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Reviewing our views: In our report entitled, “Running Low on Fuel,” we
noted that: (1) China’s passenger vehicle sector’s (PV) FY10E earnings
may surprise on the upside due to stronger-than-expected sales volume and
bigger-than-expected operating leverage; (2) China’s passenger vehicle
sector boasts of a medium-term secular growth story due to low penetration
rate and rising disposable income; (3) in FY10, we favor foreign JVs
focusing on the medium-end and above segments over China’s local-
branded vehicle producers dominating China’s small car segment because
the small car segment may suffer from oversupply risks as early as FY10.
Three months later, we find that: (1) the industry profitability in 1H10 is
better than expected; and (2) local-branded vehicle producers focusing on
the small car segment are suffering from rising inventory and price erosion.
• Key investment risks: (1) The industry’s fundamentals should worsen on
rising oversupply risks in FY11, with China passenger vehicle sector’s
demand supply ratio likely to drop from 94% this year to 85% next year.
That said, we see a moderation in China PVs’ profitability in FY11, not a
collapse in the sector’s margins, which was the case during the 2004/05
downturn because: (a) the government is more strict with the approval of
new auto expansion projects; (b) auto producers are more disciplined in
terms of producing cars based on market demand; (2) the industry may
suffer from rising royalty fee, and the possible introduction of trademark fee
as of FY11 by Honda Motor-led foreign OEMs; and (3) possible negative
sales growth in 1Q FY10 due to the possible negative wealth effect arising
from the slump in China’s property and stock market.
• Earnings, PT and rating changes: We raise our earnings forecast for
DongFeng/Great Wall/Brilliance by 18%/10%/12% for FY10, and raise our
Dec-FY10 PT for Great Wall and Brilliance from HK$15.6 and HK$2.8 to
HK$16.8 and HK$3.3 respectively. Despite our earnings upgrade, we now
apply a 20% discount to our revised DCF value of HK$16.9 to arrive at our
Dec FY10E PT for DongFeng of HK$13.5, given the worsening industry
fundamentals. We maintain OW on Minth, with a sticky growth track
record, and upside from potential M&A activities, and keep Neutral on Great
Wall, Brilliance China, but upgrade China PV sectors’ leader DongFeng
Motor from Neutral to OW because: (1) its valuation is now more appealing
after the correction and earnings upgrade; (2) it has a proven track record in
consistently growing its core earnings during both the upturn and downturn
of the cycle; and (3) its defensive growth feature due to its wide range of
competitive product flow from its three different strategic partners.
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