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11 January 2012

EquitySector Reviewwww.sgresearch.com

Capital GoodsChina losing its shine NeutralStock selection Preferred

China entering the danger zone.

SiemensLeast preferred

Chinas two main legs of growth, construction and exports, are weakening. Housing demand is slowing, property developers are slashing prices to clear out inventories and pay back their loans and land sales are falling, putting further pressure on already tight local government finances. At the same time, export demand is weakening, reflecting the recessionary environment in developed countries. The debt burden of Chinas local governments and large ongoing deficits should prevent a large stimulus plan similar to that of 2008. Moreover, with gross fixed capital formation representing nearly 50% of GDP, China stands well ahead of other BRIC countries, and we estimate that around a third of the capital stock is not efficient and yields low or even negative returns. Monetary easing could bring some relief, although we believe that Beijing lost some control of the financing system through the recent expansion of shadow banking. China has no choice but to switch from an investment-driven to a consumption-driven economy. Infrastructure, construction and mining-related industries should see their growth rates wane accordingly. On the positive side, we have identified four major long-term themes which could provide a new leg of growth for industrial companies in China: 1) consumer products manufacturing, benefiting from Chinas rebalancing efforts; 2) healthcare equipment, driven by Chinas ageing population; 3) automation, as high wage inflation calls for increased productivity; 4) energy efficiency, becoming one of the governments key priorities, with investments of >$430bn in renewable energies, smart grids and electric mobility planned over 2011-15.

Atlas Copco Do not expect another infrastructure stimulus package.

Four new major themes should drive industrial companies growth in China.

Changing competitive landscape.

Like Japanese industrial companies in the 1980s, the emergence of new entrants from China should significantly change the competitive landscape during this decade. The most at-risk industries include rail transportation, power generation, T&D and construction equipment as well as segments recently added to the Chinese governments strategic priorities such as healthcare. We are underweight stocks with high exposure to the Chinese construction theme, namely mining-related stocks (Atlas Copco and Sandvik, both of which we downgrade to Sell). We are overweight Siemens (Buy) as Chinas accelerated spending in automation and energy efficiency could offset part of the expected slowdown in infrastructure investments. SKF is also rated Buy as it offers a comparably attractive indirect exposure to consumer-related manufacturing activities.Sbastien Gruter (33) 1 42 13 47 [email protected]

Short infrastructure/mining, long automation/energy efficiency.

Gal de Bray, CFA (33) 1 42 13 84 [email protected]

Societe Generale (SG) does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that SG 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. PLEASE SEE APPENDIX AT THE END OF THIS REPORT FOR THE ANALYST(S)

CERTIFICATION(S), IMPORTANT DISCLOSURES AND DISCLAIMERS AND THE STATUS OF NON-US RESEARCH ANALYSTS.

Macro

Commodities

Forex

Rates

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Contents4 8 Investment summary Key recommendations

11 China Entering the danger zone 19 China Rebalancing is key 31 Other long-term themes driving Chinas growth 36 Changing competitive landscape 41 Power generation 48 Rail transportation 53 Transmission & Distribution 58 Healthcare 64 Construction equipment 69 Heavy and medium duty trucks 73 Automation 77 Bearings, cutting tools and compressors 80 Low voltage

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Investment summaryThe purpose of this report is to review Chinas risks and opportunities. 1) We further detail our concerns about the Chinese economic outlook (weakening exports, housing bubble about to burst, local governments debt burden, large shadow banking system) see pages 11-18. 2) We show that China has no choice but to transition towards a more consumption-driven economy, leading to waning growth for infrastructure-related capital goods and greater demand for consumer-related manufacturing see pages 19-30. 3) We show that some companies in our universe should still benefit from some specific mega-trends in China such as the countrys ageing population (driving accelerated demand for healthcare devices), high wage inflation (requiring higher productivity and automation investments) and the growing focus on environmental protection see pages 31-35. 4) The last section deals with Chinese competition risks, which are likely to intensify as domestic demand slows down see pages 36-80.

China entering the danger zoneChinese leading indicators have deteriorated for a number of months with PMI at or below 50. Chinas two main legs of growth, exports and real estate, have shown clear signs of weakness.The export engine has seized up, because Europe and the US, Chinas two key customers, are facing a tougher macro environment. This also reflects the reduced competitiveness of Chinas cost base owing to wage inflation and Yuan appreciation (+22% vs the $ from 2007).

The construction sector, the second leg of economic growth, is also jeopardized. The

construction sector, representing 20% of GDP, has been booming over the past 10 years and has grown well beyond underlying demand in our view. Every year China builds enough new housing to accommodate at least 60 million people a year, while only 20 million people are moving to the cities. Similarly, the Chinese road or railway network is already on par with that of the US. Cement consumption has hit new highs and China is consuming nearly 1,500kg per capita, 5x the rest of world average. A number of warning signals have emerged over the past few months, suggesting that the construction bubble may be about to collapse:Housing prices down. Driven by tightening actions, housing prices are starting to correct

(70% of cities are now showing negative price development).Excess new housing inventory. Among the 75 listed real estate developers, inventories

soared by 41% year-on-year at the end of September 2011. To clear out inventories and pay down their debt, some developers are slashing prices or selling entire residential projects. The situation is unlikely to improve in the coming months, bearing in mind that a lot of properties have yet to come to market, with the number of square metres under construction exceeding the number of sqm completed by up to 6x!Falling land sales. The Financial Times (FT) reported that land sales fell 13% in 130 big cities,

with most of the fall occurring in the last few months of last year. At a time when local governments are already struggling to pay down debt on infrastructure projects, this will put further pressure on their financing since land sales represent 30-40% of their fiscal revenues.

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Ways to prevent a hard landing are more remoteObviously, the Chinese authorities are not just sitting and watching these developments unfold, although their field of action looks more remote than ever. Indeed, another large infrastructure plan looks unlikely given the very low returns on investment yielded by the previous one and the countrys already high level of debt. Chinas incremental capital output ratio is already at a record high, suggesting that any new investment is likely to yield nonperforming loans rather than prosperity. Chinese authorities have started to ease monetary policy (cutting the RRR ratio by 50bps, encouraging lending to SMEs, etc.), although the size of the shadow banking system casts some doubt about the degree of control the Peoples Bank of China has on the overall financing system.

