing to fewer acquisitions. Management is still very comfortable with previous guidance to double sales in three years.

• 45% dividend payout is a positive signal. This is a record-high dividend payout. The previous dividend payout was 30%. In FY09, the payout ratio increased to 38%, and further to the current 45%.

• New business prospects include: 1) new material for cigarettes; management expects sales to kick in next year. 2) upstream aromatic material; Huabao has two bases in Wuxi and Botswana; 3) F&B flavor: Huabao entered the business in 2007; we estimate EBIT contribution at 3% in the last six months. New business will be expanded organically and through acquisition. We expect more acquisitions to come.

• Neutral, Dec-10 target price of HK$9.5. Our forecasts remain unchanged. We value the stock at 19x March 2011E earnings, which is based on a 20% discount to the average for China Staples. Risks include continued selling from management and limited interest in owning a defensive business. As the company did not beat market estimates as it had in the past, this may lead to short-term downward pressure on the stock, offering opportunities to accumulate on declines.

• Potential re-rate catalyst: The market has currently accorded a valuation discount to Huabao. We believe multiple expansion needs to be driven by: 1) a higher dividend payout; 2) more contribution from F&B flavor business; 3) future direct acquisitions; and 4) strong results as profits from new businesses begin to kick in.

Jasmine BaiAC


Vineet Sharma, CFA (852) 2800-8523 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

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EBITDA EPS Sales volume growth assumption Impact of a 1% increase 0.58% 0.7% Gross margin assumption Impact of a 1% increase 1.08% 1.3% Operating expense assumption Impact of a 5% increase -1.33% -1.60%

Source: Company and J.P. Morgan estimate.s

Price target and valuation analysis

Huabao International is a leading tobacco flavor manufacturer in China. As of 2008, it was a key supplier to nine out of 10 top tobacco brands and has about a 50% market share among Top 10 brands. The company is expected to benefit from consolidation of China’s tobacco industry and the reduction of tar in Chinese cigarettes. Huabao also entered the food flavor sector in 2004.

Revenue breakdown, FY09

We value the stock at 19x March 2011E earnings, which is based on a 20% discount to the average for China Staples.

Source: Company data. EPS: J.P. Morgan vs. consensus J. P. Morgan Consensus FY10E 0.430 0.428 FY11E 0.524 0.491 Source: Bloomberg, J.P. Morgan estimates.

Key risks: Continued selling from management and limited interest in owning a defensive business. Low visibility of new business at this point.

Peer group valuation comparison table Company Ticker Rating Price PT Mkt cap P/E P/B (HK$) (HK$) (USD MM) FY08 FY09E FY10E FY09E FY10E Tobacco and tobacco flavors China Flavors & Fragrances^ 3318 HK NR 1.55 97 22.8 7.6 10.5 0.9 0.9 China Staples Universe Tingyi 322 HK N 19.98 17.40 14,403 54.9 36.8 30.3 9.9 8.3 China Resources Enterprise 291 HK N 26.3 27.00 8,129 35.1 31.7 24.6 2.4 2.3 Hengan International 1044 HK N 57 43.00 8,968 51.8 33.3 29.5 8.0 7.2 Sector average 41.1 27.4 23.7 5.3 4.7 Source: Bloomberg, J.P. Morgan estimates. Prices as of the close on December 3, 2009. Consensus estimates used for NR stocks.

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1HFY10 net profit in line with expectations 1HFY10 results came in with revenue 5% lower, operating profit 2% higher, and net profit in line with our expectations. Results did not beat consensus as in previous times owing to fewer acquisitions. Management is still very comfortable with the previous guidance to double sales in three years.

Revenue growth was 22%, lower than the full-year guidance of 30% because only a small acquisition occurred in August. The company expects higher growth in the second half.

Operating margin improved 190bp owing to economies of scale. Results for tobacco flavor and food flavor segments are not disclosed separately. Management indicated at the analyst meeting that tobacco flavor sales grew 19.2%, gross margin was stable. Food flavor revenue growth was around 40%, gross margin improved.

Table 35: Huabao 1H10 results review

HK$ 000 1H08 2H08 1H09 2H09 1H10 yoy change

hoh change

Actural vs. estimate

Revenue 643,551 775,586 892,109 1,046,324 1,088,854 22% 4% -5% Cost -164,607 -191,382 -220,044 -257,428 -266,587 -7% Gross profit 478,944 584,204 672,065 788,906 822,267 22% 4% -4% Gross margin 74.4% 75.3% 75.3% 75.4% 75.5% other income 6,587 33,961 27,531 12,126 17,756 SG&A -95,942 -117,853 -147,763 -153,040 -145,871 Operating profit 389,589 500,312 551,833 647,992 694,152 26% 7% 2% Operating margin 60.5% 64.5% 61.9% 61.9% 63.8% PBT 398,120 505,880 560,226 651,642 700,789 25% 8% 0% Net profit to shareholders 374,487 487,658 517,256 597,437 610,927 18% 2% 0%

Source: J.P. Morgan estimates, company data.

45% dividend payout is a positive signal This is a record-high dividend payout. Previously, the company’s payout ratio was 30%. In FY09, the payout increased to 38%, and further to the current 45%.

New business prospects Management talked about three new business areas. The development strategy is similar to tobacco flavor: organic growth + acquisition. Management indicated that margins for new business will be similar to current levels. Capex guidance is for HK$30MM-HK$40MM per year but no details were given for how much will be spent for acquisitions. We expect more acquisitions to come for new business development.

New material for cigarettes. Management estimates the market at Rmb20B. Growth drivers of the market are: 1) High-end cigarette market is growing faster but high-end tobacco leaves cannot meet the demand. New material can help to enhance the quality. 2) Further cuts in tar content will necessitate new materials. Management expects sales to kick in next year.

F&B and restaurant–related products. Management estimates the market to be Rmb30B. The company entered the business in 2007 through acquisition. In FY09,

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the EBIT of F&B flavor contributed 2% of total EBIT. We believe this percentage will increase to around 3%. Upstream aromatic material. Huabao already has two units in upstream. One is Wuxi Fuhua and Wuxi jiahua established in 2004/2005. The other F&G (Botswana) was acquired last week. Potential re-rate catalyst The shares are currently trading at 19x March 2010E, 16x March 2011E earnings. The market has accorded a valuation discount to Huabao. We believe a re-rate needs to be driven by transparency improvement. The catalyst could include:

1) More dividend payouts

2) Direct transaction in acquisitions

3) Larger portion of EBIT from the F&B flavor business. Among the current business and new business prospects, F&B flavor has a more diversified client base and a different distribution system. If Huabao delivers strong results from F&B and restaurant–related flavor business, it will be evident that the company has a strong capacity to expand its franchise in the flavor business.

4) Ongoing strong earnings

Neutral, Jun-10 PT HK$ 9.5 We leave our forecasts unchanged. We value the stock at 19x Mar 2011E earnings. Our target price is based on a 20% discount to the average of the China consumer staple universe. Risks include continued selling from management and limited interest in owning a defensive business.

We believe the stock may offer opportunities to accumulate on declines. Huabao’s earnings did not beat market estimates as they had in the past; this may lead to short-term downward pressure. Further declines might put forward multiples at such a large discount to the China Staples universe, presenting opportunities to buy on declines.

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China Mengniu Dairy Co. Ltd.: More confident about product mix improvement; more initiatives in the milk powder business (This note was originally published on 8 December 2009; please see the original note for pricing dates)

• We are more confident about the product mix improvement; positive changes in the milk powder business: We believe sales of Deluxe brands have fully recovered. The company is planning new high-end product launches early next year. We believe trading up by consumers after the melamine incident and better raw milk quality will help improve the product mix further. Mengniu has taken many initiatives to manage Mengniu Arla, the 50:50 JV for the milk powder business. The JV has not performed well since its inception in 2005. The reason could be that the operating environment in China’s dairy sector is very different from the developed market. Given Mengniu’s understanding of the Chinese market and its strength in distribution, we expect upside potential from the business.

• Rising raw milk prices are not a concern: Mengniu sources 60%-70% of raw milk through long-term exclusive contracts signed for 30-50 years, and the volume, quality, and price are reset every year. We do not expect significant changes in contract prices. Even if the market price of raw milk increases backed by a global milk powder rally, we believe Mengniu will be better positioned than competitors due to low-cost pressure.

• Option granting a positive: Mengniu had announced the granting of 89MM share options on November 24, at a strike price of HK$24.4, vesting in three years. We were concerned about apparent investor worries over less management incentive and earnings dilution after COFCO-HOPU became the largest shareholder in Mengniu. After the option granting, we believe these concerns should ease somewhat.

• We raise our FY10 earning ex-option expense estimate by 9% and Dec-10 PT to HK$32, implying 30x FY10E headline net profit. On a cash basis, the implied P/E is 24x FY10E. Key risks to our PT include: 1) another surge in selling expenses; and 2) unexpected changes in raw milk prices.

Jasmine BaiAC


Vineet Sharma, CFA (852) 2800-8523 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

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Sensitivity analysis EBIT EPS Sales volume growth assumption (2010E) Impact of a 1% increase 0.69% 1.5% ASP assumption (2010E) Impact of a 1% increase 13.72% 30%

Operating expense assumption as % of sales (2010E)

Impact of a 1% increase -20.13% -44% Source: J.P. Morgan estimates.

Price target and valuation analysis

Company description Mengniu is a leading dairy producer in China. Its major products include liquid milk products and ice cream. In 2008, it was ranked No.1 in liquid milk, yogurt and ice-cream sectors in the Chinese dairy industry.

Revenue breakdown, 2008

We raised our Dec-10 PT to HK$32 from HK$23, based on the DCF method. Free cash flow = cash flow from operation - capex. We assume WACC of 11%, terminal growth rate from 2018 at 2%, and risk-free rate of 4%. The increase in our PT is due to our earnings estimate revisions.

Risk-free rate: 4% Market risk premium: 7% Beta: 1 Debt/equity: 0% Cost of debt: 6.00% Terminal “g”: 2% Source: Company data. EPS: J.P. Morgan vs. consensus

Rmb

J. P. Morgan (including

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FY09E 0.77 0.74 FY10E 0.92 0.89 Source: Bloomberg, J.P. Morgan estimates.

Excluding option expenses, we believe our net profit forecast is 3% and 6% above Bloomberg consensus for FY09/FY10. Our price target implies 30x FY10E headline net profit, and 24x cash-based net profit for FY10E. Key risks to our PT include: 1) another surge in selling expenses; and 2) unexpected changes in raw milk prices.

Peer comparison valuations

Company Ticker Rating Price PT Mkt cap P/E P/B (HK$) (HK$) (US$ MM) FY08 FY09E FY10E FY09E FY10E Tingyi 322 HK N 20.1 17.40 14,489 55.2 37.0 30.5 10.0 8.4 Uni-president China 220 HK N 5.57 4.70 2,587 31.5 22.9 20.3 2.9 2.6 Want Want^ 151 HK NR 5.54 9,442 35.7 32.5 24.6 8.8 7.4 China Huiyuan Juice 1886 HK UW 5.79 3.10 1,097 63.8 (34.7) 92.8 1.7 1.7 Sector average 46.5 14.4 42.1 5.8 5.0 Source: Bloomberg, J.P. Morgan estimates. Prices are as of December 7, 2009 close. ^Bloomberg consensus estimates are used.

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Earnings estimate changes Table 36: Mengniu earnings estimate changes Rmb in millions

Earnings estimate revisions 2009E 2010E Previous Current change Previous Current change Revenue 25,106 25,568 2% 27,239 28,561 5% Gross margin 25.9% 25.9% 26.1% 26.2% EBIT margin ex-option expense 7.7% 7.6% 8.1% 8.4% Reporting net profit 1347 1339 -1% 1614 1600 -1% Growth 20% 20% Option expense 290 310 7% 250 460 84% Net profit ex-option expense 1602 1612 1% 1831 2000 9% Growth 14% 24% Source: J.P. Morgan estimates.

In our Note, Food For Thought: Why we think dairy sector margins likely to improve”, published on October 12, 2009, we note that the change in competition dynamics (more rational pricing strategy and less A&P spending), product mix improvement, and less capex spending in liquid milk will be major drivers. Our analysis and discussions with management suggest that the company is more confident about improving the product mix. Meanwhile, we do not think a raw milk price increase is a concern as Mengniu sources 60%-70% of raw milk through contract supply.

For FY09, we leave our earnings estimates largely unchanged. However, due to the potential for more share option expense, we lower our reported net profit estimate by 1%.

For FY10, we raise our estimates for revenue by 5%, EBIT margin ex-option expense by 0.1%, net profit ex-option expense by 9%, but lower our reporting net profit estimate by 1% due to the potential for more option expense.

We note that there is a trade-off between top-line growth and margin. Our top-line growth estimate is lower, but our EBIT margin estimate is higher than Bloomberg consensus. If Mengniu extends its distribution to lower-tier cities and rural areas with low-end products, it could surpass our sales estimates. Its margin could get diluted a bit, but top line and earnings could have upside from the market expansion.

New products pipeline The company has focused on product mix improvement this year. The Deluxe brands have recovered well. After the restriction on OMP in February, Deluxe brands dropped OMP and kept three other sub-brands . Sales of Deluxe brands have fully recovered, in our view. The company is planning to launch new products by the end of this year. We are more confident about the product mix improvement.

In 1H09, Mengniu had about 10% of sales from low-end products, which are plain milk with tetra packaging, with the retail price at around Rmb2/250ml pack. These products have gone through price cuts and their gross margin is below 20%. The company’s high-margin products are mostly in milk beverage and yogurt categories. Mengniu has increased the share of high-margin products from c0% of sales to 15% in 1H09. We expect high-margin products, mid-margin products, and low-margin products to grow 25%/10%/6% in FY10.

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Table 37: Mengniu product mix improvement assumptions

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High-end above 28% 15%25% Mostly in milk beverage and yogurt; for example, yogurt

with red date flavor, farm milk, milk with fruit, etc. Mid-end 20-28% 75% 10% Low-end below 20% 10% 6% Plain milk with tetra packaging, little differentiation Source: Company data, J.P. Morgan.

Postive change in the milk powder business Mengniu started its milk powder business in 2005 through its 50:50 joint venture with Arla. The JV runs its production in Inner Mongolia for Mengniu Arla mid-range powder products. So far, the JV has not worked very well. In 1H09, milk powder sales were worth Rmb300-Rmb400 million. The capacity as of 1H09 was 1,9000 tons. We estimate the utilization rate was only 30%-40%.

Since mid-09, Mengniu has taken more management initiatives for Menngiu Arla, which we think is a positive. The operating environment of the dairy sector is very different from that of developed countries. Numerous international dairy companies have attempted but failed to penetrate the Chinese dairy market since the late 1990s. Some of them have retreated entirely from the market. In our view, the slow progress of Mengniu Arla was another example. Now, given Mengniu’s more management initiatives, its strength in market development, and improved raw milk quality, we believe the milk powder business could provide upside potential in two or three years.

Mengniu’s milk powder business has the Mengniu Arla brand. The selling price is about Rmb160/can (900g). The selling price is similar to Yili, and c50% lower than international brands. Its gross margin is more than 40%. We assume Rmb900 million and Rmb1.4 billion sales, respectively, for FY10 and FY11.

Raw milk price is less volatile than the industry average The company sources 60%-70% of raw milk through long-term contract supply, among which 15%-20% comes from big ranches and 40%-50% from centralized cow-raising centers. The remaining 30%-40% is from milk collection centers, where price is more volatile. It has a contract with big ranches and centralized cow-raising centers for 30-50 years for exclusive supply, but the volume, quality and price are reset every year. According to management, the price for this year is Rmb2.8-2.9/kg, and the company does not think the price hike will have a big impact on margins.

Table 38: Mengniu raw milk procurement % of total raw milk procurement

Cattle ranch 15-20% Centralized cow raising center 45-50% Milk collection center 30-35% Source: Company data, J.P. Morgan.

Option granting a positive More management incentive China Mengniu announced a total grant of 89.025 million share options to CEO Yang Wenjun, CFO Yao Tongshan and Executive Director Bai Ying on November

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24. The strike price was HK$24.4, and will be vested in three batches with 20%, 40% and 40% in three years, respectively.

We believe this is a positive for the company. After COFCO-HOPU became the largest shareholder in Mengniu, there appeared to be investor concern over less management incentive and earnings dilution. On July 17, the company had announced that it would not go ahead with the proposed grant of an aggregate 88.8 million share options. On the next trading day, the share price dropped 2.3%, while the HSI rose 3.7%. Now, with the grant of options, we believe these concerns should ease somewhat.

High option expense is partly due to high share price volatility Mengniu had granted about 85 million share options in 2008 and 89 million in 2009, about 9% of its current shares. According to the share option scheme, the company can grant 70 million more share options from now till 2014.

The option granting will book a high option expense in the P&L. The company estimates an additional option expense of Rmb20 million in 2009 and Rmb210 million/Rms210 million for 2010/2011. The potential high option expense is partly because the share price volatility was high.

Dec-10 price target of HK$32 Our DCF-based Dec-10 price target of HK$32 implies 30x FY10E headline net profit. On a cash basis, this implies a P/E of 24x FY10E. Key risks to our price target include: 1) another surge in selling expenses; and 2) unexpected changes in raw milk prices.

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Energy China energy demand—picking up China’s economy has been picking up very strongly in recent months due to the stimulus package being put in place in response to the global recession. This has also impacted energy demand, including petroleum products and natural gas.

YTD apparent demand, ensuing refinery throughput plus net product imports, is up 3.6% and current apparent demand has now crossed the 8-million BOPD mark. Domestic crude production has been relatively flat in the past few years, while imports have had to make up for the demand growth. China has also now definitely crossed the 50%-import dependency mark.

Figure 84: China imports over 50% of crude—Domestic production flat for many years (MM ton)

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Due to the build-up of new refining capacity in China, the country has been able to lower the import level of products. China has actually become a net exporter of both gasoline and diesel in recent months, adding additional pressure on international refining margins. Most of the product import is fuel oil, followed by LPG and some naphtha this year.

Figure 85: China imports less products due to refinery capacity build-up in 2009 (MM ton)

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Brynjar Eirik BustnesAC (852) 2800-8578 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

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Gasoline demand Car sales in China have had a very strong sales growth period in recent months due to stimulus from the government. Stimulus comes in the form of cash refund if an old car is scrapped for a new one as well as lower sales tax on buying smaller engine cars. The growth is particularly strong in the passenger vehicle sales segment, expected to reach almost 50% in 2009 (15% next year). Commercial vehicle sales are expected to grow around 25% in 2009 (8% next year). Gasoline demand growth has, however, not really reacted to the strong car sales, and is hovering around the +/- 10% level.

Figure 86: China imports less products due to refinery capacity build-up in 2009 (MM ton)

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Gasoline as a proportion of total oil demand in China has been relatively constant at 20%. It has picked up slightly in recent months due to the lagging demand growth of diesel. We expect gasoline demand to remain at around 20%.

Figure 87: Gasoline demand grows in line with total products

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smaller in size (i.e., less need to drive), owners are not as well off (drive less at higher gasoline prices), some are second or third cars (again driven less), some cities have limitations on when you can drive (odd/even number plates, which cause people to buy another car without driving more), and finally more of the cars are smaller (smaller than 1.6-litre engines), thereby consuming less gas.

Figure 88: Gasoline demand grows half of car fleet (MM vehicles)

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Looking at fuel efficiency in China is not easy considering the lack of data for car-miles driven. Hence, we look at consumption per car per day. This efficiency measure (prone to errors) shows that efficiency has doubled in the past five years from 14 litre/car/day to less than 7 litre/car/day.

Figure 89: Efficiency doubled in China in past five years (MM cars)

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Diesel demand Demand for diesel in China has not picked up as expected on the back of the strong economic performance, including industrial production data so far this year. It is generally believed that diesel demand should be well correlated to IP, both from the production but more so from the transportation of goods. Infrastructure build-up should also require diesel and generate demand growth.

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Figure 90: Diesel demand growth still weak, but picking up (MM ton)

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As with power earlier this year, diesel did not show demand growth as expected. For the power side, there were several explanations for this, including lower ramp-up in the power intensive industry. Power has now, however, caught up with IP figures.

On the diesel side, demand growth has also started to catch up with IP figures, although it is still looking a bit on the low side. This could be partially due to weak exports, causing less need for the transportation of goods.

Figure 91: Power has caught up with IP, while diesel demand is still lagging

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Other product demand Gasoline and diesel make up around 60% of total petroleum product demand in China. The remaining products are fuel oil, naphtha, LPG and other smaller groups. This “other” group of products has shown the strongest growth in recent months with 10-20% Y/Y demand growth. This is of course off a very low 2008 base as this group of products also saw the biggest drop last year. Fuel oil is by far the biggest part of this group, but demand is down around 5% YTD.

It is primarily on the naphtha side that demand has picked up strongly. Naphtha is the feedstock for most petrochemicals and china has gone from being a net exporter last year to a net importer this year.

LPG is also seeing a strong rebound in demand, as it became competitive relative to other fuels due to lower oil prices earlier this year.

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Figure 92: Naphtha, LPG and jet kerosene have seen strong demand growth in 2009 (MM ton)

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Natural gas and LNG Natural gas in China still contributes less than 4% of primary energy consumption. Coal is by far the highest (70%) followed by crude (20%). Nuclear, hydro and other sources make up the balance.

