China Autos: A medium-term secular growth story, despite the short-term oversupply risk

- 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 localbranded 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."
JPMorgan China Autos 20100730

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