Rebalancing a game changer for capital goods companiesEven if the Chinese authorities miraculously manage to avoid a hard landing and a collapse of the construction bubble, they cannot afford not to re-balance the Chinese economy towards consumption: 1) Benefits of growth have been biased towards corporates and not sufficiently received by households. 2) To boost employment in urban areas, China needs to grow its tertiary sector. 3) Overinvestment and excess capacity in some industries have led to a slowdown in productivity growth. 4) Investment-driven growth is highly energy intensive. The likely re-balancing of the Chinese economy towards consumption will have some major consequences on the growth potential of capital goods. On the one hand, industries like construction and infrastructure-related activities (rail, power or mining), key beneficiaries of the investment boom in China, should see their growth rates wane. On the other hand, consumer product manufacturing industries should see their growth potential materially improve as China enters mass consumption, giving a boost to the automotive, healthcare and civil aerospace sectors for example.Development process Consumption intensity vs GDP per capita

Consumption intensity (per capita)

Investment driven economy Oil Cem ent Steel

0

2500

5000

BRIC countries

Consumption driven economy

10000

15000GDP per capita $

20000

25000

30000

35000

Developped countries

40000

Source: SG Cross Asset Research

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New emerging growth driversWe have identified three other themes that should give industrial companies new legs of growth in China:Ageing population China will face an ageing of its population due to its one child policy. According to the World Bank, China spent only $300 per capita in healthcare expenditures in 2009, while developed countries spent more than 10x this amount. Assuming that China will catch up with the world average of $1,000 per capita by 2020, healthcare expenditures in China are on track to climb from $0.4trn to $1.3trn, for a CAGR of 15%.

Wage inflation and productivity gains Driven by economic growth but also by a growing

labour shortage, Chinas wage inflation should remain sustained in the medium term. Greater productivity through automation systems will be required to offset this trend.Environment and energy efficiency With its heavily investment-driven growth model and the size of its population, China is a major contributor to the worlds CO2 emissions. Environmental awareness is gaining momentum among Chinese authorities and energy efficiency or increased use of renewable energy is increasingly on top of the agenda.

Winners and losers of major macro trends in China

Macro trend

Rebalancing of the economy

Ageing Population

Wage Inflation

CO2 emissions

Sector impacted

Construction & Mining

Consumer-related industries

Healthcare

Automation

Energy efficiency

Top picks

Atlas Copco Sandvik Volvo

Philips SKF

Philips Siemens Smiths Group

ABB Invensys Siemens Schneider

Schneider Siemens ABB Atlas Copco

Source: SG Cross Asset Research

Competitive landscape should get tougherSimilar to the emergence of Japanese companies in the 1970s and 1980s, US and European companies will likely face a new wave of competition coming from China. However, unlike Japanese companies, Chinese companies have benefited from their huge domestic market to grow in size, and the impact on the competitive landscape of every capital goods industry should be much more material. We believe the threat of Chinese competition is not equally shared by all industrial companies, and we have identified five key criteria to assess the risk: 1) the strategic importance of the industry; 2) the consolidation of the customer base; 3) the ticket size; 4) the importance of aftermarket/distribution network; and 5) the scale of Chinese competitors. The industries most at risk in our view are rail transportation, power generation, T&D and construction equipment. In contrast, industries which still appear to be safe havens are low voltage, general engineering and automation.

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Assessing the Chinese competition risk for various industries in the Capital Goods sector *Key criteria Rail transport Power generation T&D Construction equipment Trucks Healthcare Automation Bearings Compressors Tooling Low voltage

Strategic Customer consolidation Ticket size OE vs aftermarket/distribution Chinese players Total Risk

5 5 5 4 5 24

5 5 5 2 5 22

5 4 4 3 4 20 High

2 2 4 4 4 16

2 2 4 2 5 15

4 4 3 2 2 15 Medium

3 2 2 3 2 12 Medium

2 2 1 3 2 10 Low

2 2 3 1 2 10 Low

1 2 1 2 2 8 Low

1 1 1 2 2 7 Low

Very high Very high

Medium to Medium high

Source: SG Cross Asset Research / * 5 = highest risk, 1 = lowest risk

Portfolio based on Chinese rebalancing themeWe have then ranked stocks by combining their exposure to long-term growth trends in China with their score on Chinese competition risk. As the following chart shows, the best positioned stocks are those that had both relatively high exposure to the four macro trends highlighted above (consumer-related manufacturing, healthcare, automation, energy efficiency) and relatively low risk with regards to Chinese competition. Schneider and SKF fit well into this category.Exposure to long-term growth trends in China vs Chinese competitive risk25

Best positioningExposure to LT growth trends in China

Philips Schneider

ABB Siemens

20 SKF

High growth but competitive risks

Inv ensy s 15Smiths

10

Atlas Copco

Alstom MAN Volv oNexans

Low growth but limited risk

Sandv ik

Scania

5

High risk profileVallourec

Legrand 05 7 Assa Abloy 9 11 13 15 17

19

21

23

25

China competitiv e risksSource: SG Cross Asset Research

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Key recommendationsThese conclusions have led us to make a number of changes to our recommendations. We overweight stocks with relatively low exposure to Chinese competition risk and high exposure to key long-term growth trends in China (healthcare, automation, energy efficiency, consumer product manufacturing). We also recommend avoiding high exposure to Europe and favour US exposure. Three stocks meet these criteria: Philips and SKF, both maintained at Buy and Schneider (Hold maintained). On the other hand, we underweight stocks which have been key beneficiaries of Chinas investment growth story and lowered our rating on both Atlas Copco and Sandvik, from Hold to Sell. We summarize our views in the table below.SG Capital Goods universe Key criteria for stock selectionGeographical exposure (US = +; Europe/China = -) End-market exposure (energy China competition risks efficiency/automation = +; (high =-; low = +) infrastructure/mining = -) Valuation (high = -; low = +) Ranking

Schneider SKF Siemens Philips Assa Abloy Legrand ABB Invensys Volvo Scania MAN Vallourec Atlas Copco Sandvik Alstom Nexans ArevaSource: SG Cross Asset Research