Until 2006, China has had no means of importing natural gas and relied upon domestically-produced natural gas. This limited supply also limited demand growth. Domestic production has over the past few years seen strong growth, and since the opening of CNOOC’s LNG terminal in 2006, additional natural gas has been made available. This, strong domestic growth and imported LNG have allowed relatively stronger demand growth in the natural gas segment in recent years.

Figure 93: Recent LNG import levels at close to 10% of domestic production (BCM)

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The first LNG terminal received LNG from NWS in Australia on a contract signed many years ago, with CNOOC Ltd getting a stake in the upstream aspect, on top of it. The second and third terminals which CNOOC has opened are also taking LNG from relatively low-priced supply (Tangguh and MLNG Dua), but have also recently added a contract (from Qatar) at a higher contract price. Incidentally, CNOOC reportedly had problems marketing these Qatari volumes at prices around US$10-12/mmBTU.

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There are generally little details available on contract pricing for Chinese LNG, but import data give an indication of where the price levels are. In mid-last year, CNOOC brought in quite a bit of spot LNG, which caused the average import price to increase. Due to the recent cold weather in northern China, this is again happening with PetroChina by leasing capacity from CNOOC and taking in spot.

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Financials: Banks Little clarity on capital raising a short-term overhang, but overreaction has created a good buying opportunity Change 1: Largely sufficient internal capital generation, but CBRC asked for more capital

Extracted from the note, “China Banks: Little clarity on capital raising a short-term overhang, but overreaction created a good buying opportunity," published on 30 November 2009. Please see the original note for pricing dates.

Higher ROE largely sufficient to support slower loan growth In our view, theoretically most H-share banks will not see further drop in their capital ratios in 2010 or even 2011 in some cases. The abnormally high loan growth rate in 2009 is very unlikely to repeat due to a much bigger base. We expect 2010 year end tier-1 and CAR ratios should be flattish compared with their respective capital ratios as of 2009 year end. This of course depends on ultimate loan growth. However, we believe there will be no major surprise as seen in 2009 and that our loan expectation of around Rmb7.5trn (18% in the system) reflects the government’s tone of an “appropriately loose monetary policy".

Table 39: Improved internal capital generation in 2010 would largely be sufficient to fund about 18% loan growth in the system ICBC CCB BOC BoComm Citic Minsheng Huaxia SPDB SZDB

2010E ROAE 23.3% 24.2% 21.3% 22.7% 20.5% 14.9% 16.7% 22.3% 19.3% 09 final & 10E interim divd payout as of 10E earnings 38.4% 38.8% 35.3% 29.7% 16.4% 12.2% 12.6% 7.5% 15.3% Tier-1 growth 16.3% 17.5% 15.4% 19.6% 17.5% 13.7% 14.6% 23.5% 18.3%

10E Loan growth 13.3% 16.0% 17.7% 19.4% 21.2% 20.7% 18.0% 19.8% 24.0% 10E RWA growth 15.7% 16.0% 16.9% 17.0% 18.5% 20.9% 20.3% 23.5% 22.8%

Tier-1 ratio 09E 10.2% 9.2% 9.7% 8.0% 9.0% 8.9% 6.6% 6.9% 8.1% Tier-1 ratio 10E 10.3% 9.3% 9.5% 8.1% 9.0% 8.4% 6.3% 7.0% 7.9% Source: J.P. Morgan estimates.

A slowdown in loan growth should be largely expected Although the government has reiterated need for continuity in policy stance and to maintain a relatively accommodative monetary policy and expansionary fiscal policy, it has also been a consensus that 2009’s loan growth is excessive. A recent State Council meeting also pointed out challenges including asset bubble arising from excess liquidity, potential rising inflation and over-capacity. We thus believe loan growth should slow down to about 18%, or a new Rmb-denominated loan increase of around Rmb7-7.5trn in 2010, compared with an expected Rmb9.5trn new Rmb-denominated loans (31.3%) in 2009. This would appropriately reflect the government's guideline for a slower and yet still reasonably strong growth. Note that an 18% loan growth is still above 14-16% loan growth from 2004-2008, during which annual new loan increase ranged within Rmb3.2-5trn.

Samuel ChenAC (852) 2800-8557 [email protected]

Cindy Xu (852) 2800-8502 [email protected]

Sunil Garg (852) 2800-8519 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

Improved internal capital generation should largely be sufficient to fund a slower but still very strong loan growth in 2010, estimated at c18% for system.

We think some investors’ expectation of another Rmb9.5T-10T new loan in 2010 (namely c25% y/y) is quite unrealistic

mailto:[email protected]

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Table 40: Breakdown of annual loan increase by segments: medium & long-term loans may still be a key loan growth driver in 2010 due to still high financing needs from existing projects. Rmb bn 2007 2008 1H09 YTD 2009 2009E 2010E Personal 1,139 794 1,075 2,008 2,458 1,550 Consumer 867 498 666 1,400 1,750 1,100 Personal business 272 296 409 607 707 450 Corporate 2,495 4,137 6,323 6,939 7,042 5,950 ST working capital 1,277 1,190 1,341 1,454 1,392 1,400 Discounted bills (448) 646 1,707 677 600 200 MLTM loans 1,681 2,188 3,169 4,562 4,800 4,200 Others (14) 113 106 246 250 150 Total Rmb inc 3,634 4,931 7,398 8,947 9,500 7,500 Source: PBOC, J.P. Morgan estimates.

CBRC may push for capital raising Although we believe loan growth will slow down and that banks’ 2010E ROE should be largely sufficient to fund organic balance sheet growth, possibility of equity capital raising is rising, given a stronger push from CBRC to ensure “adequate capital and improve the quality of capital base”. This implicitly means a stronger focus on tier-1 capital. In addition, in the case of a broad-sector trend, the fear of lagging behind the race may push banks to consider capital raising earlier than expected and may raise slightly more than actual needs. After all, in longer-term, these banks may still need capital for business expansion especially in non-banking financial services.

Growth capital in medium-term, but definitely not balance sheet repair capital Although CBRC repeatedly highlighted the importance of credit risk control and discourages excess growth, such message is routine warning and it’s CBRC’s primary task to ensure strong balance sheet strength including asset quality of the banking system. In fact, one can also see CBRC did mention the importance of “internal capital generation”, which implicitly refers to its expectation for higher profitability.

Since 2008 we have been arguing that the high pre-provisioning operating ROA and relatively low loan to assets ratios means many Chinese banks, especially most H-share banks can indeed afford a very high credit costs before their equities suffer. As seen below, even if annual NPL formation rate surged to above 300bps, or in other words, nearly 13-15% of new corporate loans made in 2009 going bad all suddenly in a single year of 2010, earnings for some larger banks should still decline by 20%, and ROE in most cases would be still at mid-teen percentage. Clearly, we believe there is no need for balance sheet repair.

In our view, CBRC’s push for higher capital, by far, does not reflect CBRC's fear or concern on potential ballooning of NPLs arising from exceptionally high loan growth this year

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Table 41: NPL formation rate needed in various 2010E earnings growth scenarios.

% of 09E loans Flat

down 20%

Down 30%

Down 50%

Down 100%

BoCom-H 2.2% 3.1% 3.5% 4.2% 5.9% BOC-H 2.6% 3.6% 4.0% 4.7% 6.7% CCB-H 2.3% 3.7% 4.2% 5.2% 7.6% ICBC-H 2.3% 3.9% 4.4% 5.4% 8.0% Citic-H 2.3% 2.9% 3.2% 3.8% 5.3% Huaxia 1.8% 2.5% 2.7% 3.0% 3.8% Minsheng 1.2% 1.9% 2.2% 2.8% 4.1% SPDB 1.4% 2.4% 2.7% 3.3% 4.8% SZDB 1.8% 2.0% 2.3% 2.8% 4.1%


Figure 95: NPL ratios needed in various 2010E earnings growth scenarios.

0.0%2.0%4.0%6.0%8.0%

10.0%

BoCom-H BOC-H CCB-H ICBC-H Citic-H Huax ia Minsheng SPDB SZDB

Base Case Flat earning in 2010 2010 fall by 20%

2010 fall by 50% zero profit in 2010 (breakev en)


We believe there are see some needs for capital in longer-term, especially as banks expands into other non-banking financial services, such as insurance, and brokerage. From this perspective, this may still be regarded as growth capital. For some banks, equity raising is still needed to fund balance sheet and loan growth, thus may even enhance shareholders’ value. In such case, as we will discuss later, given timing is some time away, we believe current share price largely are quite not valid reference points for the pricing of future capital raising.

That said, should equity capital raising happens around 2010 year end or 2011, we believe such new capital largely will not be used to fund lending, since internal capital generation is already sufficient to fund an expected 18% system loan growth. From this perspective, it may not be immediate growth capital indeed.

Change 2: Long time ahead, capital raising plan will reflect shareholders’ interest Extracted from the note, “China Banks: Little clarity on capital raising a short-term overhang, but overreaction created a good buying opportunity," published on 30 November 2009. Please see the original note for pricing dates.

While there are preliminary and initial talks and discussion among CBRC and bigger banks, we believe and actual capital raising could be largely a 2010 end or 2011 event at earliest, in most cases. Some banks such as BoComm that have slightly lower tier-1 may lead the progress but still could be a 2H2010 event.

• Banks just started considering various options and need time to communicate with various relevant parties to make preliminary proposal. At this point, CBRC’s threshold on capital ratios is also quite unclear.

• Once an equity raising plan is decided, it takes a minimum of 5 months or so from any announcement to actual completion, including 1-2 month for shareholder approval at minimum typically, and another 2-3 month for regulatory approval, and time for actual deal completion.

• Importantly, in our view, the whole capital raising issue would be beyond CBRC’s control. We believe any final plan needs to take consideration of various interests of the central government that are represented and guarded by various ministries. Thus it needs a higher level (State Council or politburo) to balance and decide on final plans. This will take some time.

Noise may persist for long time, and investors may be tired and would refocus back to fundamentals in three-month time

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Investors need political perspective in understanding the complexity A deep understanding of both political landscape and financial analysis should also help investors avoid all misperception and confusion some media stories create.

We fully understand CBRC is doing the right thing as it pushes for a stronger capital, a better risk-control and stronger profitability, which is its primary goal as a regulator ensures the healthiness of the banking system. The complexity, in our view, is that the central government may need to take consideration of various interests, which are guarded by various ministries. Key ministries that need to be involved include: CBRC, CSRC, Huijin (under CIC), Ministry of Finance, and to less extent Social Security Fund. Smooth communications and coordination are thus critical before any plan can be finalized, in our view.

As for the banks, in fact, at best can they can only study appropriate proposal that balances the interests and key consideration of various ministries. Thus, while CBRC may make its voice on this issue, banks have to respect the interests of CSRC, and their shareholders such as Huijin, MOF, and SSF.

In conclusion, we believe capital raising is largely not a short-term event. We do expect noise to persist, but we also believe investors may be tired of future news flow and still may refocus back to fundamentals. This may particularly be the case when they see potential strong loan growth in 1Q10, and when the sell-side may further revise up earnings estimates; we believe this will happen in 3 months time.

Figure 96: Political landscape of key ministries relevant to capital raising issues by state banks

State CouncilState Council

PBOCPBOC

• Set monetary policy– Interest rate– Money supply

• Provide guidance on loan growth etc

• Control inflation rate

• Wants to see appropriate loan growth

CBRCCBRC

• Supervise operational issues of china banking system.

• Ensure healthiness of Chinese banks.

Wants to see CAR increase and appropriate loan growth and control

CSRCCSRC

• Approval all capital raising activities.

• Supervise and monitor the efficiency, fairness and transparency in stock market

• Does not want to see big new share supply which may hurt stock market.

Regulators Shareholders

MOFMOF

• Set fiscal policies & accounting rules.

• Currently has stakes in BoComm and ICBC.

Protect its existing interests as shareholders in some banks, and may want more stake

• Major shareholders of China banks. • Monitor healthy and sustainable growth in banking system as major or key shareholders

• Concerned about shareholding dilution from further capita raising, and cares form of capital raising. Don’t like unnecessary capital raising.

• Huijin may need to apply to State Council for new capital to participate in equity raising

Monetary Policy Operational Supervisory Capital Market Approval Accounting Policy & Shareholders’ Interest Shareholders’ Interests

ICBCICBC

Hui JinHui Jin SSFSSFMOFMOF

CCBCCB BOCBOC BoCommBoComm Other State-Owned BanksOther State-

Owned Banks

State CouncilState Council

PBOCPBOC





PBOCPBOC





CBRCCBRC




CBRCCBRC




CSRCCSRC




CSRCCSRC




Regulators Shareholders

MOFMOF




MOFMOF




• Major shareholders of China banks. • Monitor healthy and sustainable growth in banking system as major or key shareholders

• Concerned about shareholding dilution from further capita raising, and cares form of capital raising. Don’t like unnecessary capital raising.

• Huijin may need to apply to State Council for new capital to participate in equity raising

Monetary Policy Operational Supervisory Capital Market Approval Accounting Policy & Shareholders’ Interest Shareholders’ Interests

ICBCICBC

Hui JinHui Jin SSFSSFMOFMOF

CCBCCB BOCBOC BoCommBoComm Other State-Owned BanksOther State-

Owned Banks

Source: J.P. Morgan research.

CBRC’s voice may not fully represent the central government’s consideration. The central government will probably need to take consideration of various other issues, such as stability of domestic equity market, and also importantly its interests as majority shareholders. These considerations will also determine the timing, size and form of capital raising

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Change 3: Size of capital raising depends on various options available Extracted from the note, “China Banks: Little clarity on capital raising a short-term overhang, but overreaction created a good buying opportunity," published on 30 November 2009. Please see the original note for pricing dates.

At this point, there is little clarity on the capital requirement threshold CBRC are comfortable with. While CBRC denies the Reuter’s report that it may ask bigger banks to raise capital ratio to 13% and says there is no change to current 10% CAR requirement, in various speeches by senior officials from CBRC, clearly CBRC would like to see higher capital ratios, and particularly tier-1 ratios too. Moreover, CBRC also does not make clear what tier-1 capital ratios bigger banks need to achieve. We believe CBRC also need time to communicate with other relevant ministries on this issue.

Possible short-fall to total regulatory capital is not equal to size of equity raising While generally referred as "capital raising", what market really fears is indeed equity raising. Given unclear threshold and possible objection from CSRC and government shareholders, it’s too early to determine the size of equity raising indeed. This is particularly the case given that larger banks indeed do have strong buffer to issue tier-2 debts.

Below we illustrate the calculation on shortfall in regulatory capital (tier-1 and tier-2) in various total CAR requirements.

• As seen, if CBRC really raises the total CAR requirement to 13%, the banks under our coverage may need to raise around Rmb370B through equity or tier-2 debts.

• If this CAR requirement reduces by 1% to 12%, size of shortfall would substantially decline to around Rmb160bn. The shortfall in some bigger banks mainly in CCB and BOC would be substantially lower.

• As we can also see, in fact, the shortfall in regulatory capital even in the case of 13% can be covered through tier-2 debt issuance. We believe most H-share banks (except BoComm) still have room to issue sub-debt, and other tier-2 debts (hybrid capital debt and convertibles, which largely have never been issued).

• Even though sub-debt is more costly and demand may be much less now due to restriction of cross-holding, we believe banks can still improve CAR through convertibles and hybrid capital debt (though hybrid capital debt is also more costly).

Even if total CAR is raised to 13%, there is still ample room to issue tier-2 debts. In particular, we believe the regulators should allow more issuance of convertibles, which is non-existent

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Table 42: Calculation of regulator capital shortfall to various total CAR thresholds Rmb bn ICBC CCB BOC BoComm Citic Minsheng Huaxia SPDB SZDB Total 10E RWA 6,953 6,044 6,118 2,326 1,351 1,275 528 1,225 450 27,840 memo: 10E RWA growth 15.7% 16.0% 16.9% 17.0% 18.5% 20.9% 20.3% 23.5% 22.8% 17.4% Deductions 48 16 66 2 0 1 0 1 1 147 Tier-1 capital 09E 644 486 530 159 103 94 29 70 30 2,263 Add: 2010E earnings 170 138 117 41 23 15 5 18 7 558 Minus: 2009 final &10E interim dividend 65 53 41 12 4 2 1 1 1 183 Others (chg in minority interest/revl. reserve) - 1 6 2 (1) (0) (0) (0) (0) 7 Tier-1 capital 10E 749 571 612 190 121 107 33 86 36 2,645 Tier-2 Capital 202 140 166 87 21 26 19 33 16 759

among which: General Provision 123 70 78 24 8 13 8 18 6 367 Revaluation reserves/others 4 11 14 0 0 2 0 -4 1 28 Others 0 0 0 10 0 0 0 0 0 10 Existing sub-debt 75 60 74 53 12 2 6 19 8 339 Existing hybrid capital debt 0 0 0 0 0 9 4 0 2 15

10E CAR if no more tier-2 debt issuance 13.0% 11.5% 11.6% 11.8% 10.5% 10.3% 9.8% 9.6% 11.3%

New regulatory capital needed for 13% CAR 1 91 83 27 34 34 17 42 8 363 New regulatory capital needed for 12% CAR 0 30 22 4 21 21 11 29 3 152 New regulatory capital needed for 11% CAR 0 0 0 0 7 8 6 17 0 39 Subdebt buffer (max 25% of tier-1) 112 83 79 - 18 25 2 3 1 328 Other tier-2 debt buffer (max 25% of tier-1) 187 143 153 48 30 18 4 21 7 647 New capital needed after all tier-2 buffer 0 0 0 0 0 0 10 17 0 28 Source: J.P. Morgan estimates.

As discussed, however, clearly CBRC is focusing more on equity capital. The table below highlights the size of potential equity raising in three scenarios. In our view, however, investors may look at second and third scenario. In the third scenario, a 10% tier-1 ratio is more than enough to boost total CAR to above 13%. Investors should not forget Chinese banks have a good amount of general provision on their balance sheet.

Table 43: Equity shortfall in various scenarios 2010E ICBC CCB BOC BoComm Citic Minsheng Huaxia SPDB SZDB Total

10E tier-1 before deduction 10.2% 9.2% 9.7% 8.0% 9.0% 8.9% 6.6% 6.9% 8.1% 10E General provisions/other reserves as % of RWA 1.8% 1.3% 1.5% 1.5% 0.6% 1.1% 1.6% 1.2% 1.4% 1.5% Tier-1 needed at 13%CAR if tier-2 at 25% of tier-1 8.9% 9.3% 9.2% 9.2% 9.9% 9.5% 9.1% 9.5% 9.3% 9.2% Scenario 1: equity shortfall to 13%CAR & tier-2 max at 25% of tier-1 - 12 3 26 13 15 15 31 7 138 Scenario 2: equity shortfall to 12% CAR & no more tier-2 debt issue - 37 22 4 21 21 11 29 3 91 Scenario 3: Equity shortfall to 10% tier-1 ratio - 44 5 42 14 21 19 37 9 219 Source: J.P. Morgan estimates.

Although quite unlikely in our view, should CBRC also allow full utilization of tier-2 buffer, Chinese banks can increase their total CAR quite significantly by approximately 3.5ppt on weighted average, boosting total CAR to about 15% on weighted average. This is particularly the case for the few largest banks. As seen in the figure 3 below, this would also probably make the sector’s total CAR as high as some other very well capitalized banking sectors in the region which are also among the highest globally.

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Table 44: Theoretical maximum total CAR reachable through tier-2 debt issuance ICBC CCB BOC BoComm Citic Minsheng Huaxia SPDB SZDB

10E Tier-1 Ratio 10.3% 9.3% 9.5% 8.1% 9.0% 8.4% 6.3% 7.0% 7.9% 10E General provisions/other reserves 1.8% 1.3% 1.5% 1.5% 0.6% 1.1% 1.6% 1.2% 1.4% Existing tier-2 debts as % if 10E RWA 1.1% 1.0% 1.2% 2.3% 0.9% 0.9% 1.9% 1.5% 2.1% 10E CAR without more tier-2 debt issue 13.0% 11.5% 11.6% 11.8% 10.5% 10.3% 9.8% 9.6% 11.3% Additional max tier-2 buffer 4.3% 3.7% 3.8% 1.8% 3.6% 3.3% 1.2% 2.0% 1.9% Theoretical max 10E CAR reachable 17.3% 15.2% 15.4% 13.6% 14.1% 13.7% 11.0% 11.6% 13.1% Source: J.P. Morgan estimates.

Banks may have various options In our view, it’s also premature to be cautious as investors also do not know the form of capital raising. This could be tier-2 debt and equity raising, a cut in dividend or a combination. Even if there is equity raising, it may not straight secondary offering and indeed could be rights issue, which in our view, is an ideal solution.

• As we discussed earlier, indeed there are theoretically enough buffer for many banks, especially the largest few state-controlled banks and Citic Bank to issue tier-2 debts. While sub-debt issuance to other banks is strongly discouraged by CBRC and could be difficult going forward , a small placement of such debt to insurance companies and other market fixed-income investors is still possible, though at higher yield. In addition, importantly, hybrid capital debt, and convertibles can also be considered.

• Dividend payout ratio does not need to be maintained. The expected strong earnings growth in 2010 may support a possible small cut in dividend payout, which should be acceptable to investors. Remember the state-controlled banks’ dividend policy is “steady dividend growth policy" rather than a fixed payout policy. With over 30% earnings growth expected in 2010, payout ratio could be slightly cut but still within the targeted payout ratio range indicated during their IPOs.

• In some cases, RWA has room to be lowered. For example, Bank of China indicated it may be able to reduce its RWA through some change to legal terms of its off-balance sheet exposures and assign more precise risk weighting to some off-balance sheet items than that is used in their conservative and rough approach. Thus even in the case of equity raising, size may not be as big as some market investors or media like Reuters speculated.

• Even in the case of equity raising, it may not all through straight secondary offering as market has feared. In our view, rights issue is not only likely but also the best solution to protect all stakeholders' interests, including various ministries and thus the central government, as well as market investors.

Rights Issue is the best solution to reconcile the interests of various stakeholders In our view, rights issue is the best solution because:

• It helps boost banks' tier-1 and total Capital ratios that CBRC is looking for.

• Given participation of government majority shareholders, the majority of funds of new capital would come from the government, thus reducing the needs from market. This substantially alleviated the pressure of new share supply and thus

We believe a combination of tier-2, and rights issue in both A and H shares are ideal solutions

Investors have appeared to be focusing on BOC’s potential capital raising, which is probably overdone. In our view, BOC indeed has room to cut RWA and so the size of any potential equity raising may also not be as big

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may be a positive surprise to the market which has worried about new papers. This option thus could also be acceptable to CSRC.

• In rights issue, importantly, all shareholders including the government majority shareholders such as Huijin, SSF, and MOF are not diluted, and importantly, given this is not balance sheet repair capital, it may not change or at least will minimize the impact on the upside to EXISTING shareholders or investors. Note in the case of rights issue, although fair value per share will be lower, given rights issue typically are priced at a big discount to market price, it also lowers the existing shareholders’ holding costs. (see below a detailed analysis)

• Similar to government majority shareholders, minority shareholders and market investors' interests are also protected: 1) There is no dilution to their percentage stake. 2) The pressure on market will also be much lower given that government participation means much less need for money from the market. 3) There is also largely no material change to upside in medium-term, after adjusting their current holding costs and number of shares held.

Rights issue: Hypothetical scenario analysis for BoComm We illustrate below in detail why in the case of a hypothetical rights issue scenario, medium/longer-term investors’ interest are largely protected, despite some short-term impact which has been more than reflected through the share price decline.

Given already lower tier-1 ratios and relatively high tier-2 in total capital, we believe BoComm does not have much room to boost capital through tier-2 debt issuance. Assuming no change in dividend policy, and assuming our expected loan growth of 19% (Rmb360bn), we estimate it needs around Rmb30bn to get total CAR to assumed target of 13%. This implies a tier-1 of 9.4% from otherwise 8.1% estimated for 2010 year end. Such money would be split between A-share and H-shares.

Table 45: Hypothetical rights issue scenarios for Bank B. Disc. To Price Price

Net Proceeds

No of new shares

% of current

Offer Size

Offering P/PPoP

Tier-1 ratio CAR

curt. price HKD RMB 10E 11E US$ bn （Bn） share

capRmb bn

Total A-shares

H-shares 10E 11E 10E 11E 10E 10E 11E 10E 11E 10E 10E

(49%) 4.5 3.97 0.99 0.76 4.30 7.56 15.4% 30.0 4.39 2.32 2.07 5.0 4.2 3.1 2.5 21.2 4.00 5.20 0.79 0.94 9.4% 13.0%(43%) 5.0 4.41 1.09 0.84 4.30 6.81 13.9% 30.0 4.39 2.32 2.07 5.6 4.6 3.4 2.7 21.2 4.05 5.27 0.79 0.95 9.4% 13.0%(38%) 5.5 4.85 1.18 0.91 4.30 6.19 12.6% 30.0 4.39 2.32 2.07 6.1 5.1 3.7 3.0 21.2 4.10 5.32 0.80 0.96 9.4% 13.0%(32%) 6.0 5.29 1.28 0.98 4.30 5.67 11.6% 30.0 4.39 2.32 2.07 6.6 5.5 4.0 3.3 21.2 4.13 5.37 0.80 0.97 9.4% 13.0%(26%) 6.5 5.73 1.37 1.06 4.30 5.24 10.7% 30.0 4.39 2.32 2.07 7.1 5.9 4.3 3.5 21.2 4.17 5.42 0.80 0.98 9.4% 13.0%(21%) 7.0 6.17 1.47 1.13 4.30 4.86 9.9% 30.0 4.39 2.32 2.07 7.6 6.3 4.7 3.8 21.2 4.20 5.46 0.81 0.98 9.4% 13.0%(15%) 7.5 6.61 1.57 1.20 4.30 4.54 9.3% 30.0 4.39 2.32 2.07 8.2 6.7 5.0 4.0 21.2 4.22 5.49 0.81 0.99 9.4% 13.0%

(9%) 8.0 7.05 1.66 1.28 4.30 4.26 8.7% 30.0 4.39 2.32 2.07 8.7 7.1 5.3 4.3 21.2 4.24 5.52 0.81 0.99 9.4% 13.0%(4%) 8.5 7.49 1.76 1.35 4.30 4.00 8.2% 30.0 4.39 2.32 2.07 9.2 7.5 5.6 4.5 21.2 4.26 5.54 0.81 1.00 9.4% 13.0%2% 9.0 7.93 1.85 1.42 4.30 3.78 7.7% 30.0 4.39 2.32 2.07 9.7 7.9 5.9 4.8 21.2 4.28 5.57 0.82 1.00 9.4% 13.0%

Offer Size (US$bn)P/B Offering PEROAE

(%)BPS

(RMB)EPS

(RMB)


Assuming a Rmb30B rights issue, and assuming a worst-case scenario, this is largely also not growth capital, then its fair multiple would decline given a lower ROE. We estimate this would decline from our current fair terminal PB value of 2.47x to 2.17x, as sustainable ROE would decline to 17.4% from 19.6% due to lower leverage. As a result, its fair value per share would decline depending on rights offering price.

However, if there is no such capital raising, for existing investors who already held BoComm as of Monday last week (when news [source: Reuters] started to circulate), then the upside as of that date to our Dec-10 fair value would be nearly 33%.

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As subsequent days’ share price declines, if an investor got in the stock at Friday’s close price, after adjusting for hypothetical rights issue, an existing investor indeed would have slightly more total return than he/she would have by Monday, taking into account of lower holding costs and more total number of shares after rights issue.

In fact, the investors would have the same upside by Thursday close (HK$9.18) if a rights issue is confirmed, as compared with his/her potential return as of last Monday’s close HK$9.8 and no capital raising is planned.

Table 46: Comparison of upside for shareholders, prior to announcement and current level

Offering

size Price New shares % of current

SO Sustainable

ROE

Fair terminal

PB Fair value Holding

cost % upside

Return for total

holding Rmb bn HK$ bn % HK$ HK$ HK$

Prior to news - - - 0% 19.6% 2.47x $13.0 9.8 32.7% 3.20 Rights issue 30 4.5 7.56 15.4% 17.4% 2.17x $11.3 8.2 36.7% 3.49 Rights issue 30 6.0 5.67 11.6% 17.4% 2.17x $11.6 8.5 36.6% 3.48 Rights issue 30 7.0 4.86 9.9% 17.4% 2.17x $11.8 8.6 36.5% 3.47 Source: J.P. Morgan estimates.

If there is ordinary secondary offering, downside already priced in If there is no rights issue, we believe downside has already been priced in. As we discuss, given the capital raising is probably 12 months away at minimum in most cases for H-shares banks, and that these banks are still growing their balance sheet and profits steadily, one cannot use the current price as reference.

In the above BoComm’s case, assuming they raise Rmb30B at around current price (1.85x 10E PB, and 8x 2011E PE), then without additional growth, fair value per share would be still HK$12. The decline from Tuesday to end of Thursday largely already reflected such change in fair value.

Information China Minsheng Banking H-share offering On November 18, 2009, China Minsheng Banking Corp (600016 CH/1988 HK) raised US$3.86 billion in its Hong Kong initial public offering, priced at HK$9.08 per share. We believe Minsheng is a volume growth opportunity, but in line with medium-sized peers. While it was one of the fastest growing banks in China, growth has stabilized since 2006. We expect its volume growth to be in line with key medium-sized banks peers, though still above state banks.

Investment case and risks: Key positives: (1) Commercial culture and tradition for changes—“Business units reform” is ahead of other banks and shall improve revenue generation and credit pricing; (2) rapid growth in retail banking and strong cross-selling to its SME customers; and (3) benign credit quality trend and centralized credit risk management/loan management. Key challenges: (1) a high cost base that is unlikely to improve materially in next 2 years; and (2) need to keep strong deposit growth.

Key comparable should be Citic and SPDB, not other H-share banks. Minsheng is very different to most H-share banks in terms of size, branch network, funding franchise, retail penetration and more importantly underlying profitability. Even compared with Citic and SPDB, to which Minsheng is similar in above aspects,

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Minsheng is slightly inferior due to lack of parent support, less retail penetration than Citic and less favorable funding mix and less favorable operating/credit cost profile than SPDB.

We derived our DDM-based Dec-10 PT of Rmb9.4, which implies a P/BV of 2.0x and P/E of 14.5x (FY10E). Our PT suggests a sustainable RoE of 15.6%, cost of equity of 11.4%, and a long-term growth rate of 6.5%. Key risks to our PT are unexpected major headwinds in the domestic economy and failure to keep up deposit growth.

Stock recommendations We believe China Citic Bank is one of the banks with the strongest earnings and ROE momentums in the sector with a 30% upside potential. We initiated coverage with an Overweight rating and our Dec-10 PT of HK$8.60 and added it to our Asia Analysts’ Focus List. Our price target is based on DDM. We use a fair P/BV-based multiple of 2.15x, with a normalized ROE of 16.6%, assuming a risk-free rate of 5.3%, cost of equity of 11.2%, and a terminal growth rate of 6.5%. Key risks to PT are unexpected significant equity capital raising and a substantial slowdown in deposit growth. We believe the earnings leverage potential in Citic-H is not fully discounted. Although the shares have nearly tripled YTD, we believe more re-rating lies ahead, given a >500bp gain in ROE in FY10E—the highest ROE uplift in the sector based on our forecasts. Our FY10/FY11 EPS estimates are 25%/28% above consensus, and we peg FY09-FY11E EPS CAGR at 38%. The stock is one of our top 2 picks for 1H10.

Investment positives: 1) NIMs are relatively more leveraged than many peers to rising interest rates. 2) Underlying profitability has improved significantly and is now in line with some state-controlled banks and higher than most medium-sized banks. 3) Rapid growth in retail banking, with particular success in wealth management and credit cards. 4) Strong support from the parent’s integrated financial services platform, which has led to more cross-selling and a larger client base. 5) Potential stake increase by BBVA should support confidence in Citic’s earning prospects.

Major weakness and challenges: 1) Lower exposure to mortgages, and medium- and loan-term project loans. The portion of collateralized loans has traditionally been lower. 2) Deposit franchise is still mainly based on corporate accounts—needs to be diversified. 3) Since 1H09, credit card delinquency has picked up notably. While the amount of NPLs remains small relative to total loans, further delinquencies in the card portfolio could postpone an overall recovery in credit costs.

Our Dec-10 PT of HK$8.6 implies 30% upside: We believe Citic-H should trade at a slightly lower P/BV than most H-share banks (except for BOC-H). However, our Dec-10 PT still suggests 30% upside from the current level. Our DDM-based Dec-10 PT of HK$8.6 implies 2.4x FY10E P/BV and 12.7x FY10E P/E.

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Financials: Insurance China Insurance Sector: Premium growth, VNB and investment returns have room for positive surprise in 2010 (This note was originally published on November 16, 2009; please see the original note for pricing dates)

• Accumulate at “three lows”: The China insurok.ance sector is currently operating in a “three-low” environment – low premium growth, low equity investment, and low interest rates, which caused the underperformance relative to banks YTD. We expect investment yields and premium growth to largely bottom out in 2009. Our positive bias remains on life insurance in 2010, with China Life as our top pick.

• Key catalysts in 2010: We expect life premium growth, particularly for China Life, to return to c15% in 2010, driven by an increase in individual agents and as a result of the premium restructuring campaign this year. This should drive VNB growth by 24%-27% in 2010. In the next 12-18 months, the LT investment assumption could be revised up to 6.0% (from 5.0%-5.5% now) if the investment scope is broadened to real estate and other sectors. A 10% increase in investment assumption would increase EV by 8.1% for China Life and 12.2% for Ping An, by our estimates.

• Valuations premium likely to persist: Chinese insurers are never cheap, in our view, and they will remain “not cheap” given their smaller market representation (7% of financial assets only versus 17% in developed markets) and faster premium growth (than loan growth). Insurers in Asia ex-Japan have consistently traded at a higher P/Es and P/BVs than banks. We believe there is still upside to the current 2.5x EV for Chinese life insurers.

• We raise our price targets: We increase our Dec-10 PT for China Life Insurance to HK$45.0 (from HK$35.1), for Ping An Insurance to HK$81 (from HK$64), and for PICC Property & Casualty to HK$4.6 (from HK$3.9) by rolling over our revised EV and VNB forecasts. We also revise our 2010 EPS forecasts – up by 11.0% for China Life and 0.5% for Ping An, but down by 4.6% for PICC.

• Key risks to our PTs: China Life: lower-than-expected premium growth and major regulatory changes. Ping An: slower-than-expected premium growth, and execution risk in integrating SZDB. PICC: stronger-than-expected underwriting income and premium growth.

Table 47: China insurance sector's valuation summary Price Dec-2010 P/EV P/AV Implied new biz P/E P/BV Reuters Rating 16-Nov-09 Price target FY09E FY10E FY09E FY10E FY09E FY10E FY09E FY10E FY09E FY10E HK$ HK$ x x x x x x x x x xChina Life 2628.HK OW 39.10 45.0 3.2 2.6 1.2 1.0 36.6 25.4 31.0 26.4 4.4 3.7 Ping An 2318.HK N 73.60 81.0 3.0 2.5 1.1 0.9 26.9 19.2 45.2 33.9 4.6 3.9 PICC 2328.HK UW 6.03 4.6 NA NA NA NA NA NA 278.8 50.8 2.4 2.0 Source: Bloomberg, Company reports and J.P. Morgan estimates.

Michael ChanAC (852) 2800-8592 [email protected]

Joseph Leung (852) 2800-8517 [email protected]

Sunil Garg (852) 2800-8518 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

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Raising our price targets Table 48: Raising our price targets for Chinese insurers

Price target (HK$) Methodology New Old Chg.

China Life 45.0 35.1 28.2% Based on appraisal valuation using a 27x new business multiple. Ping An 81.0 64.0 26.6% Based on SOTP with a 10% holding company discount, valuing life

insurance on appraisal value using 28x new biz multiple, P/BV valuation for banking (2.0x) and P&C (1.5x), and P/E (8x) for other businesses.

PICC 4.6 3.92 17.6% Based on DCF of free cash flow. Source: J.P. Morgan estimates.

Key risks to our PTs: China Life: Lower-than-expected premium growth and major regulatory changes. Ping An: slower-than-expected premium growth, and execution risk in integrating SZDB. PICC: stronger-than-expected underwriting income and premium growth.

Major revisions to EPS and actuarial estimates Table 49: Revisions to earnings and actuarial estimates Rmb

China Life Ping An PICC 2009E 2010E 2009E 2010E 2009E 2010E

EPS (New) 1.11 1.28 1.43 1.88 0.02 0.10 EPS (Old) 1.00 1.16 1.40 1.87 (0.02) 0.11 Revision, % 10.6% 11.0% 2.2% 0.5% nm -4.6%

ROE, % (New) 15.6 15.2 11.3 12.4 0.91 4.30 ROE, % (Old) 14.1 13.8 11.1 12.4 -1.12 4.51 Revision, % 10.9% 10.1% 2.1% 0.3% nm -4.6%

DPS (New) 0.33 0.38 0.29 0.47 0.00 0.06 DPS (Old) 0.30 0.35 0.28 0.47 0.00 0.06 Revision, % 10.6% 11.0% 2.2% 0.5% nm 0.0%

Value of new business (New) 0.64 0.81 1.59 1.97 na na Value of new business (Old) 0.58 0.69 1.50 1.76 na na Revision, % 10.2% 17.2% 6.2% 12.1% na na

Embedded value (New) 10.80 13.18 21.85 25.80 na na Embedded value (Old) 10.44 12.50 21.76 25.55 na na Revision, % 3.4% 5.5% 0.4% 1.0% na na Source: J.P. Morgan estimates.

Stock picks - China Life still our top pick China Life (2628.HK, Overweight) China Life remains our top pick in the sector. Our Overweight rating is predicated on the following: 1) the premium restructuring campaign this year by focusing on sales of long-term regular premium risk products (five-year and 10-year in particular) should result in strong growth in embedded value and value of new business (>30%) with expansion in new business margins; 2) the premium growth trend is expected to return to positive growth in 2010 with the restructuring completed and an increase in life insurance sales driving new business growth. China Life should have the least impact on premium growth under the new accounting standard for premium recognition; and 3) the group's investment strategy is conservative but is also swift to respond to market opportunities. The increase in equity investment in 1H09 to 13.3% was a positive surprise to the market.

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Ping An Insurance (2318.HK, Neutral) We maintain our Neutral rating on Ping An. Our rationale is based on the following: 1) the top-line premium momentum is likely to weaken after an exceptionally strong 2009; 2) the insurance-led financial model is untested in China and by increasing banking exposure through the acquisition of Shenzhen Development Bank (SZDB) may result in a reduction in overall valuation for the group as banks tend to trade at lower multiples than insurance companies in China; and 3) the risk of a potential equity raising exercise is still on the horizon.

PICC (2328.HK, Underweight) Although top-line premium growth is likely to remain robust in 2010 driven by car sales in China, we continue to worry about underwriting profitability and volatility in the annual earnings. Fundamentally, it is hard to get excited about PICC with its low ROE and a tendency to surprise in underwriting results. The competition in the P&C market remains intense with premium rates falling for most non-motor insurance lines. One of the main positives of PICC is its potential restructuring angle as its parent seeks an A-share listing.

Table 50: Positive and negative drivers of the Chinese insurers Positive Negative

China Life 1) Top line premium growth back to positive growth in 2010. 1) Relatively high valuations. 2) Double-digit growth in EV, NBV plus expansion in new biz margin. 2) Perceive as state-owned management style. 3) Increase of life agents to one million over next three years. 3) Potential market share erosion by banks in the medium-term. 4) Conservative yet opportunistic investment strategy. 4) Increasing competition in Tier-2 cities and rural area. 5) Potential strategic investment in domestic banks.

Ping An 1) Starting to be more active in Tier-2 and rural markets. 1) Top line premium growth is likely to weaken in 2010. 2) Positive earnings momentum in 2010. 2) Compression in new business margins due to competitive rates. 3) Acquisition of SZDB will boost banking exposure. 3) Potential share placements. 4) Early mover advantage in real estate investments. 4) Execution risk in SZDB acquisition. 5) A diversified financial model. 5) Re-classification of insurance premium.

PICC 1) Improved capital position after the Rmb5 billion sub-debt issue. 1) Potential competition from alternative distribution channels. 2) Continued regulation on solvency should restrain excessive competition. 2) The stake owned by AIG remains an overhang. 3) Strong car sales will continue to drive premium growth. 3) Volatile earnings track record and poor underwriting results. 4) Potential restructuring of parent and group companies. 4) Lowest ROE but highest valuation in the region.


Valuation summary Table 51: Chinese insurance sector valuations

China Life Ping An PICC 2009E 2010E 2011E 2009E 2010E 2011E 2009E 2010E 2011E

P/EV (x) 3.2 2.6 2.1 3.0 2.5 2.1 n.a. n.a. n.a. P/E (x) 31.0 26.4 23.3 45.2 33.9 26.4 278.3 50.8 16.2 P/B (x) 4.4 3.7 3.2 4.6 3.9 3.3 2.4 2.0 1.8 Implied new business multiple (x) 36.6 25.4 18.1 26.9 19.2 13.4 n.a. n.a. n.a. ROE (%) 15.6 15.2 14.7 11.3 12.4 13.5 -1.1 4.5 11.9 Source: J.P. Morgan estimates.

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Table 52: Key operating trends for China Life and Ping An 2008 2009E 2010E 2011E

Value of 1-year sales, Y/Y % China Life 15.6% 30.2% 26.7% 18.8% Ping An (Life) 18.8% 36.6% 23.9% 22.3%

Embedded value, Y/Y % China Life -4.9% 27.2% 22.0% 19.8% Ping An (Life) -5.1% 41.8% 23.1% 21.3%

Shareholders' funds, Y/Y % China Life -12.1% 21.9% 17.0% 13.7% Ping An -25.8% 23.4% 17.0% 15.1%

New business margin (on FYP), % China Life 43.0% 50.1% 49.4% 49.6% Ping An 19.6% 16.4% 15.9% 15.1%

New business margin (on APE), % China Life 21.5% 26.7% 28.5% 29.4% Ping An 38.2% 35.3% 33.1% 31.8% Source: Company reports and J.P. Morgan estimates.