= + + -= + = ++ = = --

++ + ++ ++ = = ++ + = = = --++

+ + ++ ++ = = + + ---

+ ++ = -= + + = = --+ = ---

++ ++ ++ ++ + = = = = -------------

North America (as % of sales)50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%

Western Europe (as % of sales)70% 60% 50% 40% 30% 20% 10%

China (as % of sales)16% 14% 12% 10% 8% 6% 4% 2%

Schneider

Atlas Copco

Schneider

Atlas Copco

Assa Abloy

Assa Abloy

Scania

Scania

Alstom

Vallourec

Alstom

Vallourec

Sandvik

Siemens

Siemens

Sandvik

Philips

Smiths

Philips

Legrand

Invensys

Legrand

Invensys

Nexans

Nexans

Smiths

Assa Abloy

Atlas

0%Areva

ABB

MAN

Volvo

MAN

ABB

SKF

SKF

Areva

Volvo

Schneider

Legrand

Sandvik

Scania

Philips

Alstom

Volvo

Vallourec

Siemens

Invensys

Smiths

Nexans

SKF

0%

Source: SG Cross Asset Research

Atlas Copco (Sell from Hold, TP SEK120) We have reduced our rating on Atlas Copco from

Hold to Sell and cut our target price from SEK125 to SEK120. While the companys best-inclass profile is more than discounted, with the shares trading at a 25% 2012e EV/EBIT premium to the sector, Chinese risk is fully ignored. Through its mining and construction businesses, China has been a key driver of Atlas Copcos organic growth since 2004, contributing up to 60% of its growth. The new legs of growth brought by automation

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(industrial tools) and energy efficiency (compressors) will not be sufficient to offset the waning growth stemming from mining and construction. To derive our target price, we use a 75% probability for our core scenario (DCF of SEK125 from SEK130: 9.3% WACC, 20% normalised margin, 2% LT growth) and apply a 25% weighting to our worst-case scenario (SEK 100). Key upside risk would come from a longer than expected upcycle in mining capex.Sandvik (Sell from Hold, TP SEK 75) We have reduced our rating on Sandvik from Hold to Sell

and cut our target price from SEK80 to SEK75. Like Atlas Copco, Sandvik has been a key beneficiary of the construction boom in China through its mining and construction activities. We estimate that 70% of the groups organic growth since 2004 has been driven by China either directly or through its mining equipment activity. Sandviks restructuring story is appealing but remains a slow burn with tangible results unlikely to be seen before 2013. To derive our target price, we use a 75% probability for our core scenario (DCF of SEK85 from SEK90: 9.4% WACC, 15% normalised margin, 2% LT growth) and apply a 25% weighting to our worst-case scenario (SEK45). Key upside risk is higher than expected benefits from the restructuring process (our target price discounts SEK10 value creation out of SEK25 maximum potential).Siemens (Buy, TP 85) remains our top pick. In the last downturn (2008-09), Siemens proved to

be the most resilient company in our Capital Goods universe, with EBITA falling just 12% vs a sector average of -40%. Once again, we think the groups conglomerate structure and record backlog in the energy division should help protect earnings. The groups net cash position is also a key strength (A+ rating). We expect Siemens to use its financial division SFS (14bn in assets) to support the operating businesses and gain market share. The ability to provide attractive financing packages should increasingly become a competitive weapon in the energy, healthcare and infrastructure segments. The stock trades at 7x 2012e EV/EBITA, a 25% discount to the sector average, which seems unjustified to us given continued efforts to streamline the portfolio and attractive exposure to energy efficiency, smart grid and gas turbines. We reiterate our Buy rating with a target price of 85 using a 75% probability for our central scenario (DCF of 94 with 2% growth rate, 9.2% WACC and 11% normalised EBITA margin) and a 25% weighting for a worst-case scenario (61). Risks to TP: value-destroying acquisitions and unexpected project charges.SKF (Buy, TP SEK 165 up from SEK 150) We reiterate our Buy rating on SKF and raise our

target price to SEK165 from SEK150. Through its sales to automotive or aerospace industries, SKF is relatively well positioned to benefit from Chinas re-balancing. Its energy efficient and state-of-the-art bearings should also prove key assets to benefit from Chinas growing environmental awareness. The latest massive contract signed with Sinotruk is a key evidence of this trend. At the same time, our analysis shows that SKF is relatively well protected against Chinese competition. Still trading at a 25% EV/EBIT discount to its Swedish peers, SKF deserves to re-rate. To derive our target price, we use a 75% probability for our core scenario (DCF of SEK180 from SEK160: 9.3% WACC, 15% normalised margin, 2.0% LT growth) and apply a 25% weighting to our worst-case scenario (SEK115). Key downside risk would come from lower than expected productivity gains.Schneider (Hold, TP 47 up from 44) Despite the groups recent issues in terms of execution,

we believe the stock remains a long-term core investment vehicle in our universe given its exposure to attractive long-term growth drivers, energy efficiency and automation. Short term, we also expect the new company program to be unveiled on 22 February to reassure on the strategy. 1) Management should increase transparency in the solutions business margins and provide a

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roadmap on how it intends to reach critical mass in solutions, achieve more well-balanced growth and profitability and reap the benefits of recent investments. 2) Management should also detail a plan to generate further productivity gains (>1.2bn over 3 years) and reduce support function expenses as a % of sales (potential 200bp improvement over 3 years, we estimate) after significant investment in 2011. 3) M&A does not look to be on the agenda for 2012, with the group currently focusing on integrating its numerous recent acquisitions. The shares already trade at a 9% premium to the sector average on 2012e EV/EBITA and we retain our Hold rating. Our 47 target price uses a 75% probability for our central scenario (DCF of 52 with 2% growth rate, 9.3% WACC and 14% normalised EBITA margin) and a 25% weighting for a worst-case scenario (32). Risks to TP: weaker than expected price rises; value-destroying M&A.Philips (Buy, TP 17). Despite the groups recent profit warning, we believe self-help measures

will eventually pay off. Taking complexity out of the organisation by cutting 15% of overhead costs (800m out of 5bn) and keeping just one layer of support costs (to avoid duplication) should make the savings more structural this time. With the FY results, management should also come up with a plan to reduce inventory by 3% of sales, thus structurally enhancing the groups FCF generation capability. Finally, given its large exposure to healthcare (40% of sales) and consumer-related markets (30% of sales), Philips looks comparatively more defensive than other capital goods companies, in the event of a pronounced infrastructure slowdown in China. Our 17 target price uses a 75% probability to our central scenario (DCF 19, normalised EBITA margin 9%, WACC 9.6%, growth 2%) and a 25% weighting on a worst-case scenario (11). Risks to TP: weaker than expected consumer markets in Europe and failure to deliver on the cost-cutting programme.