Underperformance relative to banks Chinese insurers have underperformed the Chinese banks YTD. We believe one of the key factors for the underperformance relates to the weak headline premium growth versus loan growth in 2009. China Life has underperformed Ping An YTD, again for the reason of slower premium growth. We expect performance of the insurance sector to improve with premium growth returning to double-digit growth in 2010.

Table 53: Sector performance: China insurance vs. China banks % YTD 1M 3M 6M 12M Insurance 73.6% 9.2% 18.7% 38.5% 95.0% Banks 86.1% 9.8% 26.3% 49.1% 93.1% Difference -12.5% -0.6% -7.5% -10.6% 1.9% China Life – H 66.0% 8.8% 19.2% 39.4% 84.0% Ping An - H 95.7% 10.3% 18.9% 38.5% 115.9% Difference -29.7% -1.5% 0.3% 0.9% -31.9% HSI 59.5% 4.9% 12.9% 30.8% 64.7% MSCI China 48.2% 1.9% 11.9% 30.9% 75.2% Source: Bloomberg and J.P. Morgan. Note: China banks include ICBC, BOC, CCB, BOCOM, CMB and Chinese insurers include China Life, Ping An and PICC.

Figure 97: China: Insurance premium growth vs. Loan growth %, Y/Y

0.05.0

10.015.020.025.030.035.040.045.0

2006 2007 2008 2009E 2010ELoan growth Premium growth

Source: CIRC, Company reports and J.P. Morgan estimates.

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Global insurance sector valuations Table 54: Global peer valuations

Source: Bloomberg, Company reports and J.P. Morgan estimates. Bloomberg consensus estimates for non-rated companies.

Key catalysts for Chinese insurers in 2010 Apart from the performance in the A-share market and the interest rate trends in China that are key to the insurance sector next year, we expect there will be at least three major sector-specific catalysts that should drive the insurance sector next year.

Premium growth should rebound in 2010 After a very strong year driven by bancassurance sales in 2008, premium growth in China in 2009 has been largely consolidating, with premium growing by 4.0% January-September this year due to business restructuring. Among the major insurers, China Life is more negatively affected this year as the company turns its focus to growing policies with a duration of five and 10 years.

We expect life premium growth to pick up in 2010 in China due to the following:

• The business shift from a single-premium and bancassurance-centric strategy to a long-term regular premium business (five years and 10 years) is likely to be largely complete in 2009. This should remove the drag on premium growth.

16-Nov-09 Price Bloomberg Mkt cap P/EV (x) P/E (x) P/BV (x) Yield (%) ROE (%)(LC) Code Rating US$m FY09e FY09e FY10e FY09e FY10e FY09e FY10e FY09e FY10e

Australia QBE 22.51 QBE AU N 21,513 n.a. 10.1 10.0 2.0 1.9 5.9 6.2 21.3 19.8Suncorp 8.99 SUN AU OW 10,660 n.a. 13.2 9.4 0.7 0.7 1.4 1.4 7.0 8.1IAG 4.07 IAG AU UW 7,894 n.a. 13.8 12.5 1.7 1.7 5.5 5.5 11.7 12.7AMP 6.41 AMP AU N 12,252 1.7 14.6 13.1 5.1 4.9 6.2 6.4 33.6 35.6AXA Asia Pac 5.99 AXA AU 11,552 1.9 19.8 22.0 2.8 2.7 3.8 4.2 19.2 19.2

Taiwan Cathay FHC 61.50 2882 TT N 18,503 2.8 75.4 22.7 3.0 2.7 0.9 3.1 4.6 12.3Shinkong FHC 14.40 2888 TT UW 3,278 3.4 203.7 71.4 1.4 1.4 0.6 1.1 0.7 2.0Fubon FHC 38.80 2881 TT OW 9,741 2.3 14.7 11.6 1.7 1.6 4.1 5.2 13.0 14.0

China China Life 39.10 2628 HK OW 134,720 3.2 31.0 26.4 4.4 3.7 1.0 1.1 15.6 15.2Ping An 73.60 2318 HK N 67,781 3.0 45.2 33.9 4.6 3.9 0.4 0.7 11.3 12.4PICC 6.03 2328 HK UW 8,669 n.a. 278.3 50.8 2.4 2.0 0.0 0.8 0.9 4.3CIIH 27.20 966 HK NR. 5,974 3.6 41.6 33.3 6.2 5.1 0.2 0.4 16.0 16.3CPIC 26.88 601601 CH NR. 30,317 3.0 38.2 34.2 3.9 3.0 0.9 1.0 8.4 8.3

Korea Samsung F&M 219,000 000810 KS OW 8,983 1.4 14.4 13.2 1.8 1.6 n.a. n.a. 13.0 12.8Dongbu Insurance 33,450 005830 KS OW 2,050 n.a. 7.1 6.5 1.3 1.1 1.2 1.3 20.5 18.2Korean Re 10,100 003690 KS OW 997 n.a. 5.8 5.6 1.0 0.9 3.2 3.5 15.2 17.8Hyundai M&F 19,500 001450 KS N 1,509 n.a. 6.6 n.a. 1.2 n.a. 2.1 n.a. 18.9 n.a.LIG Insurance 22,800 002550 KS OW 1,184 n.a. 6.0 n.a. 1.1 n.a. 2.4 n.a. 19.5 n.a.Meritz Insurance 7,460 000060 KS OW 800 n.a. 7.6 6.3 1.3 1.2 3.4 4.0 17.3 18.7

U.K. Aviva 409 AV/ LN OW 18,632 0.7 8.8 8.1 2.6 2.5 8.1 8.1 9.2 13.6Prudential 617 PRU LN OW 26,005 1.1 11.0 9.3 3.2 3.0 0.0 3.1 15.1 12.6Legal & General 86 LGEN LN UW 8,395 0.7 10.4 8.3 1.1 1.1 8.6 8.6 2.3 7.1Royal & SunAlliance 122 RSA LN OW 6,836 1.1 9.0 8.7 1.1 1.1 6.5 6.7 12.4 12.2

Europe Allianz 85.10 ALV GR OW 57,873 1.8 12.0 8.2 1.2 1.1 4.1 4.7 9.5 14.1

AXA 16.46 CS FP N 55,728 0.9 9.1 10.4 0.9 0.9 0.0 2.4 10.9 8.3GENERALI 18.25 G IM NR 42,337 1.0 15.1 11.0 2.2 2.2 2.2 3.3 11.0 14.2

Canada Manulife 20.07 MFC CN NR 31,067 0.7 23.7 9.5 1.2 1.1 3.8 2.6 5.4 12.4

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• Renewal business should naturally pick up following the increase in regular premium business in 2009.

• Increase in individual agents by the main insurance companies including China Life and Ping An. China Life is targeting to increase its life insurance salesforce to one million in the next three years.

Table 55: Premium growth trends for China Life and Ping An Year-on-year, %

2008 2009E 2010E 2011E Based on PRC GAAP: Total premium growth China Life 51.2% -3.1% 15.7% 14.7% Ping An (Life) 29.1% 33.0% 23.4% 21.1%

Regular premium growth - FYP China Life 21.5% 13.7% 20.5% 16.2% Ping An (Life) 30.2% 45.5% 33.6% 27.2%

Single premium growth - FYP China Life 101.4% -21.5% 11.2% 10.2% Ping An (Life) 52.8% 66.0% 23.5% 29.2%

Total FYP growth China Life 75.0% -13.4% 14.0% 12.2% Ping An (Life) 42.1% 57.0% 27.6% 28.3%

Based on HK GAAP or IFRS: Total premium growth China Life 20.9% 16.0% 20.8% 18.4% Ping An (Life) 18.3% 17.7% 12.5% 12.1%

Regular premium growth - FYP China Life 24.3% 12.4% 29.2% 18.9% Ping An (Life) 26.1% 28.6% 23.0% 25.0%

Single premium growth - FYP China Life 7.9% 1.8% 17.8% 7.5% Ping An (Life) 33.1% 15.3% 4.8% -7.3%

Total FYP growth China Life 23.1% 11.7% 28.5% 18.2% Ping An (Life) 28.3% 24.2% 17.4% 16.1% Source: Company reports and J.P. Morgan estimates.

China Life is likely better than Ping An in terms of premium trends China Life should see a recovery in premium growth in 2010 after contracting in 2009 due to the business campaign to restructure the business mix. Ping An is likely to see a moderation in its premium growth in 2010 after an outstanding year in 2009. From a trading standpoint, the momentum in premium growth is likely to be more positive for China Life than for Ping An.

China Life has higher agent productivity Both China Life and Ping An are aiming to increase their life insurance salesforce over the next several years, particularly China Life, which aims to increase its salesforce from approximately 740,000 at present to about one million over the next three years. Compared to Ping An, China Life has been relatively slow in adding new

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individual agents. The total number of individual agents in China Life has only increased by approximately 15% since 2005, while that of Ping An Life has risen by almost 100% during the same period. This also explained traditionally faster premium growth at Ping An.

Figure 98: Total number of individual life agents No. of agents

640,000

650,000

638,000

676,000

716,000

740,000

200,193

205,437

301,801

315,000

355,852

393,576

0 500,000 1,000,000 1,500,000 2,000,000 2,500,000

2005

2006

2007

1H08

2008

1H09

Life industry China Life Ping An Life

Source: CEIC and company reports.

Figure 99: Number of agents as a percentage of total pool % of total

48% 47%36% 32% 35% 31%

15% 15%

17%16% 16% 17%

0%

10%

20%

30%

40%

50%

60%

70%

2005 2006 2007 1H08 2008 1H09

China Life Ping An Life

Source: Company reports and J.P. Morgan.

Based on first-year premiums (FYP), China Life appears to have higher productivity per agent than Ping An. This is also true if we take the total premium income per agent.

Figure 100: Agent productivity (based on FYP) Rmb

050,000

100,000150,000200,000250,000300,000350,000400,000450,000

2005 2006 2007 1H08 2008 1H09


Source: Company reports and J.P. Morgan estimates.

Figure 101: Agent productivity (based on total premium income) Rmb

0

100,000

200,000

300,000

400,000

500,000

600,000

2005 2006 2007 1H08 2008 1H09



Investment in the real estate sector Further broadening of investment channels should be a positive catalyst for the sector because it would improve the long-term investment returns of the insurers. The recent change to expand the investment in corporate bonds including issues by H-shares and red-chips to 40% from 30% of total assets is long-term positive as yields are above 4.5% at five-year or above. The next in the pipeline that may be relaxed by the CIRC includes property investments and further relaxation in overseas investments. In Asia, real estate investments by insurers are common. In countries like Australia, Korea, and Taiwan, the insurance companies have approximately 5%-10% of their total assets invested in the real estate sector. We expect if Chinese insurers were to invest in properties and broaden their investment in infrastructure,

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the long-term investment assumption has the potential to increase to 6.0% from 4.5%-5.0%, at present. This would have a notable positive impact to their embedded value (see next section for more details).

Figure 102: Real estate investment in Asia % of total investments

0%2%4%6%8%

10%12%

FY04 FY05 FY06 FY07 FY08 FY09

Taiw an Korea Australia

Source: Company reports.

Figure 103: Potential investment in real estate by Chinese insurers Rmb in billions

3,342

2,400

167

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Total assets in sector, FY08 Total inv estment in sector, FY09E Real estate as % of total assets

5% of total assets,7% of total inv estment

Source: CIRC and J.P. Morgan estimates.

Potential changes to long-term investment assumptions Our long-term investment assumption for the Chinese life insurers is averaging about 5.0% at present. Based on final results for FY08, the life insurance companies reduced their investment assumption to take into account the fall in China interest rates and bond yields. Despite the downward revisions, both China Life and Ping An continue to forecast an upward sloping trend in investment returns for the next several years. Since there are still new asset classes to be opened for investment and the fact that interest rates should have largely bottomed in China, the investment assumption trend may increase next year.

Figure 104: China Life's investment assumption %

3.5

4.0

4.5

5.0

5.5

6.0

6.5

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

2008 assumption 2007 2006 2005 2004


Figure 105: Ping An Life's investment assumption %

3.5

4.0

4.5

5.0

5.5

6.0

6.5

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

2008 assumption 2007 2006 2005 2004


We expect in the long run the investment return can improve further from the current levels assumed when more asset classes are added to the investment portfolio. We

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estimate that the long-term sustainable investment returns can reach approximately 6% for Chinese insurers from 5.0%-5.5% at present.

Table 56: Long-term investment assumption for Chinese insurers ROI % of total Attributable assumption investment returns

Equity 11.50% 15% 1.7% Bonds 4.5% 58% 2.6% Bank deposits 3.0% 10% 0.3% Infrastructure 10.0% 8% 0.8% Property 8.0% 5% 0.4% Others 6.0% 4% 0.2% LT investment assumption 100% 6.1% Source: J.P. Morgan estimates.

EV sensitivity to investments Insurance companies’ embedded value (EV) is sensitive to changes in investment assumption. We estimate that a 10% increase in investment assumption would translate into an 8.1% increase in EV for China Life and 12.2% increase for Ping An. Based on our estimated potential long-term investment assumption of 6%, if the property sector is included and an increase in infrastructure investment, the investment returns would be roughly 20% higher than the investment yield assumed at present. This would result in significant enhancement to the embedded value estimates (Table 57).

Table 57: China Life: EV sensitivity to investment Rmb in millions

LT investment yield Net worth VIF EV Chg. in EV Investment returns Base case 5.1% 153,759 113,561 267,320 0.0% +10% 5.6% 153,759 135,146 288,905 8.1% +15% 5.8% 153,759 145,939 299,698 12.1% +20% 6.1% 153,759 156,731 310,490 16.1% +25% 6.4% 153,759 167,524 321,283 20.2% +30% 6.6% 153,759 178,316 332,075 24.2% +35% 6.9% 153,759 189,109 342,868 28.3% +40% 7.1% 153,759 199,901 353,660 32.3% Source: Company reports and J.P. Morgan estimates.

Table 58: Ping An: EV sensitivity to investment Rmb in millions

LT investment yield Net worth VIF EV Chg. in EV Investment returns Base case 5.0% 36,744 52,055 88,799 0.0% +10% 5.5% 36,744 62,862 99,606 12.2% +15% 5.8% 36,744 68,266 105,010 18.3% +20% 6.0% 36,744 73,669 110,413 24.3% +25% 6.3% 36,744 79,073 115,817 30.4% +30% 6.5% 36,744 84,476 121,220 36.5% +35% 6.8% 36,744 89,880 126,624 42.6% +40% 7.0% 36,744 95,283 132,027 48.7% Source: Company reports and J.P. Morgan estimates.

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China insurers are currently at “three lows” The insurance sector in China is currently operating at three lows – low interest rates, low equity exposure, and low premium growth. This has resulted in low investment yields and low top-line growth in the sector, and helped to explain the underperformance this year relative to the Chinese banks which have at least strong loan volumes to support share price performance. We believe the insurance sector is currently at a watershed and the “three lows” will only improve from here.

Low premium growth The first low is the low premium growth in 2009, which only increased by 4.0% from January to September this year. This is largely the result of premium optimization campaign initiated by the major insurance companies this year and is unlikely to be repeated in 2010, in our view. The top-line premium growth in 2010 is likely to be stronger than 2009 with the rebasing from single and short-term policies to long-term regular business completed.

Table 59: Premium growth in China Jan-Sep 2009 FY08 Market share Premium growth, y/y Market share Premium growth, y/y

China Life 38.0% -4.6% 40.3% 50.3% Ping An Life 16.5% 33.5% 13.8% 27.8% Taikang Life 7.6% -1.8% 7.9% 68.7% CPIC Life 8.1% -6.9% 9.0% 30.4% New China Life 7.9% 10.2% 7.6% 70.8% Taiping Life 2.6% 5.7% 2.6% 19.4% Others 19.3% 8.0% 18.9% 61.6% Total 100.0% 4.0% 100.0% 48.3% Local 95.1% 3.8% 95.1% 53.2% Foreign JV 4.9% 8.9% 4.9% -8.8% Source: CEIC and J.P. Morgan estimates.

Low interest rates The second low is the low interest rate environment, which has had an adverse effect on the investment returns of the insurers this year. Except for 2003, the interest rates and bond yields in 2009 are likely to be the lowest in a decade. An increase in interest rates should improve investment returns incrementally through higher bond yields and negotiable deposit rates. Our house view is that interest rates in China will start to rise in the middle of 2010.

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Figure 106: Recurring investment yield %

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

2001 2002 2003 2004 2005 2006 2007 2008 2009eChina Life Ping An PICC


Figure 107: Total investment yield %

-5.0%

0.0%

5.0%

10.0%

15.0%

2002 2003 2004 2005 2006 2007 2008 2009E

China Life Ping An PICC


Low equity exposure The third low is the low equity exposure. At the end of June 2009, the three major insurers had a total equity investment of 7.0%-13.3%. This is considered low relative to the peak of 25% in 2007. The low equity investment and volatile A-share market have resulted in lower dividend income and capital gains this year. By comparison, the equity investments by Chinese insurance companies have appeared to converge with other Asia markets.

Figure 108: Equity investments by Chinese insurers % of total investments

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

2002 2003 2004 2005 2006 2007 2008 2009E

China Life Ping An PICC


Figure 109: China insurers used to have the lowest equity investments% of total investments

0%

5%

10%

15%

20%

25%

30%

35%

40%

2002 2003 2004 2005 2006 2007 2008 2009E

China Australia Taiwan Korea

Source: Company reports and J.P. Morgan estimates. Note: Australia is based on total shareholders' funds only. The ratio on a like-with-like basis would be a lot lower.

Premium valuations for superior growth? Chinese insurers have consistently traded at higher valuations than rest of Asia and the developed markets (Figure 110). We think the higher valuations of the Chinese insurers are likely reflecting the following:

• Higher growth market due to low penetration and increasing wealth accumulation in China.

• Scarcity value as there is a lack of life insurance companies listed in Asia.

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• Chinese insurers are high-beta and tend to be played as a proxy to the A-share market.

Figure 110: P/BV multiples: China vs. Asia vs. Developed markets x

0.01.02.03.04.05.06.07.08.09.0

10.0

2004 2005 2006 2007 2008

China Asia ex -China US/UK/JP

Source: FactSet and J.P. Morgan.

Chinese insurers are not cheap, but they could get very expensive One of the common concerns about the insurance sector is that it is not a cheap sector, by almost all valuation yardsticks. Insurers are trading at higher P/E and P/BV multiples than banks which are presumably more transparent and easier to understand. In terms of P/EV, Chinese insurers are the most expensive ones in Asia and when compared to insurers in the developed markets. In fact, the valuations of the Chinese insurers are only reaching the levels achieved at the beginning of 2007, and still far off from the peak. Although the conditions are somewhat different right now than they were in 2007, the sector has underperformed the market and the banking sector this year.

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Figure 111: P/EV x

0

1

2

3

4

5

6

7

Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09

China Life Ping An


Figure 112: Implied new business multiple x

-10.0

0.0

10.0

20.0

30.0

40.0

50.0

60.0

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Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09

China Life Ping An


Valuation versus other insurers Chinese insurance companies have the highest valuations in Asia on all yardsticks. This has been the case since their listing several years ago. We expect these premium valuations of the Chinese insurance companies will continue due to the companies’ superior growth profile. On a top-line basis, by focusing on premium growth, Chinese insurers have been growing faster than other insurers in the region during the past several years. The scarcity value also counts as there are limited fast-growing life companies in the region that are listed. The big traditional listed life companies such as Manulife and Prudential are mainly international insurance companies that do not offer a pure localized story like that of the Chinese insurers or the Korean non-life companies, in our view.

Figure 113: P/BV multiples: China vs. Asia vs. developed markets x

0.0

2.0

4.0

6.0

8.0

10.0

2004 2005 2006 2007 2008China Asia ex -China US/UK/JP

Source: FactSet.

Figure 114: Premium growth in key Asian markets %, y/y

14.1% 14.5%

24.7%

39.1%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

2005 2006 2007 2008China Korea Taiw an

Source: CEIC and J.P. Morgan.

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Insurance valuations versus banks Insurance stocks are normally less transparent than banking stocks given the long-term business nature of insurance underwriting. Apart from the fact that insurers are less understandable to the general market than banks, they are also not straightforward for investors to value because simple earnings and book value are not very relevant for young life insurance companies that are growing a lot of new premium income. In China, insurance stocks are trading at higher P/E and P/BV multiples than banks, which are generating higher ROE.

In Korea, listed insurance stocks are mainly non-life companies and therefore P/E and P/BV multiples are more relevant to compare with the banking stocks. In Korea, insurance companies have higher ROE and trade at slightly higher P/BV multiple than banking stocks.

In Taiwan, insurance companies are mainly in financial holdings structure which includes banking and other financial services. There is limited room to compare valuations between banks and insurers in Taiwan, in our opinion.

Figure 115: P/BV multiples: Insurers vs. Banks; Asia vs. Developed market x

0.0

1.0

2.0

3.0

4.0

5.0

6.0

2004 2005 2006 2007 2008

Asia Pac Banks Asia Pac Insurance

Dev eloped market Banks Dev eloped market Insurance


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Figure 116: P/E multiples: China banks vs. insurance x

0.0

20.0

40.0

60.0

80.0

100.0

120.0

Nov-0

3

May-0

4

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4

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5

May-0

6

Nov-0

6

May-0

7

Nov-0

7

May-0

8

Nov-0

8

May-0

9

CH banks CH ins

Source: Bloomberg, company reports, and J.P. Morgan estimates.

Figure 117: P/BV multiples: China banks vs. insurance x

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Nov-0

3

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6

Nov-0

6

May-0

7

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7

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8

Nov-0

8

May-0

9

CH banks CH ins


Figure 118: P/E multiples: Korea banks vs. insurance x

0.02.04.06.08.0

10.012.014.016.018.020.0

Nov-0

3

May-0

4

Nov-0

4

May-0

5

Nov-0

5

May-0

6

Nov-0

6

May-0

7

Nov-0

7

May-0

8

Nov-0

8

May-0

9

KR banks KR ins


Figure 119: P/BV multiples: Korea banks vs. insurance x

0.00.51.01.52.02.53.03.5

Nov-0

3

May-0

4

Nov-0

4

May-0

5

Nov-0

5

May-0

6

Nov-0

6

May-0

7

Nov-0

7

May-0

8

Nov-0

8

May-0

9

KR banks KR ins


Figure 120: P/E multiples: Taiwan banks vs. insurance x

0.0100.0200.0300.0400.0500.0600.0700.0800.0900.0

Nov-0

3

May-0

4

Nov-0

4

May-0

5

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5

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6

Nov-0

6

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7

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7

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8

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8

May-0

9

TW banks TW ins


Figure 121: P/BV multiples: Taiwan banks vs. insurance x

0.00.51.01.52.02.53.03.5

Nov-0

3

May-0

4

Nov-0

4

May-0

5

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6

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6

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8

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8

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9

TW banks TW ins


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Insurance looks attractive from a top-down perspective Upside to the size of the insurance sector in Asia China insurance sector remains relatively insignificant to the banking sector in China, both in terms of market cap and total assets. In fact, this inequality is common across other markets, but the skew is more acute in the emerging markets. We believe this is largely created by the fact that the bulk of the financial base in most of these markets is still predominantly bank deposits. With insurance only accounting for approximately 7% of total financial base in China by our estimates (Figure 123), we see significant upside to the size of the insurance sector.

Figure 122: Market cap of financial sector (ex-property) % of total

77%

22%

0%

87%

7% 6%

65%

22%14%

0%

20%

40%

60%

80%

100%

Banks Insurance OthersChina Asia Pac US/UK/Japan


Figure 123: Total assets of financial sector (ex-property) % of total

93%

7%0%

91%

4% 4%

71%

17%11%

0%

20%

40%

60%

80%

100%

Banks Insurance OthersChina Asia Pac US/UK/Japan


China penetration is low by Asian standards This is not a new argument to favor the China insurance sector, but it is still a powerful one, in our view. The penetration rate (premium-to-GDP) and insurance density (premium per capita) remain generally low in China, and this is in sharp contrast to the more developed markets in Asia. Assuming a narrowing of the gap between China and the rest of Asia is likely to generate premium growth for a sustained period of time in the future. We estimate that premium income in China could double to Rmb1.5 trillion if the penetration rate were to increase from the current 2.5% to 5.0%. At 5% penetration rate, the insurance density (premium per capita) would be approximately Rmb1,000 (US$160). This is still well below the figures in some of the more developed markets in Asia back in 1999.

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Figure 124: Penetration rate (Life premium-to-GDP) %

4.2

8.910.3

1.0

8.4

1.4

4.83.64.1

7.6

12.8

2.2

8.0

4.0

13.3

9.9

0

2

4

6

8

10

12

14

USA Japan UK PRC Korea India Taiwan Hong Kong

1999 2008

Source: Swiss Re.

Figure 125: Life insurance density (Premium per capita) US$

0

1,000

2,000

3,000

4,000

5,000

6,000

USA Japan UK PRC Korea India Taiwan Hong Kong

1999 2008

Source: Swiss Re.

Investment returns have upside potential Despite the gradual broadening of investment channels in China since 2003, the investment scope for insurance companies is still relatively narrow with regulatory limitations imposed on almost all major asset classes including equities and bonds. There are still segments in which Chinese insurance companies are prohibited from investing, including the property sector (though some insurance companies actually hold property assets through their trust companies) and derivatives. Major overseas investments on top of the approved QDII quota normally require government or regulatory approvals. In our view, the investment returns of the Chinese insurers are artificially capped and heavily dependent on the performance of the A-share market, though on the liabilities side regulations have also capped the guarantee returns on insurance policies at 2.5%. We expect there is still upside to the investment returns on the Chinese insurers in the long run.

Table 60: Investment limitations of Chinese insurers Corporate bonds Prior to June 03: Only allowed to invest 10% in corporate bonds issued by four

types of state-owned enterprises.

Post June 03: Relax from 10% to 20%, and allow to invest in bonds rated AA or above.

2005: Further relax to 30% of total assets. 2009: Further relax to 40% of total assets.

Equity investment funds Investment in equity investment funds may not exceed 15% of total assets. Direct equities Direct A-shares investment (up to 5% of total assets) has been permitted since

2004. Further relaxed to 10% since 2006.

Overseas Chinese stocks Jun 2005: Invest up to 10% of total foreign investment quota permitted by SAFE. Also allow to invest through QDII and RMB conversion.

Infrastructure Allow indirect investment in selective infrastructure projects since March 2006.

Non-publicly traded entities Allow to invest in non-publicly traded commercial banks since Sep 2006. Likely to extend to other sectors including resources, telecom and energy.

Others including property Investment in commercial property sector may open up.

Source: CIRC.

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Figure 126: Investment yields by country in Asia %

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

2002 2003 2004 2005 2006 2007 2008 2009E

China Australia Taiw an Korea

Source: Company reports and J.P. Morgan estimates. Note: investment yield for Australia represents investment returns on shareholders’ funds only.

Potential risk factors Do not compete head on with the banks on short-term business

Table 61: Banks versus insurance Business characteristics Insurers Banks Main products Risk, savings and investment Loans and fees products Product life Medium- to long-term Short-term Investment horizon Long-term Medium-term Investment scope Equities, bonds, deposits Debt securities Source of funds Insurance premiums Customer deposits Business margins Built-in at policy inception Driven by funding costs Distribution capability Individual sales agents Branches Business cross-over Not proven Bank-led FI Future growth Pension market, health Wealth management Key investment focus Embedded value; VNB Earnings; BV; ROE Risks Lapse, surrenders NPLs Source: J.P. Morgan.

Insurance companies should not compete head on with the banks, in our view. Banks are conducting largely short-term businesses (with the exception of mortgage loans and some medium-term financing). Customer deposits are ‘sticky’ and tend to stay with the banks for a long period of time. In contrast, insurance business is more long term, especially in the life business, where policies can last for a few decades. In our view, Chinese insurers have focused too much on short-term business (single and three-year regular premiums) in the past, and in doing so have competed head on with the banks, which have a natural competitive advantage on customer deposits. In China, short-term insurance policies are mainly distributed through the bancassurance channel and it involves insurers paying high commissions to their banking partners. We believe insurers are better off using their strengths by selling long-term regular premium policies through the individual agents because this is the business the banks find it hard to compete with without a dedicated insurance sales force.

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Hong Kong experience in insurance market The threat from banks distributing and manufacturing insurance products is captured in the market share changes in Hong Kong. The traditional insurance companies were once the dominant players in Hong Kong before 2000. This shape of the insurance market in Hong Kong has changed since the Asian currency crisis in 1998 when bigger local banks started to sell insurance products to generate higher non-interest income.

Table 62: Market share of new life business in Hong Kong 1Q 2009 2001 +/-

Banks: BOC Group Life 8.1% 5.4% 2.7% HSBC Life 17.3% 5.1% 12.2% Hang Seng Insurance 11.6% 5.1% 6.5% Other banks 2.8% 1.1% 1.7%

Traditional insurers: AIA 4.3% 11.4% -7.1% Manulife 4.3% 5.7% -1.4% AXA China 4.4% 4.5% -0.1% Other insurers 47.2% 61.7% -14.5% Source: OCI.

An insurance-led financial group in China is a new concept Ping An is adopting what it calls a “three-pillar” strategy to develop insurance, banking, and asset management in order to build an integrated financial services provider in China. Given that insurance is already quite well established (second-largest in market share in China) relative to the other two businesses, the group is still predominantly an insurance-led financial institution, in our view. Although Ping An plans to enhance its banking platform by acquiring a 30% stake in Shenzhen Development Bank, it is too early to judge whether such an insurance-led banking model will work in China. Based on our understanding, there are not many leading insurance-led financial institutions in the world (e.g., AIG in the past), and some European banks are actually disposing of their insurance subsidiaries following the recent financial crisis in order to preserve capital.

Capital is adequate but not excessive Chinese insurance companies do not strike us as having excessive capital, with the exception of China Life. Both Ping An Life and PICC have a solvency margin that is slightly above the minimum requirement. Both companies have resorted to raising subordinated debt to increase their capital ratios, but the setback of this is that the closer to the expiry date of these debts the less it will be counted as capital in the solvency calculation. Fund raising through equity issuance is another possibility but given the relatively high volatility and low-return of the listed insurance companies in China, the dilution effect is likely to deter potential investors. We believe the insurers should work harder to deliver a more stable return to shareholders, but this may imply a reduction in equity exposure and much improved risk management.

Table 63: Solvency above statutory requirement Actual solvency Excess solvency Margin, 1H09 above min. % (Rmb mm)

China Life 324% 99,744 Ping An Life 221% 24,572 PICC* 118% 2,408 Ping An P&C 161% 2,386 Source: Company reports. Note: PICC solvency margin has improved to 157% after the recent issuance of Rmb5 billion sub-debt.

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Healthcare We prefer pharmaceuticals and distribution now and suggest waiting for medical equipment and consumables We believe that investments in the healthcare sector will continue to be strong even after the current round of stimulus-related spending because healthcare is one of the few industries in China with no excess capacity, very little demand for resources, and can employ a large number of skilled workers. Therefore, we believe that the investment in new healthcare facilities to continue to be strong even after other stimulus-related spending in infrastructure (rail, roads, subways, etc) starts to fade away as the government focus less on stimulus and more on containing inflation and asset prices. We also see government policies fostering more private investments, consolidation in the industry, and the promotion of enterprises that can become global leaders.

Investing in more healthcare infrastructure We expect healthcare spending to grow at a much faster rate of GDP as China lifts its healthcare spending as a percentage of GDP from the current 5% to a level closer to the international level of c. 10%. Recently, the stimulus package, which resulted in a doubling of spending in railways, has also resulted in a surge in fixed asset investment in the healthcare arena (more hospitals, clinics and equipment). And, we believe that would result in a rise in demand for equipment in 2010 followed by a rise in demand for drugs and medical consumables in 2011.

Figure 127: China’s healthcare-related fixed asset investment

0%

20%

40%

60%

80%

Feb-07

May-07

Aug-07

Nov-07

Feb-08

May-08

Aug-08

Nov-08

Feb-09

May-09

Aug-09

Medical FAI (Y/Y Chg)

Source: Bloomberg (CNFAHC Index).

Figure 128: China—Government expenditure in healthcare

0%

20%

40%

60%

80%

Mar

-08

May

-08

Jul-0

8

Sep-

08

Nov-

08

Jan-

09

Mar

-09

May

-09

Jul-0

9

Sep-

09

Pct C

hg Y

/Y

Gov ernment healthcare ex penditures (% Y/Y)

Source: Bloomberg. (CNGE7 Index).

In the meantime, the focus on capital spending, combined with credit tightening, has ironically resulted in more subdued expenditure in healthcare by the government as well as public hospitals. We believe this has contributed to a lull in spending in 2H09 which we believe to be temporary (see the falling Y/Y growth in overall government expenditure in healthcare in the right-hand side figure above). Typically, credit availability improves in the first half of the year and we expect demand from new hospitals should start in 2H10. If this is the case, then the slowdown in 2H09 should result in pent-up demand for 2010.

Leon ChikAC (852) 2800-8590 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

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Next major sector but timing is everything We believe that macroeconomic conditions are right for healthcare to become a major sector in both the economy and the stock market. In China, healthcare expenditure is just less than 5% of GDP compared with over 10% for most developed nations. Healthcare in aggregate is one of the largest sectors in the US economy and the aggregate market capitalization is approximately 12-15% of the entire stock market. In comparison, there are no healthcare stocks in China with over US$10 billion market capitalization and the percentage of market capitalization is well under 2%, by our estimates. We believe that the sheer size of the population and the propensity of Chinese to take care of their elders should lead to ample opportunities in the next 10-15 years.

In the next three-six months, we believe the best opportunity would be in the pharmaceutical distribution sector and traditional Chinese medicines as well as low-cost western medicines. These sectors can participate in the long-term secular growth of the healthcare industry in China but not suffer the risk of falling demand for bigger ticket items such as medical equipment and medical consumables that may see demand being temporarily delayed from 2009 until 2010, due to the government’s huge commitments to construct hospitals and other infrastructure projects in 2009.

Longer term, we suggest that investors look towards the increase in demand that the new hospitals should bring over the next two years. We expect the pent-up demand for healthcare products (equipment and consumables) to resume once the stimulus-related spending slows down, perhaps in late 2010 or early 2011.

Company highlights: Our top pick in this sector is Sinopharm (1099HK, OW) due to its simple growth story, comprising strong pharmaceutical sales growth in China and market share gains by the largest operator. We also see good value in China Shineway (2877HK, OW), China’s leading maker of traditional Chinese medicines (TCM) that is doubling its sales force over two years to sell its products to the rural population. Shandong Weigao (8199HK, OW) is one of China’s leading medical consumables makers, which is growing slower than normal due to hospitals cutting back on purchases due to a lack of credit, but we see this as a buying opportunity before sales pick up again in 2010E. We have a Neutral rating on Mindray (MR US) because more than half of its sales are in overseas markets which have contracted in 2009, and we prefer to wait for more evidence of an export recovery.

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Real estate We expect near-term stable policy for the property sector Monetary policy likely to remain accommodative After the CPC meeting, investors are relieved that the central government intends to maintain its pro growth policy stance; hence, the accommodative monetary policy is unlikely to be reverted soon. Homebuyers expect some of the incentives provided at local government level to expire by end of this year, but property prices should remain firm in FY10. Hence, the secondary markets in Beijing and Shanghai were buoyant in the past few weeks.

Urbanization likely to pick up speed in small- to medium-sized cities/counties At the Annual Economic Summit, facilitating agricultural population to migrate into cities was identified as one of the key initiatives to boost domestic consumption; it was mentioned that the residency restriction at small- to medium-sezed cities/counties would be relaxed to facilitate their migration. No details on when/where/how it would be implemented is announced yet, but we believe relaxing residency restrictions will encourage more people to move into the cities, given that discrimination between residents/non-residents is still one of the major concerns when making migration decisions. We believe the new policies should benefit developers with more exposure to third/fourth-tier cities/lower-end housing.

We expect stable policy in the near term but more risk in the medium term We expect relatively accommodative policies to stay in the near term, although in the medium term, we believe the risk may emerge from the implementation of property tax on high-end residential. Shenzhen was cited to be one of the first pilot cities to try implementing property tax, and the key risk lies in the fact that the tax rate of property tax might be high so as to deter speculative demand and hoarding of properties. We would probably get more details around the next National People’s Congress (NPC) meeting in around March/April next year.

Raymond Ngai, CFAAC (852) 2800-8527 [email protected]

Lucia Kwong, CFA (852) 2800-8526 [email protected]

Sunny Tam, CFA (852) 2800-8524 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

Ryan Li (852) 2800-8529 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

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Information Primary sales fell only 5% M/M in November, a traditionally slow season Property sales volumes in the eight major cities we track were down around 5/% in November, after strong sales in October during the Golden Week holidays and also trade fairs held in the same month. We believe this was not bad at all, given that November is a traditionally slow season.

We expect nationwide sales volume to slow 8% Y/Y in 2010. We believe strong sales in 2009 were driven by pent-up demand in 2009 and investment demand; we do not expect this to be sustained in 2010. Actually sales volume in first-tier cities may drop 10%-20% next year, on an even higher base of comparison.

Table 64: Monthly sales Million sqm Beijing Shanghai Hangzhou Guangzhou Shenzhen Chongqing Chengdu Tianjin Jan-08 0.91 1.53 0.20 0.35 0.27 1.13 0.57 0.43 Feb-08 0.39 0.72 0.09 0.23 0.06 0.53 0.32 0.21 Mar-08 0.66 1.84 0.16 0.38 0.19 0.79 0.63 0.53 Apr-08 0.65 1.41 0.20 0.40 0.33 0.89 0.69 0.47 May-08 0.91 1.72 0.30 0.39 0.38 1.25 0.52 0.51 Jun-08 1.00 1.41 0.19 0.67 0.30 0.73 0.41 0.49 Jul-08 0.71 1.19 0.18 0.61 0.26 1.05 0.37 0.40 Aug-08 0.41 1.01 0.13 0.61 0.28 0.57 0.44 0.32 Sep-08 0.74 0.99 0.17 0.51 0.34 0.87 0.46 0.33 Oct-08 0.79 0.86 0.13 0.36 0.34 1.23 0.41 0.43 Nov-08 0.81 1.03 0.17 0.54 0.36 1.01 0.46 0.49 Dec-08 0.81 1.56 0.19 0.49 0.71 1.10 0.55 0.42 Jan-09 0.73 0.81 0.13 0.46 0.52 0.70 0.54 0.29 Feb-09 0.92 1.22 0.17 0.47 0.36 1.41 0.85 0.57 Mar-09 1.69 2.31 0.40 0.64 0.69 1.83 0.92 1.24 Apr-09 2.12 2.57 0.69 0.83 0.79 2.26 1.02 1.08 May-09 1.98 2.69 1.08 0.67 0.76 1.78 1.15 1.28 Jun-09 2.00 2.66 1.36 0.72 0.66 1.68 0.67 1.16 Jul-09 2.06 2.68 0.61 1.26 0.55 1.75 0.96 1.34 Aug-09 1.69 2.40 0.84 1.26 0.39 1.73 0.92 1.42 Sep-09 1.67 2.04 0.65 0.91 0.33 2.05 0.96 1.22 Oct-09 1.63 2.44 0.61 0.55 0.50 2.97 1.05 1.09 Nov-09 (e) 1.89 2.19 0.56 0.61 0.47 1.91 1.45 1.24 M/M %Chg 16% -11% -4% 11% -6% -36% 36% 14% Y/Y % Chg 132% 112% 231% 13% 31% 89% 217% 4% YTD Y/Y% Chg 130% 77% 234% 76% 100% 103% 100% 53% Source: Centaline, City real estate trading centres, J.P. Morgan estimates.

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Table 65: Selected major Chinese cities—Average daily sales

No. of units BJ

M/M % chg SZ

M/M % chg SH

M/M % chg CQ

M/M % chg CD

M/M % chg TJ

M/M % chg HZ

M/M % chg GZ

M/M % chg

Jan-08 222 -33% 74 0% 510 -3% 406 -11% 264 -12% 166 -49% 166 -49% na Feb-08 118 -47% 28 -62% 256 -50% 196 -52% 104 -60% 99 -40% 99 -40% na Mar-08 218 78% 102 265% 546 113% 289 47% 256 130% 200 102% 63 -36% na Apr-08 197 -9% 90 -11% 460 -16% 354 23% 260 2% 152 -24% 72 13% na

May-08 241 22% 175 94% 555 21% 435 23% 242 -7% 152 0% 96 34% na Jun-08 308 28% 98 -44% 465 -16% 301 -31% 173 -28% 166 9% 75 -22% na Jul-08 200 -35% 81 -17% 346 -26% 304 1% 165 -5% 123 -25% 61 -19% na

Aug-08 158 -21% 96 19% 340 -2% 298 -2% 180 10% 98 -21% 49 -19% na Sep-08 369 133% 112 17% 290 -15% 323 8% 186 3% 106 9% 48 -2% na Oct-08 331 -10% 121 8% 246 -15% 356 10% 204 10% 124 17% 47 -3% na Nov-08 431 30% 191 57% 388 58% 444 25% 236 16% 146 18% 60 29% na Dec-08 435 1% 255 34% 451 16% 419 -6% 268 14% 126 -13% 74 23% na Jan-09 246 -43% 149 -42% 267 -41% 340 -19% 236 -12% 93 -27% 46 -38% 195 Feb-09 310 26% 194 30% 420 57% 650 91% 419 78% 207 124% 64 39% 282 45% Mar-09 461 49% 277 43% 716 70% 731 12% 423 1% 380 84% 152 139% 353 25% Apr-09 639 38% 245 -12% 744 4% 894 22% 460 9% 352 -7% 198 30% 357 1%

May-09 558 -13% 282 15% 793 7% 789 -12% 455 -1% 390 11% 355 80% 449 26% Jun-09 580 4% 234 -17% 889 12% 635 -20% 279 -39% 361 -7% 427 20% 358 -20% Jul-09 539 -6% 191 -18% 783 -12% 724 6% 359 27% 407 13% 307 -28% 166 -54%

Aug-09 485 -10% 132 -31% 696 -11% 661 -9% 341 -5% 467 15% 238 -23% 226 36% Sep-09 481 -1% 95 -28% 632 -9% 643 -3% 340 0% 383 -18% 298 26% 226 0%

Source: Beijing Online Trading Centre, Shanghai Online Trading Centre, Shenzhen Land Resources and Housing Management Bureau, Chengdu Housing Management Bureau, Chongqing Land Resources and Housing Management Bureau, Tianjin Land Resources and Housing Management Bureau, Focus.cn BJ: Beijing, SZ: Shenzhen, SH: Shanghai, CQ: Chongqing, CD: Chengdu, TJ: Tianjin, HZ: Hangzhou, GZ: Guangzhou.