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China Entering the danger zoneWeakening short-term indicatorsWeakening PMI data should drive weaker IP growth in coming monthsChina PMI recovered slightly to 50.3 in December from 49 in November, which had signalled the first contraction since February 2009. Although there was obvious improvement across the board, all the major sub-indices, except for production, remained in contraction albeit at slower paces. The new export orders remained subdued at 48.6 vs 45.6 in November. Inventories were still piling up, while backlog orders kept contracting. The gap between the two another good leading indicator the upcoming manufacturing growth was -4 points, still among the weakest reading ever recorded. Industrial production (IP) growth slowed to 12.4% yoy from 13.2% yoy in October. However, according to the National Bureau of Statistics, growth over the month was stable at 0.9%. Yoy production growth decelerated in most sectors, with automobile production contracting 1.5% yoy even. The steel sector weakened more sharply, with output down more than 4% mom for the second month in a row. Given the latest PMI data, it would be fair to assume that IP growth will further decelerate in coming months. The extent of the deceleration remains unknown and mainly depends on corporates reaction to the latest easing initiatives launched by the Chinese government.Chinese official PMI vs yoy growth in industrial production25%

Chinese official PMI Inventory index vs backlog index70 65 15

IP growth yoy

PMI

20%

105 0 -5 -10 -15 -20

60 55

15%

50

10%

4540

5%

35 30

0%

25

Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-05

May-05

May-06

May-07

May-11

May-08

May-09

May-10

Sep-11

Jan-05

Jan-09

Jan-10

Jan-11

Jan-06

Jan-07

Jan-08

Jan-05

Jan-07

Jan-08

Jan-09

Jan-10

Jan-06

May-06

May-08

May-09

Jan-11

May-11

May-05

May-07

May-10

Sep-05

Sep-07

Sep-08

Sep-09

Sep-10

Sep-06

Source: National Bureau of Statistics

Exports show signs of weaknessesDriven by the recessive macro environment in developed countries and notably in Europe, the Chinese export machine, a key pillar of Chinese GDP growth, has shown signs of weakness since September 2011. Exports were up only 14% in November, while accumulated growth stood at 24% at the end of August. Given the weak momentum in PMI data (latest December reading showed new export orders below 50) and ongoing macro risks in developed countries, further weakness is expected to emerge in Chinese exports over the coming months.

Sep-11

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Chinese exports ($100 million)2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0% 20% 10% 30% 50%

Chinese export growth vs PMIyoy chge60% 65

Export - $100m

PMI - New export orders (SADJ)

Exports - 3m chge yoy50% 40% 30% 20% 10%

40%

6055 50 45 40 35

0% -10% -20% -30%May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11

Mar-10

Mar-11

Jul-10

Aug-10

Dec-10

Jul-11

Aug-11

Oct-10

Apr-11

Jan-10

Jun-10

Jan-11

May-11

May-10

Feb-10

Sep-10

Feb-11

Jun-11

Sep-11

Oct-11

Apr-10

Source: Datastream

Some weakness emerged in FAI growth due to real estateFixed asset investment slowed in October, up 21% yoy vs +25% year-to-date. Most of the deceleration occurred in the property sector with fixed asset investment in real estate decelerating to +23% yoy vs 31% year-to-date. We have seen a slight pick-up in infrastructure spending with railway at -4% yoy in October vs -20% YTD and road building at +5% yoy in October. Fixed asset investment in manufacturing remained strong at +31%.Weakening FAI in real estateTotal FAI 80%200% 60% 40% 150% 100% 50% 0% -50% -100%

Nov-11

Nov-10

30

offset by slight uptick in infrastructure spendingFAI Real Estate250%

FAI manufacturing

Road

Railways

20%0% -20% -40%

01/02/08

01/06/08

01/10/08

01/02/09

01/06/09

01/10/09

01/02/10

01/04/10

01/06/10

01/08/10

01/10/10

01/12/10

01/02/11

01/04/11

01/08/11

01/04/08

01/08/08

01/12/08

01/04/09

01/08/09

01/12/09

01/06/11

01/04/08

01/06/08

01/10/08

01/12/08

01/04/09

01/06/09

01/10/09

01/12/09

01/04/10

01/06/10

01/10/10

01/12/10

01/02/11

01/04/11

01/08/11

Source: National Bureau of Statistics

Housing prices start to decline, developers struggleIn November, at least 70% of cities reported a decline in housing prices (on both the new built and second hand markets), a steep increase compared to the c.50% recorded in October. Housing prices are clearly on a downward trend and the key issue remains to assess how home owners will react to this decline since many of them used property as an inflation proof investment vehicle. Residential property sales contracted for a second month in a row by 3.3% yoy in volume and 4.5% in value in October. New starts rose 2.6% yoy from -1.3% yoy in September, but only because of a positive base effect. Property investment also slowed but remained above 20%, which seems odd given waning market confidence and dwindling demand for new land from developers.