Table 66: Supply outlook

GFA available for

sale# Avg monthly take-up

in 10M09 Months of supply based

on 9M09 avg sales Take-up in

Oct-09 Months of supply based

on latest month’s take-up MM sqm MM sqm Sales/mthly take-up MM sqm Sales/mthly take-up

Guangzhou 4.5 0.88 5 1.10 4 Shenzhen 3.8 0.58 7 0.50 8 Beijing 13.8 1.65 8 1.63 8 Shanghai 5.2 2.20 2 2.44 2 Hangzhou* 1.7 0.59 3 0.61 3 Chongqing 10.8 1.85 6 2.97 4 Chengdu^ 5.5 0.90 6 1.05 5 Source: City real estate trading center websites, J.P. Morgan estimates. #Defined as units with presale permits but not sold and unsold stocks. *Includes six major districts; excludes Yuhang and Xiaoshan. ^Includes six main districts only; districts such as Shuangliu, Pi'xian, Wenjiang, Xindu, etc. are excluded.

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Table 67: Chinese developers’ 2009 YTD contracted sales 2009 2009 09 ASP Contract Contract Contract Contract Cumu FY09 Contract sales sales sales sales sales sales lative sales Pct sales YTD Avg YTD Jul 09 Aug 09 Sept 09 Oct 09 Y/Y target Achieved figure until Rmb MM Rmb psm Rmb MM Rmb MM Rmb MM Rmb MM chg Rmb MM % Beijing Capital Land End-Oct 9,990 11,616 1,430 1,247 1,400 920 295% 10,000 100% Sino-Ocean Land End-Oct 11,000 NA 700 1,300 >1,100 NA NA 11,000 100% China Vanke End-Oct 52,690 9,226 5,110 4,820 5,460 6,540 35% 60,000 88% China Overseas Land End-Oct 36,839 8,452 3,603 3,091 3,894 3,660 87% 40,000 92% CR Land End-Oct 20,060 10,421 2,270 2,520 >700 NA NA 18,000 111% Guangzhou R&F End-Nov 22,621 10,092 1,545 2,063 2,035 2,194 61% 23,000 90% Greentown End-Oct 41,000 14,420 4,400 5,800 5,200 3,864 204% 45,000 91% Hopson End-Aug 9,000 10,449 NA NA NA NA NA 11,437 79% KWG End-Oct 6,000 NA 700 570 700 900 NA 5,000 120% Shanghai Forte End-Sept 6,468 8,972 712 708 901 NA NA 6,500 100% Shui On Land End-Jul 3,065 NA 720 NA NA NA NA 3,300 93% Yanlord End-Sept 10,000 NA 2,240 NA NA NA NA 9,600 104% Agile End-Oct 13,700 6,438 1,100 1,700 1,100 2,000 NA 15,900 86% Source: Company data, J.P. Morgan estimates.

Non-consensus calls Gaining market share is key for 2010 While we expect an overall slowdown in sales in 2010, and a possible softening in prices, we believe some developers can still achieve sales growth via more new project launches in more cities and capturing larger market share. Most developers have locked in 50%-70% of their FY10 earnings through pre-sales already; in our view, the winners will be those who are able to achieve good sales in 2010 and secure strong growth for 2011. We believe mid-caps will offer more upside than large caps, as they should be able to deliver higher growth on a lower base.

Key stock picks for 2010 We prefer stocks with higher exposure to commercial properties, which we believe should be less vulnerable to policy risks, and stocks that we believe could deliver strong earnings growth in 2010/2011. Our top picks are:

Franshion Property (817.HK, OW): A state-owned enterprise with a unique exposure to commercial properties—there could be potential asset injections from the parent company, Sinochem. Our Dec-10 PT of HK$3.3 implies a P/E of 28x and a P/BV of 1.8x on FY11E, considering strong earnings growth in FY12E. Our PT is based on a 20% discount to NAV, the same target discount we assign to SOL. In comparison, for CRL, we assign a 12% target premium to NAV. We take into account Franshion’s high-quality portfolio in prime locations and NAV growth potential from injections. Key risks to our PT include further weakening of leasing demand and rental rates in Shanghai.

Glorious Property (845.HK, OW): An undervalued mid-cap stock with a low-cost prime land bank—we expect net profit growth of 95% in 2010 and a further 21% growth in 2011. Our Dec-10 PT of HK$5.0 is based on 12x FY10E P/E, 9.9x FY11E P/E, and 2.2x FY10E P/BV. Our target FY10E/11E P/E is at the mid-range of 11x-14x, which we apply to mid-cap regional homebuilders, despite its strong cash position. We take into account the relatively low-profile brand name of the company but its relatively good land bank quality, and believe the stock should trade closer to the average valuation of its nearest peers, which are at 12x-13x FY10E P/E and c. a 30% discount to NAV. Key risks to our PT are policy risks, price risks in Shanghai,

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and heavy weight of Shanghai Bay assumptions in our EPS forecasts and NAV estimate.

Guangzhou R&F (2777.HK, OW): Strong management and good execution capability. By applying a 12x FY10 P/E, we derive our Jun-10 PT of HK$17.5. We believe R&F can maintain earnings growth at a minimum of low teens beyond FY10 and hence we use a PEG of 1.0x to derive our target P/E of 12x. Our PT represents an undemanding 3.0x P/BV. Key risks to our price target are a potential economic recession, a widespread nationwide housing prices correction, the progress of contract sales, its high financial leverage, and the outcome of A-share listing.

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Figure 129: China property—Sector P/E ratio (all stocks under coverage)

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Transportation Summary The transport sector is highly leveraged to a global recovery. We have forecast a moderate 7% and 8% rebound in passenger and shipping volumes in 2010, respectively. However, upside surprises are possible as passenger and cargo demand have historically grown at 1.7x and 2.0x real GDP growth, respectively, and J.P. Morgan Economics team forecasts a 7.2% real GDP growth for Asia ex-Japan in 2010. We are more bullish on the airline and land transport sectors’ earnings recovery than shipping, as the former does not face structural overcapacity once demand normalizes. We believe the slew of deliveries will delay the shipping sector’s return to sustainable profitability to 2H10 at the earliest. However, as this is already widely known, a smaller supply-demand gap (especially for dry bulk) could drive an earlier re-rating. Rebounding fuel prices are less of a concern when demand recovers as surcharges help to offset this impact—the transport sector’s record-high profits in 2007 testify to this. Most transport stocks are beneficiaries of a weaker US dollar, given their large US$ capex and debt. This downturn will likely drive consolidation, but cross-border M&A is more difficult due to regulatory restrictions and political sensitivity.

How much of the recovery has been priced in? Transport stocks are early cyclicals and have started to price in part of the recovery. Most are near their historical average valuations, partly because huge losses have significantly eroded their book values. Although the stocks could trade range-bound in the near term or correct when they announce weak 2H/4Q results, we see any weakness as a good opportunity to accumulate airlines and select shipping and land transport companies as they have historically provided large absolute and relative returns in a cyclical upturn.

Recommendations We prefer airlines to shipping in the Chinese transport sector and our top pick is Air China, which we expect to outperform more than the domestically-focused China Southern and the restructuring China Eastern. We remain cautious on the shipping sector but are incrementally more positive in 2010 than we were in early 2009 and our top pick is China Shipping Container Lines, given its backend-loaded vessel deliveries and capex.

Corrine PngAC (65) 6882-1514 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

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Figure 135: Asian airlines passenger demand-supply projection

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Figure 136: Dry bulk shipping demand—Supply projection

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Figure 137: Container shipping demand-supply projection

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Telecom We remain cautious on the Chinese telecom sector going into 2010 We do not have an Overweight rating on the sector. Our top pick on a relative basis is China Mobile and our top stock to avoid is China Unicom.

• Capex leading itself to overcapacity: We believe all three operators will spend high capex budgets in 2009. China’s telecom sector will spend its highest annual capex on record this year of close to Rmb400 billion. This could be the highest annual capex spend on record, representing a rise of 72% in 2009 from 2007 levels and 33% from 2008 levels. This compares with 2002- 2007, when the capex CAGR was only 1.6%. Operators have aggressive network expansion and 3G rollout plans for 2009. We believe there could be a plethora of capacity coming on board in 2010.

• Previous capex bubbles saw underperformance: Previous capex humps have led to several years of industry overcapacity. Being SOEs, we feel the three telecom operators are being asked by the government to do their part in stimulating the domestic economy via infrastructure spend on telecom equipment. It also reflects more fundamentally the worsening competitive position for the industry over the next 1-2 years, as all new capex could turn into empty capacity, in our view. Fundamentals will likely be steered by this capex issue which keeps us cautious. This impact has just started to hit financials.

• Industry restructuring leading to more credible competition: In the past several years CM has been enjoying a very comfortable competitive environment whereby it captured most of the industry’s new subscribers, revenues and profitability. Industry restructuring changed all that. There are now two credible competitors to challenge CM’s dominance. Both CT and CU have intentions to significantly lift their mobile market share. We think price competition could accelerate.

• 3G earnings risk: 3G rollouts and associated high sales and marketing costs are likely to depress margins and profitability, affecting earnings over the next several quarters. As we conclude that the 3G service plan take-up is likely to remain lackluster due to high pricing, stocks riding on the success of 3G subscriptions (i.e. China Unicom) have the highest risk to disappoint, in our view.

China Mobile Ltd: Analyst Day takeaways: TD progressing well, lots of fancy apps and 4G is closer than you think

(Extracted from the note, “China Mobile Ltd: Analyst Day takeaways: TD progressing well, lots of fancy apps and 4G is closer than you think”, published on 20 November 2009; please see the original note for pricing dates)

• Shenzhen Analyst Day: CM’s Analyst Day showcased what they believe to be the next major area of growth. With penetration at 55%, continued tariff pressures, declining elasticity and lower ARPU from new rural customers, CM admitted that it will be challenging to maintain growth. However, management is confident future growth will come from 3G-4G value-added

Jimmy CheongAC (852) 2800 8566 [email protected]

Michelle Wei (852) 2800-8562 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

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services and applications such as Mobile TV, Mobile Wallet, Mobile eReaders, and increased data usage through greater smartphone penetration.

• TD improving with 4G just around the corner: Management stated that

TD-SCDMA development is progressing well with key KPIs such as call drop out rates, call connection rates, and 3G/2G handover success rates reaching acceptable standards as seen with other 3G technologies. TD terminal selection is also getting larger. In addition, CM will try to make the transition to 4G via TD-LTE as soon as possible. It forecasts TD-LTE data cards to be available in mid-2010 and TD-LTE smartphones to be ready by end-2011. A trial TD-LTE network will be on show at the 2010 Shanghai World Expo.

• Good strategy with solid track record: We are generally impressed with CM’s clear vision and strategy. We do not dispute CM’s strong track record in developing VAS services. CM grew VAS (data & non-voice) revenues as a percentage of ARPU from almost zero in 2000 to 28% today. It aspires to emulate Japanese operators who have a VAS contribution of more than 40% of ARPU. However, we think new products and services are more of a medium- to long-term story rather than something that is going to contribute materially to earnings over the next two years. We hold this view because smartphone–type terminals need to enable these services such as Mobile TV, Mobile Gaming, etc. are still expensive (+ US$500) and it will take some time for prices to decline for it to be appealing to the mass market.

• CM is our top pick in the space but we remain cautious on the sector: We rate CM Neutral with a Dec 10 DCF-based PT of HK$75. Our price target is based upon a 10 year DCF model. We assume a WACC of 11.4% derived from a cost of equity of 10.5%, cost of debt of 5%, equity risk premium assumption of 6.5%, and a risk-free rate of 4% with 5% target gearing. Our price target is a one-year forward price target. Key risks to our price target are excessive mobile competition and asymmetric policies. CM is still our preferred pick in the space for its strong cash-generating ability. We think CM’s valuation appears reasonable given its expected financial performance and its growth outlook. However, we are cautious on the sector as we are concerned about the aggressiveness of China Unicom and China Telecom.

Industry news (Extracted from the note, “China Telco Monthly: Oct-09 MIIT industry data highlights: Slight revenue drop, capex still high and the mobile net adds momentum continues”, published on 27 November 2009; please see the original note for pricing dates)

MIIT and NDRC mandate local fixed-line tariff cap: MIIT and NDRC jointly issued revised regulations on local fixed-line call tariffs on November 24. Effective immediately, basic monthly fee and local call rates for fixed-line local telephone services (including PHS services) will change from the current government-mandated prices to a price cap system. Operators must provide customers with at least one pricing plan in which the fee structure and accounting units are equivalent to the current standard tariffs, and this plan should not exceed current standards (set in 2001). At the same time, operators can create their own plans in accordance with market condition and customer needs. The notice also stipulates a price cap management scheme for long-term leased line fees. Our view is that these changes will not have a material impact on the market.

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Operators offer more aggressive subsidy plans China Telecom’s Beijing branch has brought into effect more aggressive subsidy plans. The new plans apply to customers who deposit an upfront fee, which will be rebated over a 24-month period, and also promise a monthly minimum spend. CT Beijing will be giving away free e-Surfing handsets the value of which could equal up to 70% of the total required minimum spending for a 24-month contract, much higher than the previous 30%. Meanwhile, CM is also stepping up sales and marketing efforts nationwide. CM’s Shanghai branch recently jointly kicked off a mobile phone trade-in program with Suning Appliance chain store, China's second largest home appliance retailer. This program offers customers an e-coupon worth 10% of the new 3G handsets selling price which could be used for their future purchase. CM’s Guangdong branch and Suning Appliance also took joint initiatives to lower 3G handset prices by 10-20% starting on the second weekend of November. On top of the price cuts, CM will continue to offer subsidies of Rmb500-1,800 to customers. The two companies are targeting at selling 2G and 3G handsets at similar price levels. Meanwhile in Beijing, China Mobile has been offering recharge bonus to Gotone, M-Zone and Easyown customers and the promotion will last until the end of November. Gotone customers can get recharge bonus worth 50% of the amount they credit their account with if they promise a minimum monthly spend for 12 months and Easyown customers are also offered recharge bonus equaling 20% of their top up credits. Meanwhile, China Mobile will give away free airtime in November to TD-SCDMA customers who use TD services in October.

CM invests Rmb40mn in wireless-fixed phone joint project China Mobile commenced a joint development initiative with vendors for TD-SCDMA office wireless-fixed phone project on November 24. Investment will be around Rmb40 million which will come from the parent company’s TD-SCDMA R&D development fund. The so-called fixed wireless phone uses the TD network and could switch between 2G and 3G networks. The phone is also installed with China Mobile's value-added services and can access the internet with a speed of 2.8 Mbps, and surf on the internet via PC. CT has also recently launched its new 3G fixed-wireless service called “e-Surfing Biztalk”.

iPhone initial sales disappointing China Unicom announced on 3 November 2009 that around 5,000 iPhones have been sold since the handset hit shops on October 30, 2009. China Unicom CEO Chang Xiaobing said in a recent interview with Bloomberg that the sales numbers were acceptable but could have been better. He disclosed China Unicom will start more aggressive iPhone marketing campaigns starting November 16 and is focused on subscriber growth with a target of 1million new 3G customers each month. We are concerned with CU’s competitive positioning and the divergence between CU’s reputation as a discount mobile carrier with inferior network coverage and its 3G ambitions to turn itself into a high-end operator. Heavily relying on the success of the iPhone is a strategy which may disappoint, in our view.

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Update on subscriber data

Year-to-date monthly subscriber data are summarized below Table 68: Year-to-date monthly subscriber data

Units in thousands Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09China Mobile GSM 443,309 450,179 457,250 463,920 470,671 477,164 482,987 488,105 493,124 497,677 502,936 508,370 513,466China Unicom GSM 131,945 132,941 133,365 134,204 135,844 137,692 138,833 139,515 140,377 141,057 141,864 142,799 143,600China Telecom CDMA 28,400 27,970 27,910 28,930 30,630 32,840 34,710 36,910 39,280 41,730 43,810 46,780 49,920Total wireless subs 603,654 611,090 618,525 627,054 637,145 647,696 656,530 664,530 672,781 680,464 688,610 697,949 706,986China Telecom fixed 211,880 210,370 208,350 207,380 205,830 204,000 202,100 200,750 199,360 197,690 196,170 194,390 192,930China Netcom fixed 106,537 105,017 100,146 109,445 108,944 109,167 108,996 108,707 108,452 108,121 107,639 107,131 106,184Total fixed subs 318,417 315,387 308,496 316,825 314,774 313,167 311,096 309,457 307,812 305,811 303,809 301,521 299,114China Telecom broadband 42,880 43,570 44,270 45,030 45,900 46,770 47,490 48,240 49,050 49,870 50,560 51,450 52,150China Netcom broadband 25,204 25,438 25,416 31,052 31,687 32,614 33,154 33,933 34,913 35,727 36,598 37,467 38,006Total broadband subs 68,084 69,008 69,686 76,082 77,587 79,384 80,644 82,173 83,963 85,597 87,158 88,917 90,156Source: Company. Note: All subscribers in thousands.



Utilities and infrastructure What is changing? Change 1: China water: Expect positive earnings surprises from Guangdong Investment Extracted from the note, “Guangdong Investment Limited: Our low risk, reasonable return pick in the space,” published on 6 December 2009. Please see the original note for pricing dates.

We are positive on GDI’s 2H09 results because of the following three catalysts:

1) Potential positive surprises from China water sales As reported by the press (including sohu.com), Southern China (including Guangdong) suffered a severe drought in early Nov 2009. In fact, our findings

Edmond Lee, CFAAC (852) 2800-8575 [email protected]

Boris Kan (852) 2800-8573 [email protected]

Karen Li (852) 2800-8589 [email protected]

Ajay Mirchandani (65) 6882-2419 [email protected] J.P. Morgan Securities (Asia Pacific) Limited

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(Figure 139) suggest that, in addition to Nov 09, rainfall in Jul-Oct 09 were also lower than in 2008 and the long-term historical average. Hence, we believe demand for GDI’s water supplies will be higher in 2H09 given that users will have less water supplies from other alternative sources (e.g. local reservoirs, etc). More importantly, we have confirmed with management that the dry weather has not affected GDI’s own water supplies, and its water business operations remain as usual.

In addition, continued economic recovery in Guangdong (Figure 138) should also provide strong support on demand for GDI’s water supplies in 2H09, particularly for industrial users which account for Dongguan’s >40% of water demand.

Figure 138: Guangdong GDP : Signs of economic recovery

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Figure 139: Guangdong: Monthly avg. rainfall differential (in mm) *

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Our calculations suggest that every 10% increase in China water sales will lead to a potential 3-4% 2009E EPS upside. While that might not sound like a lot, we believe it will surprise investors given that the stock has only delivered ~11% core earnings growth over the past 2-3 years.

Guangdong’s rainfall in Jul-Oct09 was much drier than historical avg., while Jul-Oct08 had higher rainfall. We believe Nov09 will also record low rainfall figures



Table 69: Sensitivity analysis on increased China water sales

Impact on 2009E pre-

tax profits China water sale vol 20% > base case + 6.8% China water sale vol 15% > base case + 5.1% China water sale vol 10% > base case + 3.4% China water sale vol 5% > base case + 1.7% China water sales - base case 0% China water sale vol 5% < base case - 1.7% China water sale vol 10% < base case - 3.4% China water sale vol 15% < base case - 5.1% China water sale vol 20% < base case - 6.8% Source: J.P. Morgan estimates.

F

ScP

GDI’s losing position in 1H09 was mainly driven by a HK$75MM impairment provisionin Yue Jiang Power Plant.

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2) Continued recovery in the power business With the continued recovery in power demand (Figure 140) and without further impairment provisions expected, we believe profitability of GDI’s power business to improve in 2H09 from 1H09 levels (vs. HK$43MM losses in 1H09, of which HK$75MM being impairment provision). This is consistent with our findings in other listed IPPs.

igure 140: Power production in Guangdong Province

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Table 70: GDI’s power business profit & loss position (in HK$ MM) 1H07 2H07 1H08 2H08 1H09 Segmental profit / losses during the period

94 (383) (101) (180) (33)

Attributable profits (losses) from associates / JCE

12 16 (32) (3) (10)

Total profits (losses) after impairment losses

106 (367) (133) (183) (43)

Of which: Impairment losses recorded

- (469) (55) (134) (75)

Total profits (losses) incurred before impairment losses

106 102 (78) (49) 32

Source: Company

3) Potential property revaluation gain Thanks to the continued improvement in the property market, we expect GDI’s property assets to enjoy further revaluation gain in 2H09, in particular the Teem plaza. A quick review of the company’s income statements from 1H07 to 1H09 indicated that GDI’s investment properties have recorded an aggregate net revaluation loss of HK$216MM.

While it might be too simplistic to draw the conclusion that GDI’s investment property assets are recorded at a lower valuation level in Jun 2009 than in Dec 2006 (due to constant changes in its property asset portfolio from period to period), it is conceivable that there is room for further upward revision on property values in 2H09. Our calculations suggest that every HK$100MM property revaluation gain might lead to a potential ~5% 2009E EPS boost.