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01/08/08

01/02/09

01/08/09

01/02/10

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% of cities with falling housing prices month-on-month80% 70% 60%

Property sector cooling120 % yoy, 3mma Housing starts 100 Property sales vol 80 Property investment (RHS)60

New built

Second hand

50 45 4035 30

50%40% 30% 20% 10%

4020

25 20 1510 5

0 -20Mar-11 Aug-11 Apr-11Jul-11

0%

Jan-11

May-11

Feb-11

Jun-11

Sep-11

Oct-11

Nov-11

-40 2005

0 2006 2007 2008 2009 2010 2011

Source: National Bureau of Statistics

Source: CEIC, SG Cross Asset Research

Inventory is building among Chinese property developers, which offered steep discounts to clear out their inventories before the end of 2011. China Securities Journal reported that the number of housing projects on sale at the Beijing Equity Exchange climbed in September and October with developers selling whole development projects. Projects worth up to CNY5bn were on offer. In the week of Dec. 5-12 2011, housing projects worth CNY1.3bn were offered for sale, and housing projects worth CNY1.9bn changed hands. The Journal also reported that some developers opted to pay their debtors, such as building material suppliers or contractors with unsold properties. Among 75 of listed real estate developers listed in the A share market, we calculate that total inventories have reached CNY726bn, an increase of 41% yoy. This situation is expected to get worse in the coming months. Indeed, while demand for new real estate weakens as buyers anticipate lower prices, the number of sqm under construction still far exceeds (by up to 6x) the number of sqm completed, suggesting that a lot of real estate projects have yet to come to market, putting further downward pressure on prices.Residential space under construction by far exceeds space completedSpace floor under construction (12M rolling basis) / space floor completed (12M rolling basis)7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0

Nov -99

Nov -00

Nov -01

Nov -02

Nov -03

Nov -09

Nov -10

May -98

May -99

May -04

May -05

May -06

May -07

May -08

May -00

May -01

May -02

May -03

May -09

May -10

Source: National Bureau of Statistics

May -11

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Nov -11

Nov -97

Nov -98

Nov -04

Nov -05

Nov -06

Nov -07

Nov -08

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Mounting fears about the Chinese financing systemThe Chinese financing system has become increasingly complex over the past two to three years, with the rapid expansion of Local Government Financing Vehicles (LGFVs) and of the shadow banking system. The next chart shows a summary of this financing system together with its close links to the construction industry.Summary of the Chinese financing system and its links with the construction industry

PBoC + Central GVTRRR cut by 50 bps in Dec 11 Loan to deposit ratio still at 75%

Local GVT Financing Vehicles(36% of GDP)

BANKS

Shadow Banking(32% of GDP)

Local GVTs

Public companies- Lo w emplo yment rate - Lo w gro wth - Lo w pro fitability

Private companiesUnde r pre s s ure : - Wage inflatio n - Lo wer expo rt o ppo rtunities - Dependence o n shado w banking

Households- High savings rate - Hurt by inflatio n - 658,000 7,000 6,000 5,000 4,000 3,000 2,000

Population ages 15-64

50%40% 30% 20% 10%

1,000UKRussia

Euro area

France

China

World

India

Brazil

Japan

0%1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Source: World Bank

Stocks exposed to the ageing population themeAlthough investors might obviously favour pure plays in the medical/pharmaceutical industries to gain exposure to the ageing population theme in China, some stocks offer some exposure, as follows:Siemens derives 17% and 21% of sales and EBITA respectively from its healthcare division. Siemens healthcare (51,000 employees, 12.5bn of revenues) provides imaging systems, invitro diagnostics laboratory equipment, hearing instruments and healthcare IT. Asia/Australia

OECD members

Germany

US

-

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accounts for 22% of divisional sales, with China experiencing a 31% CAGR over 2008-2010. Siemens estimates that it holds a 37% market share in emerging markets for imaging systems. For the next two years, Siemens expects the healthcare market to expand moderately, below the long-term growth rates for the industry. Healthcare budgets should remain under pressure in developed markets generally, but the US healthcare IT market should be supported by the development of Affordable Care Organisations (ACOs) and Electronic Medical Record (EMR) systems. Emerging markets should continue to lead global growth, particularly China, with double-digit growth rates. Every 4th MR and every 2nd CT sold by Siemens in the world already comes out of China. For more details, please refer to the Healthcare section on page 58.Philips derives around 40% and 60% of sales and EBITA respectively from its healthcare division. Philips activities (35,000 employees, 8.6bn of revenues) include imaging systems, clinical informatics, cardiac resuscitation and patient monitoring. Home healthcare is also a core part of Philips strategy and regroups the medical alert, remote cardiac, sleep management and respiratory care products and services. North America remains the largest healthcare market, currently accounting for close to 45% of Philips sales. Around 20% of sales are generated in emerging markets, which are expected to outgrow significantly other markets.

Smiths Group derives 31% of sales and EBIT from its medical division. It is specialized in disposables such as syringes and catheters and light equipment such as infusion pumps. The group still has limited presence in China with Asia accounting for only 13% of sales and 6% of headcount. To increase its exposure to the Chinese market, the group acquired a Chinese

company called ZDMI in 2009. This company makes infusion pumps for the local market and is now used as a low-cost R&D centre by Smiths Medical to develop this product range for other emerging markets.

Wage inflation and rising demand for automationAlthough wage inflation in China has been running high now for a number of years (see chart on the left-hand side), it has become a hot topic over the last 18 months due to the increased number of labour disputes. Moreover, this trend is not expected to abate since the Chinese labour force is entering a downward trend over the next few years. Despite ongoing urbanisation, the labour shortage is particularly pronounced in coastal areas.Wage inflation in manufacturing in China25%