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Figure 141: Power production in Guangdong Province

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Table 71: Sensitivity analysis on increased China power business

Impact on 2009E pre-

tax profits HK$400MM revaluation gain in 2H09 19.6% HK$300MM revaluation gain in 2H09 14.7%

Price target and valuation aOur Dec-10 price target of H

NAV Breakdown HK water China water Power Toll roads Hotel Departments stores New projects Property Total Source: J.P. Morgan estimates. Risk to our PT includes lowe
Total net loss position ofHK$216MM from 1H07 to 1H09 (RHS)
H08 2H08 1H09(800)(600)(400)(200)-

ain (loss) (RHS in HK$MM)rofits (LHS in %)

HK$200MM revaluation gain in 2H09 9.8% HK$100MM revaluation gain in 2H09 4.9% Base case (no revaluation gain in 2H09) 0%

Source: J.P. Morgan estimates

Asset injections unlikely in near term, but gearing falling fast: Our recent discussions with management lead us to believe that any potential asset injections will not be likely over the next 3-6 months. But with its strong FCF position, we expect GDI’s gearing to fall to <15% by 2010YE from 33% in 1H09A.

Impact: Low risk, reasonable return pick: While investors might remain disappointed over the continued delay in potential asset injections, we reiterate OW due to (1) its expected strong 2H09E earnings (including the expected non-core property revaluation gain) and (2) undemanding valuation at 11x 2010E PER, 3% dividend yield & ~11% 2009-11E EPS CAGR. GDI is one of the cheapest stocks in our China utility / infrastructure space (other than Huaneng / Harbin / Huadian / CCCC) while having one of the lowest risk profile & highest earnings visibility, in our view. The stock might appeal to investors who are concerned about (1) potential macro tightening, (2) margin squeeze & (3) demanding valuation in other sectors.

nalysis K$5.2 is based upon sum-of-the-parts valuation which can be broken down as follows:

Val. Method. Total value Per sh NAV % DCF 18,413 2.99 58% DCF 8,046 1.31 25% DCF 819 0.13 3% DCF 626 0.10 2% 8x 2010E EV/EBITDA 912 0.15 3% 14x 2010E EV/EBITDA 969 0.16 3% N/A - - 0% NAV -mark-to-market 2,148 0.35 7% 31,934 5.2 100%

r water sales in China.

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Information Information 1: China wind—Expect strong 2H09 results Extracted from the note, “China High Speed Transmission: Riding the wave; reiterate OW,” published on 11 November 2009. Please see the original note for pricing dates.

Our recent discussions with CHSTE’s management indicated that operations in 2H09 remained strong. We believe this implies that the company’s core businesses are in line to deliver the full-year target in FY2009, in particular the wind gearbox business (6,000MW, vs. 2,055MW in 1H09).

Strong YTD addition in new installed wind capacity, potentially surpassing US The potentially strong performance of CHSTE is consistent with our understanding in the wind sector. In Jan-Sep’09, China’s total new installed wind capacity reached 4.1GW (vs. 4.7GW for FY2008). And according to china5e.com, China is expected to double its wind capacity from ~13GW in 2008YE to 26GW in 2009YE. Considering that new wind capacity addition in the US will be <9GW this year, China might rank #1 in new wind capacity addition in 2009 (vs. #2 in 2008).

Table 72: Global wind annual new installed capacity addition & o/s installed wind capacity

Country 2008 Annual capacity

add'n (MW) Y/Y % Country

2008 Installed capacity, EOY

(MW) Y/Y %

1 USA 8,358 137% USA 25,170 50% 2 China 6,300 278% Germany 23,903 7% 3 India 1,800 4% Spain 16,754 11% 4 Germany 1,665 -68% China 12,210 102% 5 Spain 1,609 -53% India 9,645 21% 6 Italy 1,010 67% Italy 3,736 37% 7 France 950 119% France 3,404 39% 8 UK 836 96% UK 3,241 36% 9 Portugal 712 84% Denmark 3,180 2% 10 Denmark 77 -91% Portugal 2,862 33%

ROW 3,739 117% ROW 16,686 28% Total 27,056 35% Total 120,791 0%

Source: GWEA

Government raising 2020 renewable targets a LT positive In addition, the Chinese Government has also raised its 2020 targets where (1) renewable capacity will account for 17% of total installed capacity by 2020, and (2) 2020 wind capacity target has now raised to 150GW from 100GW. This is significant as the Government was lagging behind to revise up wind capacity targets in the past. The fact that the Government has now gone ahead of the market shows their commitment in developing the sector.

It is expected that China (13GW) will surpass the USA (<9GW) to be #1 country in new installed wind capacity in 2009E

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Figure 142: China’s renewable target (excluding hydro, in MW)

83% 98%

1%

9%

1%

5%1%

~0%

2%

~0%

-

500

1,000

1,500

2,000

2008A 2020E

Coal+hydro Wind Nuclear Solar BiomassSource: NDRC

Figure 143: Upward revision on 2020 wind target by the Government

020406080

100120140160

2008A 2020E target(2005)

2020E target(2008)

2020E target(now )

0%

2%

4%

6%

8%

10%w ind capacity (LHS MW)As a % of total cap. (RHS %)

Source: NDRC

Other companies in the sector also had strong 3Q09 results CHSTE’s expected strong performance in 2H09 is also is consistent with the strong 3Q2009 results by other players in by other companies in the sector such as Goldwind and Dongfang Electric.

Figure 144: Wind turbine sales revenue for GW & DF (in Rmb MM)

+178%

+198%

+320%

+168%

01,0002,0003,0004,0005,0006,0007,0008,000

1-3Q09 1-3Q08 3Q09 3Q08

GW DF

Source: Company. % Figures represent Y/Y % growth.

Figure 145: Wind turbine gross profit for GW & DF (in Rmb MM)

23%

27%26%

25%

6%19%13%

16%

010002000300040005000600070008000

1-3Q09 1-3Q08 3Q09 3Q08

GW DF

Source: Company. % Figures represent % gross margin.

We believe the strong 3Q09 performance by Dongfang and Goldwind also helped alleviate market concerns about CHSTE and the sector on (1) margin pressure due to over-capacity in downstream wind turbine producers, (2) bottleneck created by grid connection.

Concern #1: Margin pressure from downstream turbine producers There was originally a concern that CHSTE might suffer margin pressure as downstream wind turbine producers might transfer ASP (and hence margin) pressure of their own to upstream component suppliers in light of increased competition in the wind turbine market. While this still holds true, the concern has largely been alleviated as (1) 3Q09 gross margin for wind turbine producers have actually improved, (2) CHSTE can create cost savings through increased internal production after the acquisition of the acquisition of Jiangsu Hongsheng in 2008.

CHSTE’s gross margin on wind gearbox sales in 1H09: 31.0% vs. 29.9% in 1H08

We expect 2H09 margin to hold up on 1H09 levels

2020E: Total renewable target = 290GW, vs. 18GW in 2008A

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Table 73: Recent price cuts by Goldwind on key component suppliers Remarks Supplier 1 Date of company announcement 18 Sep 2009 Name of supplier Zhuzhou CSR Electric Corp Key component supplies 1.5 Permanent magnet direct drive power

generator stator Original contract amounts Contract 1: Rmb 240MM

Contract 2: Rmb 960MM Revised contract amounts Contract 1: Rmb 198MM (18% cut)

Contract 2: Rmb 878MM (9% cut) Supplier 2 Date of company announcement 9 Sep 2009

Name of supplier China National Building Materials Blades Corp

Key component supplies Wind turbine blades Original contract amount Rmb 630MM Revised contract amount Rmb 595MM (6% cut)

Source: Company reports

Figure 146: Capacity ramp-up by major Chinese WTG producers (MW)

-2,0004,0006,0008,000

10,00012,00014,000

2008E 2010E

Windey

Baoding

Xiangtan

SHE

Huay i

DFE

GW

Sinov el

Source: CWEA, China Electricity Newspaper, JPM estimates Note: The above analysis exclude capacity for foreign players (e.g. Suzlon / GE / Vestas), implying that overcapacity situation might be more severe than expected.

Over-capacity in downstream wind turbines, not upstream gearboxes so far Another issue worth highlighting is that while the downstream wind turbine market is suffering over-capacity problems currently, that is not the case in the upstream wind gearbox market. As seen from the figure below, CHSTE, Chongqing Gearbox Co. (and China No.2 Heavy Machinery Co., not included here) are the only 3 gearbox producers in China that are capable of producing >1MW wind gearboxes (vs, 10-15 players in the wind turbine market), whereas Hangzhou Advance Gearbox Group has yet to develop technology in >1MW gearboxes so far.

Figure 147: Major global wind gearbox producers

Source: Hansen

Concern #2: Grid connections being the bottleneck Another key concern by the market is that grid connections might become a bottleneck in the overall development of the wind sector. While the concern is valid, we believe the situation is not as significant as the market expects given that (1) Goldwind & Dongfang still delivered >150% Y/Y growth in wind turbine revenue in

~45% 2008-10E CAGR

JPM 2010E new wind capacity addition in China

2008A

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1-3Q2009 despite the bottleneck situation and (2) the NDRC has already identified this as one of the major problems in the development of the sector and hence more remedies will likely be remedies from Grid Companies going forward.

In addition, upstream component suppliers like CHSTE will likely have less direct impact on the issue than downstream players such as wind turbine producers / wind farm operators, as the former do not need to deal with Grid Companies directly.

Table 74: Key problems on grid connections to wind farms in China Key issues Remarks High-voltage lines 20-30% of newly installed wind turbines not being able to connect to the grid in 2008,

especially for wind projects which require high-voltage 500kV / 750kV lines Grid network system 55% wind capacity in 7 provinces requires connections to 220kV grid network system Capex by Gridco Significant capex burden by the two grid companies under the stimulus package Other reasons Lack of planning on routes of power dispatch and destinations (e.g. 2 100MW wind

farms in Inner Mongolia West & Inn. Mon East). Lack of co-ordination between wind farm & grid on building transmission network.

e.g. a 460MW in Jiuchuan (Gansu) can only dispatch 65% of power. Lack of co-ordination between peak / base load power (coal vs. hydro vs. wind). e.g.

Inner Mongolia in winter time, Jilin / Jiajiu in Gansu Source: Company reports

Impact: Top pick in power equipment sector We stay positive on CHSTE thanks to its (1) geared exposure to the wind sector, (2) more attractive valuation with higher EPS growth (>40% 2008-11E core EPS CAGR vs. 12%/ 20% for Shanghai/Dongfang), (3) less exposure to the grid connection bottleneck (upstream) than downstream wind turbine producers and wind farm operations. Key near-term catalysts are impending listing of other wind companies & new wind capacity additions.

Price target and valuation analysis Our Dec-10 price target of HK$21.5 is based on DCF assuming a 11.9% WACC and a 2% terminal growth. Risks to our PT include lower-than-expected wind installed capacity in China.

Information 2: China city gas—New gas pricing policy still under review Extracted from the note, “China City Gas Distributors: Maintaining our bullish stance,” published on 06 November 2009. Please see the original note for pricing dates.

Our latest understanding of the impending gas pricing policy is that it is still under review by various involved parties. As reported by Bloomberg on 2 Nov 2009, management of the ENN Group (Xinao’s parent) “received a proposal of the price reform from the government about two months ago. The Chinese government was seeking feedback on potential changes to the (gas) pricing”. China City Gas Association (26 Oct 2009) also reported that the oil majors have received gas pricing proposals from the Government authorities for feedback. We maintain our view that the policy will likely be in place by 1H10, given that more gas will be imported into China next year (e.g. Turkmenistan).

Potential magnitude of gas price hike In addition to timing of the policy, the magnitude of the increase is another key area of focus. However, views from various industry players are inconclusive so far on this issue. ENN Group management, for instance, expected that wholesale gas prices

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might increase by 20-30% (Bloomberg 2 Nov 2009). An official from Petrochina (China City Gas Association 26 Oct 2009) expected natural gas prices to be based on a standardized (across the country), blended & weighted-average principle between (1) domestic and (2) imported gas.

Table 75: Potential key terms of proposed gas pricing policies as quoted by industry participants Pricing methodology JPM Comments

Upstream gas prices to increase by 20-30% and retail prices may rise about 10 %, accordingly.

Hard to tell which “base” gas price they are referring to. But if we use Xinao’s 1H2009 average gas purchase price of Rmb 1.72 / m3, gas price might increase to Rmb 2.06-Rmb 2.23 / m3 under the new policy. Still, it is lower than the >Rmb 3/m3 for Turkmenistan / Qater LNG.

ENN Group (Xinao’s parent)

Future gas prices might be linked to products including coal and crude oil

We already have similar mechanism under the current regulatory regime, except that the annual increase is capped at 8%.

Downstream natural gas prices will more closely reflect upstream price movements

Similar in nature to the automatic pass through mechanism

Petro-china

Standardized (across the country), blended & weighted-average principle between (1) domestic and (2) imported gas.

If a standardized price is used, there will be no problem in dealing with the amount of gas price increment for each gas source (e.g. WE1, WE2, etc). As a reference, China’s total natural gas consumption in 2008 was 80.7B m3, of which 4.4B m3 (5%) were from imports. Under this method, natural gas price will only be able to rise gradually given that the imported portion will likely remain small over the next 3-5 years. We believe there will be certain "one-off" increment (say Rmb 0.4 / m3 hike) first before such method is adopted. One potential issue to deal with will be how to align end-user tariffs amongst different cities if input gas prices were adjusted to a standardized price.

Source: Bloomberg, China City Gas Association

Automatic pass-through mechanism still holds the key It is difficult to pinpoint the potential winners and losers among different city gas distributors on potential gas price changes until we actually see the finalized version. One thing that looks more certain is that any gas price increases will likely accompany an automatic pass through mechanism to protect gas sales margins for city gas distributors. And any gas price increase will not likely erode natural gas’s competitiveness against other alternative fuels.

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Figure 148: Fuel cost competitiveness in Shanghai for residential users (in Rmb / GJ)

+32% 0%

+140%

+70% + 67%

406080

100120140160180

Nat Gas(Current)

Nat Gas(SEP) *

Nat Gas(int'l price)

**

LPG(Current)

Electricity(Current)

Source: NDRC. China Gas Association. Note: % figures represents % premium on natural gas at current price levels. * Assume 100% pass-thru on end-user tariffs when gas costs increase from WE1 level to SEP. ** Same principle as *, except that gas cost increase from WE1 level to int'l level (US$12/mmbtu)

Figure 149: Fuel cost competitiveness in Beijing for residential users (in Rmb / GJ)

127 %

+ 54% +83%

+128%

0% +20%

406080

100120140

Nat Gas(Current)

Nat Gas(CTG) *

Nat Gas(SJ3) *

Nat Gas(int'l price)

**

LPG(Current)

Electricity(Current)

Source: NDRC. China Gas Association. Note: % figures represents % premium on natural gas at current price levels. * Assume 100% pass-thru on end-user tariffs when gas costs increase from current level to CTG and SJ3 respectively. ** Same principle as *, except that gas cost increase from WE1 level to int'l level (US$12/mmbtu)

Impact: Still positive on the gas sector We remain positive on the China city gas sector in light of the recent developments. The new gas pricing policy will likely enhance the future growth of the sector and should justify the current valuation premium of gas utilities (15-20x 2010E P/E) over IPPs (10-15x) as we see in their counterparts in other regions (e.g. HK and Korea). Xinao is our top pick in view of its attractive valuation (13x 2011E P/E) and the likelihood it will benefit more from the new policy. We also like BJE as we expect (1) positive surprises on 2009 gas sales thanks to the recent cold weather, and (2) potential water asset injections into BJE Water (371 HK, NR) after 4-5 months. A key NT catalyst is developments on the new gas policy.

Valuation methodology and risks to our price targets Ratings JPM PT

(HK$) PT date Valuation methodology Risks to our price target

Xinao (2688 HK) OW 22.2 Dec-10 Based on DCF with a 10.1% WACC and a 2% terminal growth rate.

Lower than expected gas sales

BJ Enterprises (392 HK)

OW 56.1 Dec-10 SOTP Lower than expected gas sales

Towngas China (1083 HK)

N 3.64 Dec-10 Based on DCF with a 10.3% WACC and a 2% terminal growth rate.


China Gas (384 HK) N 3.5 Dec-10 Based on DCF with a 9.8% WACC and a 2% terminal growth rate.



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Appendix I: Following text used by permission from Professor Robert D. Fiala of Concordia University, Nebraska, USA--as excerpted from www.orientalarchitecture.com The Bund (Waitan) is one of the most recognizable architectural symbols of Shanghai. "Bund" derives from an Anglo-Indian word for an embankment along a muddy waterfront and that is what it was in the beginning when the first British company opened an office there in 1846. Located on the west bank of a bend (running north and south at this point) in the Huangpu River and just south of Suzhou Creek, the Bund became the site of some of the earliest foreign settlements after Shanghai was opened as one of five "Treaty Ports" in the Treaty of Nanjing that ended the Opium War in 1842. Because of its proximity to the Yangtze (Changjiang) River--the path into central China, Shanghai grew rapidly as the economic center of foreign interests. Jardine Matheson & Company bought its first land here in 1848 and the river front soon became vital to the interests of the entire foreign settlement. In the latter 19th early 20th century the Bund became the financial and political center of the international community and (indeed of much of China). It was China’s Wall Street, as Shanghai's financial market became the third largest in the world (behind London and New York). Nearby were located a number of important consulates, including the British, American, Russian and Japanese. The twenty-four major structures, of uneven height along approximately 1.5 kilometers of Zhongshan Lu and the Huangpu River, have changed little externally since the 1930s. All were constructed in western-inspired styles—classical, Gothic, renaissance, eclectic and modern—a reported seventeen styles of architecture. The Bund has been called a 'museum of international architecture’, and indeed it was and still is. But it was also much more. Here were located the banks, hotels, exclusive clubs, press organizations and headquarters of international concerns. After the establishment of the People's Republic of China in 1949 the old tenants were gone. They had already been impacted by the wartime crises. Many of the structures were subdivided into government offices, department stores or storage areas, furnishings were sold off or destroyed, and architectural features covered. The Bund, one might say, was moribund. Much of this now is changing with the revitalization of Shanghai, strongly encouraged by a visit of Deng Xiaoping in 1992. The next year the plans for the Bund were finalized and the renewal of Shanghai began in earnest. Although many of the state-protected historic buildings of the Bund remain vacant, or perhaps underutilized as government offices as of this writing (April 2002), there are strong indications that this might change—even though the old tenants have outgrown their old quarters and will not return since many are now in more spacious and comfortable quarters on the east side of the river in Pudong. But their old buildings are newly appreciated, with even brass plates outlining their previous use, and efforts are being made to bring elements of the international community back to where it started in the Bund, as well as on the Pudong side.

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The area does have a new vitality. Zhongshan Dong Lu has been widened to ten lanes to accommodate the increased Shanghai motor traffic, and the promenade along the banks of the Huangpu has also been elevated and enhanced as a place to view the ever-changing skyline of Pudong across the water. It actually is part of a new dike to protect the city. One only need look at a few images of this area taken in 1980 that are on this site to gain an appreciation of this new vitality. A decade ago there was little in Pudong besides warehouses, shipping facilities and small shops. Now it is the most extensive construction site in the world. Both sides of the Huangpu River reflect important aspects of Shanghai's heritage—its past, present and future. Text by Professor Robert D. Fiala of Concordia University, Nebraska USA.