Labour force in China (m)840 820 800

20%

15% 780 10%

760740

5%

720 0%2006 2007 2008 2009 2010 9M2011

Source: National Bureau of Statistics

Source: Economist Intelligence Unit

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030F179665

Capital Goods

The number of people aged 15-24 entering the Chinese labour market is expected to fall by a third over the next five years. That means wages will rise even more quickly than in the past. Moreover, according to Caixin Online, labour productivity in Chinas manufacturing industry is only 29% that of the US. This makes the case for automation increasingly compelling in China. Investing in industrial automation machinery will make factories more productive since the fundamental purpose of automation is to improve productivity, i.e. generate increased output with reduced costs (by reducing labour, optimizing the use of raw materials, saving energy and waste, improving quality and saving time). Note that installing industrial automation may well ease demand for unskilled and semi-skilled assembly workers but increase demand for highly skilled engineers. Fortunately, China started graduating engineers in numbers that today exceed US and European levels. Rockwell CEO Keith Nosbusch recently commented that rising standards of living, including a rapidly growing middle class will increase a need for consumer products manufacturing, and wage inflation is a natural tailwind for automation investment. We have further used the example of industrial robots to highlight the opportunities for automation players. We calculate that to achieve $1m of manufacturing output, China uses less than 20 robots, while Japan or South Korea use nearly 20x more industrial robots than China to achieve the same output. Industrial robots are mostly used in the automotive industry, and we find that China uses less than 300 robots to manufacture 100,000 cars, which is about 10 times less than countries like Japan or Germany. To catch up with developed countries China will have to multiply its installed base of robots by nearly 10x. If China were to achieve this target by 2025, 45% of the installed base of industrial robots will be in China (vs 5% in 2010) and annual deliveries should triple and reach 45k units per year vs 15k in 2010. For instance, Foxconn, the worlds largest contract electronics manufacturer, plans to increase its robot fleet from 10,000 this year up to 1 million by the end of 2013.How many industrial robots to achieve $1m of manufacturing output?400 350 300 250 200 150 100 50UK

How many industrial robots to produce 100,000 vehicles?

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

1,000500

Spain

Italy

UK

-

China

North America

Spain

North America

China

France

Germany

France

Japan

Germany

Source: SG Cross Asset Research, International Federation of Robotics

Key picks on the productivity/automation theme

ABB derives 38% of group sales from automation businesses (excluding low voltage) and is

the second-largest automation player behind Siemens. In particular, the group is the leader in process automation (oil & gas, metals, pulp & paper, power generation) with an estimated 23% market share globally. The groups flagship automation system is 800xA, which is a33

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South Korea

South Korea

Japan

Capital Goods

flexible and evolutionary system that enables the user to analyse and control the plant, as well as simulate different operating scenarios. ABB has also a strong presence in industrial robots, drives and motors. China accounts for 14% of sales.Siemens derives 27% of sales from its newly-created industry sector, comprising its PLC, DCS, motors, drives and gearboxes activities and its plant solutions in the mining, pulp and paper, cement, water and metals industries. Siemens is the worlds largest automation company. Capitalising on its historically very strong franchise in discrete automation, Siemens has also managed to become one of the leading players in process automation. The group offers very strong technological know-how, with an integrated approach, and offers clients all products, services and solutions in the factory and process automation from a single supplier, under the TIA (Totally Integrated Automation) and TIP (Totally Integrated Power) umbrellas. China represents 9% of group sales and around 13% of industry sales.

Schneider derives 20% of sales from industrial automation. Its main products are PLCs, contactors, overload relays, speed drives and motor circuit breakers. Schneider also offers automation solutions to enhance productivity, flexibility, traceability and energy management/efficiency. Schneiders customers are mainly systems integrators, OEMs, panel builders, heavy industry and electrical equipment distributors. We estimate the group holds a #4 position in the discrete automation market. Schneider can be seen as a low-cost assembler of electrical and control products. Its strategy has historically been quite different from that of Siemens and ABB. The group is not really a solutions or systems provider in the discrete automation space but rather has a product-related business model. More recently, however, Schneider has gradually moved up the curve towards solutions, with several acquisitions

made so far to complete its product offering and strong investments to develop greater project and solution capabilities. China accounts for 12% of sales.

Environment and energy efficiencyWith its heavily investment-driven growth model and the size of its population, China is a major contributor to CO2 emissions. According to the CDIAC (Carbon Dioxide Information Analysis Center), Chinas CO2 emissions reached 8.2m tonnes, almost 25% of worldwide emissions. According to the IEA, China utilizes 1.27kwh of electricity to produce $1 of GDP, more than twice the world average.Amount of electricity used (kwh) to produce $1 of GDP1.27

0.79

0.72

World average0.36 0.29 0.21

0.51

0.46

Japan

Germany

US

China

India

Middle East

Brazil

World

Source: IEA

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All these metrics mean that environmental awareness is gaining momentum among Chinese authorities and energy efficiency is increasingly on top of the agenda. According to the National Bureau of Statistics, China has already reduced its energy intensity by 19.1% from 2005 levels, close to the 20% target set under the 11 five-year plan. In the 12 five-year plan adopted in 2011, the target is to reduce the energy consumption per unit of economic output by 16-17% by the end of 2015. The plan foresees substantial investments of over $430bn in renewable energies, smart grids and electric mobility.th th

Key picks on the energy efficiency theme

ABB estimates that energy efficiency is a primary buying criteria for around 45% of its sales.

The groups offering includes efficient motors and drives, HVDC and FACTS systems, turbochargers, high-efficiency transformers, intelligent circuit breakers, metering systems, etc. In the area of smart transmission, ABB provides connection solutions to remote sources (hydro, wind, solar), stable integration of renewables to the grid, low loss transmission systems and solutions to maintain grid stability and maximize existing power assets. In the emerging smart distribution market, ABB offers substation automation, data management, real-time pricing, home automation, etc.

Schneider sees itself as a leader in energy management. Energy efficiency is a key growth

driver and is a primary purchase criterion for around 35% of group sales. Schneiders products

and solutions include energy audits and metering (to establish a baseline and assess the potential for energy savings), low energy use devices, current control and power reliability systems, automation (to manage building utilities, electricity use, motors and lighting) and monitoring (surveillance and consulting). The implementation of smarter grids should further boost the groups growth profile in the next decade. Schneider is involved in both the supply side (medium voltage and distribution automation) and demand side of the grid (building and home automation) and is therefore well positioned to help optimise interconnections between electricity producers and consumers.

Siemenss environmental portfolio officially accounted for 29.9bn of sales in FY 2011, and we

estimate energy efficiency was the main buying criteria for about 30% of revenues. We believe

that Siemens offers the most complete green portfolio in our universe with its strong positioning in the four key steps required to optimise the energy chain: The optimisation of the energy mix, including more renewable energy sources (wind) and retrofitting fossil-fuel power plants for carbon capture and storage. The need to increase efficiency along the energy conversion chain such as using advanced combined cycle power plants with >60% efficiency or HVDC transmission lines. The optimisation of the grid infrastructure, with smart grid solutions to make the network more flexible and intelligent in order to accompany the fluctuating feed-in from renewable energy sources and to meet growing power demand. The need for more energy-efficient solutions in buildings (building automation systems, etc.) and industry (energy-efficient motors, variable speed drives, etc.).

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Changing competitive landscapeOver the last decade, the story on China for industrial companies has been mainly focused on two main features: benefiting from Chinas low cost base to improve returns and targeting Chinas huge industrial market potential. But nowadays, if these two features remain largely intact, China is also emerging as a new competitor. Like the Japanese industrial companies in the 1980s, the emergence of new entrants from China in industrial markets should significantly change the competitive landscape during this decade. We believe the threat of Chinese competition is not equally shared by all industrial companies and, in the following table, we show those industries which are in our view the most at risk.Assessing the Chinese competition risk for various industries in the Capital Goods sector *Key criteria Rail transport Power generation T&D Construction equipment Trucks Healthcare Automation Bearings Compressors Tooling Low Voltage

Strategic Customer consolidation Ticket size OE vs aftermarket/distribution Chinese players Total Risk

5 5 5 4 5 24

5 5 5 2 5 22

5 4 4 3 4 20 High

2 2 4 4 4 16

2 2 4 2 5 15

4 4 3 2 2 15 Medium

3 2 2 3 2 12 Medium

2 2 1 3 2 10 Low

2 2 3 1 2 10 Low

1 2 1 2 2 8 Low

1 1 1 2 2 7 Low

Very high Very high

Medium to Medium high

Source: SG Cross Asset Research / * 5 = highest risk, 1 = lowest risk

Where Chinese firms have caught up with global playersIn order to set the scene, this first chart compares, for each industrial market, the revenues of the top global player with those of the top Chinese players. On this simple metric, the rail transportation and power sectors look particularly at risk.Top global player vs top Chinese player by industry (based on 2010 revenues)30 25 20 15 10 5 0 27x 22x 18x

13x 10x 9x 7x 4x 4x 3x 1x 1x

Bearings

Wind turbine *

Healthcare

Cutting tools

Trucks

T&D

Air compressors

Source: SG Cross Asset Research, Company Data * Based on GW

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Rail Transportation

Mining equipment

Low voltage

Construction Equipment

Powergen

Capital Goods

Growing Chinese competition in strategic big-ticket industriesWe believe that capital goods companies are set to experience growing competition from Chinese companies and price pressure when the following conditions are in place:1) The industry is strategic. For the Chinese government, which is currently building the

countrys infrastructure (power installed base, grid network, transportation network), associated capital goods industries are strategic for the countrys development. This explains why China has prevented foreign companies from entering freely into these markets, required technology transfers and systematically favoured the development of local champions.2) The customer base is highly consolidated, with only a handful of clients (utilities,

municipalities) by country. This gives customers stronger bargaining power. It also enables the low-cost competition to address these markets more efficiently as their commercial efforts can be focused on a small number of key clients. In contrast, in scattered markets such as the low-voltage industry, it is very time-consuming and expensive for a new entrant to build up the required commercial network to address all distributors and electricians.3) Demand is characterized by big-ticket contracts (typically worth more than 15m). By nature,

the larger the contract, the greater the price sensitivity, as price increases represent a significant additional amount of spending by the client. In contrast, when demand is characterized by a flow of low-ticket items (switches, bearings, locks, etc.), the products sold only represent a small cost component of customers total manufacturing or installation costs, which limits competition on price. As illustrated below, we believe that the power generation, rail transportation and T&D sectors typically share these characteristics, making them particularly exposed to Chinese competition.Low-cost competition more likely to hit big-ticket items with a consolidated customer base

Industries most at riskAttractive Pricing risks but volatile

Consolidation of the customer base

NuclearHigh

Transportation

Auto Equipment Wind Power T&D

Mining equipment

Fossil Power Generation

Medical Equipment

Automation CableLow

Compressors

Bearings

Tooling

Locks Ultra - low Voltage

Pricing power High Size of each contract Low

Source: SG Cross Asset Research

Chinas 12 five-year plan highlighted seven new strategic industries. Most of these industries are still in a nascent phase of development in the country. The government will provide financial support to these industries and preferred access to capital.th

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Alternative fuel cars Investment is likely to focus on the development of hybrid cars and

electric cars as well as better fuel-cell batteries. The country aims to produce 5 million newenergy vehicles by 2020.Biotechnology This includes biomedicines, new vaccines for disease prevention, advanced medical equipment and even extends to marine biology.

Environmental and energy-saving technologies Energy efficiency (lighting, building

automation, energy efficient motors, etc.), pollution control, clean coal, waste-matter recycling and seawater usage are among the many targets.Alternative energy China wants to further develop nuclear power plants, solar power, wind power, smart grids and bioenergy. The plan also targets promoting the internationalisation of these strategic industries.

Advanced materials Rare earth, special-usage glass, high-performance steel, high-

performance fibres and composites, engineering plastic, nano and superconducting material.New-generation information technology The plan includes the development of cloud computing, high-end software, virtual technology and new display systems.

High-end equipment manufacturing This mostly includes aircraft, high-speed rail, satellites

and offshore equipment.

Local companies are gradually moving up the learning curveFor a number of years, industrial companies have downplayed the risk of Chinese competition, arguing that in their premium segment offering the risk was relatively low and that their technological edge would prevent the emergence of any threats from Chinas low-cost competition. Although innovation is a key driver behind market share, it would be foolish not to assume that Chinese companies will move up the value chain and increasingly become technological leaders, as recently highlighted by Chinas outstanding ability to master high-speed train technology in just a few years. We list below the three key assets which should allow Chinese companies to get up to speed with Western standards:Strong support from the government When the Chinese government decides to invest in an industry, it usually supports the development of domestic companies by imposing temporary import restrictions (e.g. wind) and allocating significant financial resources to R&D (e.g. T&D). Another example is the healthcare industry, where the central government is expected to have spent >$9bn in technology R&D through the 2009-2011 stimulus package, which, on an annual basis, represents around 3x the R&D spending of Philips or Siemens.