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Companies Recommended in This Report (all prices in this report as of market close on 18 December 2009, unless otherwise indicated) Air China (0753.HK/HK$5.44/Overweight), Alibaba.com Limited (1688.HK/HK$16.32/Neutral), Anhui Conch Cement Company Limited - H (0914.HK/HK$47.25/Overweight), Baidu.com (BIDU/$415.84 [17-December-2009]/Overweight), Bank of China - H (3988.HK/HK$4.03/Overweight), Bank of Communications Co (3328.HK/HK$8.73/Overweight), Beijing Enterprises Holdings Limited (0392.HK/HK$51.85/Overweight), Brilliance China Automotive (1114.HK/HK$2.29/Overweight), China Citic Bank - H Share (0998.HK/HK$6.18/Overweight), China Coal Energy (1898.HK/HK$13.40/Overweight), China Construction Bank (0939.HK/HK$6.36/Overweight), China Cosco Holdings, Ltd. (1919.HK/HK$9.23/Neutral), China Dongxiang Group Co Ltd. (3818.HK/HK$5.28/Neutral), China Gas Holdings Limited (0384.HK/HK$3.68/Neutral), China High Speed Transmission (0658.HK/HK$18.32/Overweight), China Life Insurance Co. Ltd (2628.HK/HK$37.80/Overweight), China Mengniu Dairy Co. Ltd. (2319.HK/HK$27.45/Overweight), China Merchants Bank - H (3968.HK/HK$19.56/Neutral), China Minsheng Banking (600016.SS/Rmb7.50/Neutral), China Mobile Ltd (0941.HK/HK$71.30/Neutral), China Mobile Ltd (CHL/$45.55 [17-December-2009]/Neutral), China Overseas Land & Investment (0688.HK/HK$16.32/), China Resources Power Holdings (0836.HK/HK$14.68/Neutral), China Shenhua Energy (1088.HK/HK$37.15/Neutral), China Shineway Pharmaceutical Group Limited (2877.HK/HK$14.74/Overweight), China Shipping Container Lines (2866.HK/HK$2.65/Overweight), China Southern Airlines (1055.HK/HK$2.47/Neutral), China Telecom Corporation Ltd (0728.HK/HK$3.16/Neutral), China Telecom Corporation Ltd (CHA/$41.20 [17-December-2009]/Neutral), China Unicom (0762.HK/HK$9.86/Underweight), China Unicom (CHU/$12.74 [17-December-2009]/Underweight), China Yurun Food Group (1068.HK/HK$20.05/Overweight), CNOOC (0883.HK/HK$11.84/Neutral), DongFeng Motor Co., Ltd. (0489.HK/HK$10.62/Overweight), Franshion Properties (China) Ltd. (0817.HK/HK$2.67/Overweight), Glorious Property (0845.HK/HK$3.50/Overweight), Great Wall Motor Company Limited (2333.HK/HK$8.46/Neutral), Greentown China Holdings (3900.HK/HK$12.06/Neutral), Guangdong Investment Limited (0270.HK/HK$4.25/Overweight), Guangzhou R&F Properties (2777.HK/HK$13.40/Overweight), Hengan International Group Ltd (1044.HK/HK$55.05/Neutral), Huabao International Holdings Limited (0336.HK/HK$7.87/Neutral), Industrial and Commercial Bank of China - H (1398.HK/HK$6.20/Overweight), Li Ning Co Ltd (2331.HK/HK$25.50/Neutral), Maanshan Iron and Steel - H (0323.HK/HK$5.66/Overweight), Mindray Medical (MR/$33.89 [17-December-2009]/Neutral), Netease (NTES/$37.51 [17-December-2009]/Overweight), PetroChina (0857.HK/HK$9.19/Underweight), PICC Property & Casualty Co. Ltd (2328.HK/HK$6.84/Underweight), Ping An Insurance (2318.HK/HK$66.50/Neutral), Qingling Motors Co (1122.HK/HK$1.89/Underweight), Shandong Weigao Group Medical Polymer Co. Ltd. (8199.HK/HK$25.40/Overweight), Shanghai Pudong Development Bank (600000.SS/Rmb20.73/Overweight), Shenzhen Development Bank (000001.SZ/Rmb23.93/Overweight), Sina Corp (SINA/$44.86 [17-December-2009]/Neutral), Sinopec Corp - H (0386.HK/HK$6.66/Overweight), Sinopharm (1099.HK/HK$26.95/Overweight), Sinotruk (3808.HK/HK$9.36/Neutral), Sohu.Com (SOHU/$53.97 [17-December-2009]/Overweight), Towngas China Company Limited (1083.HK/HK$2.99/Neutral), Tsingtao Brewery (0168.HK/HK$39.15/Underweight), Weichai Power (2338.HK/HK$60.35/Neutral), Xinao Gas (2688.HK/HK$18.62/Overweight), Yanzhou Coal Mining - H (1171.HK/HK$16.12/Neutral), ZTE Corp (0763.HK/HK$43.65/Neutral)

Analyst Certification: The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.

Important Disclosures

• Market Maker: JPMSI makes a market in the stock of Baidu.com, Brilliance China Automotive, Netease, Sina Corp, Sohu.Com. • Market Maker/ Liquidity Provider: JPMSL and/or an affiliate is a market maker and/or liquidity provider in Alibaba.com Limited,

Bank of China - H, Bank of Communications Co, Brilliance China Automotive, China Coal Energy, China Construction Bank, China Cosco Holdings, Ltd., China High Speed Transmission, China Merchants Bank - H, China Overseas Land & Investment, China Shenhua Energy, China Shipping Container Lines, Hengan International Group Ltd, Industrial and Commercial Bank of China - H, Li Ning Co Ltd, Sina Corp, Sinotruk, Sohu.Com, Yanzhou Coal Mining - H, ZTE Corp.

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• Director: A senior employee, executive officer or director of JPMorgan Chase & Co. , JPMSI, and/or its affiliates is a director and/or officer of China Resources Power Holdings.

• Analyst Position: The following analysts (and/or their associates or household members) own a long position in the shares of Bank of China - H: Adrian Mowat. The following analysts (and/or their associates or household members) own a long position in the shares of China Citic Bank - H Share: Cindy Xu. The following analysts (and/or their associates or household members) own a long position in the shares of China Construction Bank: Robert Smith. The following analysts (and/or their associates or household members) own a long position in the shares of China Cosco Holdings, Ltd.: Adrian Mowat. The following analysts (and/or their associates or household members) own a long position in the shares of China Life Insurance Co. Ltd: Adrian Mowat. The following analysts (and/or their associates or household members) own a long position in the shares of China Overseas Land & Investment: Robert Smith.

• Beneficial Ownership (1% or more): JPMSI or its affiliates beneficially own 1% or more of a class of common equity securities of Alibaba.com Limited, Anhui Conch Cement Company Limited - H, Bank of China - H, Bank of Communications Co, China Coal Energy, China Construction Bank, China Life Insurance Co. Ltd, China Merchants Bank - H, China Mobile Ltd, China Shenhua Energy, China Shipping Container Lines, China Telecom Corporation Ltd, DongFeng Motor Co., Ltd., Industrial and Commercial Bank of China - H, PetroChina, PICC Property & Casualty Co. Ltd, Sina Corp.

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China Overseas Land & Investment is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services. China Resources Power Holdings is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services. China Shineway Pharmaceutical Group Limited is or was in the past 12 months a client of JPMSI. China Shipping Container Lines is or was in the past 12 months a client of JPMSI. China Southern Airlines is or was in the past 12 months a client of JPMSI. China Telecom Corporation Ltd is or was in the past 12 months a client of JPMSI. China Unicom is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services. China Yurun Food Group is or was in the past 12 months a client of JPMSI. CNOOC is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-investment banking securities-related services. Franshion Properties (China) Ltd. is or was in the past 12 months a client of JPMSI. Glorious Property is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services and non-investment banking securities-related services. Great Wall Motor Company Limited is or was in the past 12 months a client of JPMSI. Greentown China Holdings is or was in the past 12 months a client of JPMSI. Guangzhou R&F Properties is or was in the past 12 months a client of JPMSI. Hengan International Group Ltd is or was in the past 12 months a client of JPMSI. Huabao International Holdings Limited is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services. Industrial and Commercial Bank of China - H is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services, non-investment banking securities-related services and non-securities-related services. Li Ning Co Ltd is or was in the past 12 months a client of JPMSI. Mindray Medical is or was in the past 12 months a client of JPMSI. Netease is or was in the past 12 months a client of JPMSI. PetroChina is or was in the past 12 months a client of JPMSI. PICC Property & Casualty Co. Ltd is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-investment banking securities-related services and non-securities-related services. Ping An Insurance is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-investment banking securities-related services. Shandong Weigao Group Medical Polymer Co. Ltd. is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services. Shanghai Pudong Development Bank is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-investment banking securities-related services and non-securities-related services. Shenzhen Development Bank is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-investment banking securities-related services and non-securities-related services. Sinopec Corp - H is or was in the past 12 months a client of JPMSI. Sinotruk is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services. Sohu.Com is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-investment banking securities-related services and non-securities-related services. Towngas China Company Limited is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-investment banking securities-related services. Tsingtao Brewery is or was in the past 12 months a client of JPMSI. Yanzhou Coal Mining - H is or was in the past 12 months a client of JPMSI. ZTE Corp is or was in the past 12 months a client of JPMSI.

• Investment Banking (past 12 months): JPMSI or its affiliates received in the past 12 months compensation for investment banking services from Bank of China - H, China Construction Bank, China Cosco Holdings, Ltd., China Dongxiang Group Co Ltd., China Life Insurance Co. Ltd, China Merchants Bank - H, China Overseas Land & Investment, China Resources Power Holdings, China Unicom, Glorious Property, Huabao International Holdings Limited, Industrial and Commercial Bank of China - H, Shandong Weigao Group Medical Polymer Co. Ltd., Sinotruk.

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• Investment Banking (next 3 months): JPMSI or its affiliates expect to receive, or intend to seek, compensation for investment banking services in the next three months from Alibaba.com Limited, Bank of China - H, Bank of Communications Co, China Construction Bank, China Cosco Holdings, Ltd., China Dongxiang Group Co Ltd., China Life Insurance Co. Ltd, China Merchants Bank - H, China Minsheng Banking, China Overseas Land & Investment, China Resources Power Holdings, China Shineway Pharmaceutical Group Limited, China Shipping Container Lines, China Telecom Corporation Ltd, China Unicom, CNOOC, Glorious Property, Great Wall Motor Company Limited, Greentown China Holdings, Guangzhou R&F Properties, Huabao International Holdings Limited, Industrial and Commercial Bank of China - H, Mindray Medical, PICC Property & Casualty Co. Ltd, Ping An Insurance, Shandong Weigao Group Medical Polymer Co. Ltd., Sinopec Corp - H, Sinotruk.

• Non-Investment Banking Compensation: JPMSI has received compensation in the past 12 months for products or services other than investment banking from Air China, Bank of China - H, Bank of Communications Co, China Citic Bank - H Share, China Construction Bank, China Life Insurance Co. Ltd, China Merchants Bank - H, China Minsheng Banking, China Mobile Ltd, CNOOC, Glorious Property, Industrial and Commercial Bank of China - H, PICC Property & Casualty Co. Ltd, Ping An Insurance, Shanghai Pudong Development Bank, Shenzhen Development Bank, Sohu.Com, Towngas China Company Limited. An affiliate of JPMSI has received compensation in the past 12 months for products or services other than investment banking from Air China, Bank of China - H, Bank of Communications Co, China Citic Bank - H Share, China Construction Bank, China Life Insurance Co. Ltd, China Merchants Bank - H, China Minsheng Banking, CNOOC, Franshion Properties (China) Ltd., Glorious Property, Greentown China Holdings, Industrial and Commercial Bank of China - H, PICC Property & Casualty Co. Ltd, Shanghai Pudong Development Bank, Shenzhen Development Bank, Sohu.Com, Tsingtao Brewery.

• MSCI: The MSCI sourced information is the exclusive property of Morgan Stanley Capital International Inc. (MSCI). Without prior written permission of MSCI, this information and any other MSCI intellectual property may not be reproduced, redisseminated or used to create any financial products, including any indices. This information is provided on an 'as is' basis. The user assumes the entire risk of any use made of this information. MSCI, its affiliates and any third party involved in, or related to, computing or compiling the information hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of this information. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in, or related to, computing or compiling the information have any liability for any damages of any kind. MSCI, Morgan Stanley Capital International and the MSCI indexes are services marks of MSCI and its affiliates.

Important Disclosures for Equity Research Compendium Reports: Important disclosures, including price charts for all companies under coverage for at least one year, are available through the search function on J.P. Morgan’s website https://mm.jpmorgan.com/disclosures/company or by calling this U.S. toll-free number (1-800-477-0406)

Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] The analyst or analyst’s team’s coverage universe is the sector and/or country shown on the cover of each publication. See below for the specific stocks in the certifying analyst(s) coverage universe.

Coverage Universe: Frank Li: Aluminum Corporation of China Limited (2600.HK), Angang Steel Company Limited - A (000898.SZ), Angang Steel Company Limited - H (0347.HK), Baoshan Iron & Steel - A (600019.SS), Brilliance China Automotive (1114.HK), China Coal Energy (1898.HK), China Shenhua Energy (1088.HK), Denway Motors (0203.HK), DongFeng Motor Co., Ltd. (0489.HK), Great Wall Motor Company Limited (2333.HK), Maanshan Iron and Steel - A (600808.SS), Maanshan Iron and Steel - H (0323.HK), Minth Group (0425.HK), Qingling Motors Co (1122.HK), Sinotruk (3808.HK), Weichai Power (2338.HK), Yanzhou Coal Mining - A (600188.SS), Yanzhou Coal Mining - H (1171.HK), Zijin Mining Group Co Ltd (2899.HK)

https://mm.jpmorgan.com/disclosures/company

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J.P. Morgan Equity Research Ratings Distribution, as of September 30, 2009

Overweight (buy)

Neutral (hold)

Underweight (sell)

JPM Global Equity Research Coverage 39% 46% 15% IB clients* 56% 57% 42% JPMSI Equity Research Coverage 38% 51% 10% IB clients* 76% 72% 56%

*Percentage of investment banking clients in each rating category. For purposes only of NASD/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold rating category; and our Underweight rating falls into a sell rating category.

Valuation and Risks: Please see the most recent company-specific research report for an analysis of valuation methodology and risks on any securities recommended herein. Research is available at http://www.morganmarkets.com , or you can contact the analyst named on the front of this note or your J.P. Morgan representative.

Analysts’ Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues, which include revenues from, among other business units, Institutional Equities and Investment Banking.

Registration of non-US Analysts: Unless otherwise noted, the non-US analysts listed on the front of this report are employees of non-US affiliates of JPMSI, are not registered/qualified as research analysts under NASD/NYSE rules, may not be associated persons of JPMSI, and may not be subject to NASD Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public appearances, and trading securities held by a research analyst account.

Other Disclosures

J.P. Morgan is the global brand name for J.P. Morgan Securities Inc. (JPMSI) and its non-US affiliates worldwide.

Options related research: If the information contained herein regards options related research, such information is available only to persons who have received the proper option risk disclosure documents. For a copy of the Option Clearing Corporation’s Characteristics and Risks of Standardized Options, please contact your J.P. Morgan Representative or visit the OCC’s website at http://www.optionsclearing.com/publications/risks/riskstoc.pdf.

Legal Entities Disclosures U.S.: JPMSI is a member of NYSE, FINRA and SIPC. J.P. Morgan Futures Inc. is a member of the NFA. JPMorgan Chase Bank, N.A. is a member of FDIC and is authorized and regulated in the UK by the Financial Services Authority. U.K.: J.P. Morgan Securities Ltd. (JPMSL) is a member of the London Stock Exchange and is authorised and regulated by the Financial Services Authority. Registered in England & Wales No. 2711006. Registered Office 125 London Wall, London EC2Y 5AJ. South Africa: J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. Hong Kong: J.P. Morgan Securities (Asia Pacific) Limited (CE number AAJ321) is regulated by the Hong Kong Monetary Authority and the Securities and Futures Commission in Hong Kong. Korea: J.P. Morgan Securities (Far East) Ltd, Seoul Branch, is regulated by the Korea Financial Supervisory Service. Australia: J.P. Morgan Australia Limited (ABN 52 002 888 011/AFS Licence No: 238188) is regulated by ASIC and J.P. Morgan Securities Australia Limited (ABN 61 003 245 234/AFS Licence No: 238066) is a Market Participant with the ASX and regulated by ASIC. Taiwan: J.P.Morgan Securities (Taiwan) Limited is a participant of the Taiwan Stock Exchange (company-type) and regulated by the Taiwan Securities and Futures Bureau. India: J.P. Morgan India Private Limited is a member of the National Stock Exchange of India Limited and Bombay Stock Exchange Limited and is regulated by the Securities and Exchange Board of India. Thailand: JPMorgan Securities (Thailand) Limited is a member of the Stock Exchange of Thailand and is regulated by the Ministry of Finance and the Securities and Exchange Commission. Indonesia: PT J.P. Morgan Securities Indonesia is a member of the Indonesia Stock Exchange and is regulated by the BAPEPAM LK. Philippines: J.P. Morgan Securities Philippines Inc. is a member of the Philippine Stock Exchange and is regulated by the Securities and Exchange Commission. Brazil: Banco J.P. Morgan S.A. is regulated by the Comissao de Valores Mobiliarios (CVM) and by the Central Bank of Brazil. Mexico: J.P. Morgan Casa de Bolsa, S.A. de C.V., J.P. Morgan Grupo Financiero is a member of the Mexican Stock Exchange and authorized to act as a broker dealer by the National Banking and Securities Exchange Commission. Singapore: This material is issued and distributed in Singapore by J.P. Morgan Securities Singapore Private Limited (JPMSS) [MICA (P) 132/01/2009 and Co. Reg. No.: 199405335R] which is a member of the Singapore Exchange Securities Trading Limited and is regulated by the Monetary Authority of Singapore (MAS) and/or JPMorgan Chase Bank, N.A., Singapore branch (JPMCB Singapore) which is regulated by the MAS. Malaysia: This material is issued and distributed in Malaysia by JPMorgan Securities (Malaysia) Sdn Bhd (18146-X) which is a Participating Organization of Bursa Malaysia Berhad and a holder of Capital Markets Services License issued by the Securities Commission in Malaysia. Pakistan: J. P. Morgan Pakistan Broking (Pvt.) Ltd is a member of the Karachi Stock Exchange and regulated by the Securities and Exchange Commission of Pakistan. Saudi Arabia: J.P. Morgan Saudi Arabia Ltd. is authorised by the Capital Market Authority of the Kingdom of Saudi Arabia (CMA) to carry out dealing as an agent, arranging, advising and custody, with respect to securities business under licence number 35-07079 and its registered address is at 8th Floor, Al-Faisaliyah Tower, King Fahad Road, P.O. Box 51907, Riyadh 11553, Kingdom of Saudi

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Arabia. Dubai: JPMorgan Chase Bank, N.A., Dubai Branch is regulated by the Dubai Financial Services Authority (DFSA) and its registered address is Dubai International Financial Centre - Building 3, Level 7, PO Box 506551, Dubai, UAE.

Country and Region Specific Disclosures U.K. and European Economic Area (EEA): Unless specified to the contrary, issued and approved for distribution in the U.K. and the EEA by JPMSL. Investment research issued by JPMSL has been prepared in accordance with JPMSL's policies for managing conflicts of interest arising as a result of publication and distribution of investment research. Many European regulators require that a firm to establish, implement and maintain such a policy. This report has been issued in the U.K. only to persons of a kind described in Article 19 (5), 38, 47 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (all such persons being referred to as "relevant persons"). This document must not be acted on or relied on by persons who are not relevant persons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only with relevant persons. In other EEA countries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction. Australia: This material is issued and distributed by JPMSAL in Australia to “wholesale clients” only. JPMSAL does not issue or distribute this material to “retail clients.” The recipient of this material must not distribute it to any third party or outside Australia without the prior written consent of JPMSAL. For the purposes of this paragraph the terms “wholesale client” and “retail client” have the meanings given to them in section 761G of the Corporations Act 2001. Germany: This material is distributed in Germany by J.P. Morgan Securities Ltd., Frankfurt Branch and J.P.Morgan Chase Bank, N.A., Frankfurt Branch which are regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. Hong Kong: The 1% ownership disclosure as of the previous month end satisfies the requirements under Paragraph 16.5(a) of the Hong Kong Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission. (For research published within the first ten days of the month, the disclosure may be based on the month end data from two months’ prior.) J.P. Morgan Broking (Hong Kong) Limited is the liquidity provider for derivative warrants issued by J.P. Morgan Structured Products B.V. and listed on the Stock Exchange of Hong Kong Limited. An updated list can be found on HKEx website: http://www.hkex.com.hk/prod/dw/Lp.htm. Japan: There is a risk that a loss may occur due to a change in the price of the shares in the case of share trading, and that a loss may occur due to the exchange rate in the case of foreign share trading. In the case of share trading, JPMorgan Securities Japan Co., Ltd., will be receiving a brokerage fee and consumption tax (shouhizei) calculated by multiplying the executed price by the commission rate which was individually agreed between JPMorgan Securities Japan Co., Ltd., and the customer in advance. Financial Instruments Firms: JPMorgan Securities Japan Co., Ltd., Kanto Local Finance Bureau (kinsho) No. 82 Participating Association / Japan Securities Dealers Association, The Financial Futures Association of Japan. Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul Branch. Singapore: JPMSS and/or its affiliates may have a holding in any of the securities discussed in this report; for securities where the holding is 1% or greater, the specific holding is disclosed in the Important Disclosures section above. India: For private circulation only, not for sale. Pakistan: For private circulation only, not for sale. New Zealand: This material is issued and distributed by JPMSAL in New Zealand only to persons whose principal business is the investment of money or who, in the course of and for the purposes of their business, habitually invest money. JPMSAL does not issue or distribute this material to members of "the public" as determined in accordance with section 3 of the Securities Act 1978. The recipient of this material must not distribute it to any third party or outside New Zealand without the prior written consent of JPMSAL. Canada: The information contained herein is not, and under no circumstances is to be construed as, a prospectus, an advertisement, a public offering, an offer to sell securities described herein, or solicitation of an offer to buy securities described herein, in Canada or any province or territory thereof. Any offer or sale of the securities described herein in Canada will be made only under an exemption from the requirements to file a prospectus with the relevant Canadian securities regulators and only by a dealer properly registered under applicable securities laws or, alternatively, pursuant to an exemption from the dealer registration requirement in the relevant province or territory of Canada in which such offer or sale is made. The information contained herein is under no circumstances to be construed as investment advice in any province or territory of Canada and is not tailored to the needs of the recipient. To the extent that the information contained herein references securities of an issuer incorporated, formed or created under the laws of Canada or a province or territory of Canada, any trades in such securities must be conducted through a dealer registered in Canada. No securities commission or similar regulatory authority in Canada has reviewed or in any way passed judgment upon these materials, the information contained herein or the merits of the securities described herein, and any representation to the contrary is an offence. Dubai: This report has been issued to persons regarded as professional clients as defined under the DFSA rules.

General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMSI and/or its affiliates and the analyst’s involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMSI distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise.

“Other Disclosures” last revised December 7, 2009.

Copyright 2009 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan.

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