Buying out US/EU technologies Through partnerships or JVs, Chinese companies have

managed to gain access to EU/US technologies, as shown in the rail transportation, the wind and the truck industries. In exchange for these transfers of technologies, EU/US companies have gained first access to the Chinese market, often with lump sum income but no control over quality and pricing afterwards.The greatest source of engineers The Chinese government claims that more than 500,000 students who majored in engineering, computer science, information technology, and math

will collect bachelors degrees this year. This is 3x higher than in the US. We have seen a large number of industrial companies setting up R&D centres in China to benefit from this large source of engineering capability.

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Being a leader in the Chinese mass market is keyTo respond quickly to new and changing requirements (a typical feature of fast-growing markets like China), capital goods companies need more than a local presence. They also need to have local offerings tailored to the booming entry-level market segments.Mid-segment strategies open up new growth areas. After focusing on the high-end segment over the past few years, most companies are now further boosting their growth profile by moving into these additional low- and medium-end markets. ABB, Philips, Atlas Copco and Siemens have been the most vocal in this regard.

A more comprehensive presence will also make it harder for local competitors to penetrate

western companies already established presence in premium markets, because it forces them

to compete on their home turf.

Such a strategy involves a complete shift in the value chain for emerging markets , from sales

and procurement to production and product management. This is represented by Siemens top+ SMART initiative launched in 2008 to develop Simple, Maintenance friendly, Affordable, Reliable and Timely to market products. In this respect, one of the groups flagship products is the Somatom Spirit Computed Tomography (CT) system, a multi-slice scanner for the entrylevel market segment, whose entire value chain is located in Shanghai. Some 600 Somatom Spirits have already been installed in China, primarily in rural areas. But such cost-optimization expertise is also used worldwide, with another 1,200 such scanners installed outside of China. As demonstrated by ABB (with the company facing a steady intrusion of low-cost, midsegment competitors in its traditional T&D market with increasing price pressure as a result), western capital goods companies must be quick at moving towards the medium-end market segment before local players move up the value chain. At ABB, already more than 80% of products for the Chinese market are now engineered and made locally.

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China competition risks Industry profiles41 Power Generation 48 Rail Transportation 53 Transmission & Distribution 58 Healthcare 64 Construction Equipment 69 Heavy and medium duty trucks 73 Automation 77 Bearings, cutting tools and compressors 80 Low Voltage

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Power generationChinese competition risks VERY HIGHWe view the power generation equipment industry as one of the most at risk in our universe in terms of emerging-market competition. Facing excess capacity in their home market, Chinese thermal power equipment companies are likely to look increasingly for growth opportunities in overseas markets, as illustrated by Dongfang and Shanghai Electrics major contract wins in India and Vietnam over the past two years.Power Generation Chinese competition risksKey criteria Score (out of 5) Comments

Strategic industry Customer consolidation Ticket size Aftermarket/Distribution Chinese players TotalSource: SG Cross Asset Research

5 5 5 2 5 22

Highly strategic industry, often controlled by governments High customer consolidation a couple of utilities by country Very large ticket items (EPC contracts, etc.) Very profitable aftermarket business 3 large players, already controlling 80% of the domestic market Very high risk Chinese players already very active overseas in the coal-fired and hydro markets

China remains the largest power market worldwideChinese utilities have been adding power generation capacity at an extraordinary pace over the past ten years. Chinas power generation capacity increased at a CAGR of 14% between 2000 and 2010 to reach 962GW at the end of 2010 (or 20% of the global installed base). Chinese capacity additions amounted to 33% of total global capacity additions in 2010, making China the largest market by far for new power generation capacity.Global capacity additions in GW by region since 1970300 CHINA 250 Asia ex-China LATAM 200 AFRICA / M-E EUROPE N AMERICA 100

150

50

0

Source: Platts Global Power Plants database

But activity is now declining from its highsA decade of exceptional demand growth for the Chinese power equipment sector is coming to an end. The pace of new additions is slowing down, with 90GW added during 2010 vs 101GW at the peak in 2006. According to the projections made by the International Energy Agency (IEA) in its World Energy Outlook, China should add 68GW per year on average over the next

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

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ten years, which represents a 25% decline vs 2010 levels. While the IEA forecasts may appear prudent, they do indicate that Chinas capacity additions are past the peak.Power generation installed base in China1200 1040 1000 792 800 625 600 392 400 200 0 5% 440 962 876 20% 100 83 80 15% 60 10% 40 24 20 0 20 16 28 68 25%

Capacity additions are past the peak (GW)120 100 101 88 90

713 517

68

40

0%

2003

2004

2005

2006

2007

2008

2009

2010

2011e

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Installed base (GW)Source: Platts Global Power Plant Database

Growth rate (%, RHS))Source: IEA

IEA 20102020

Nuclear and wind are taking share from coalCoal and hydro remain by far the dominant categories used in power generation in China, with a respective share of 74% and 17% of installed capacities in 2010. In comparison, wind and nuclear only accounted for respectively 2% and 1% of installed capacities. This mix is, however, expected to change rapidly as the Chinese government, through its stimulus plan, has decided to push for CO2-free power generation, setting up a plan to increase the share of renewable energy in its energy mix to 20% by 2020. This decision is driven by the necessity to reduce the countrys reliance on fossil fuels and cut CO2 emissions (China is now a larger source of energy-generated CO2 emissions than the US). China therefore intends to diversify away from coal in favour of wind and nuclear, which should represent 20% and 8% of new capacity additions respectively over 2011-2020e, according to IEA estimates. For example, nuclear and wind already accounted for 25% of new orders in 2010 at Dongfang Electric.Chinese installed capacity by fuel, 2010Nuclear Other Wind 1% 2% Gas 2% 4%Hy dro 17% Wind 20%

New capacity additions by fuel, 2011-2020eNuclear 8% Other 4%

Coal 40%

Coal 74%

Gas 8% Hy dro 20%

Source: Platts Global Power Plants Database

Source: IEA

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Three Chinese companies control the domestic marketThree Chinese companies (Shanghai Electric, Dongfang Electric and Harbin Power Equipment) control close to 80% of the domestic market. With a combined order book of over CNY480bn (54bn) in 2010, the three Chinese companies have reached critical mass and are now serious competitors for the European and US historical leaders in international markets.Chinese power generation market share, 2010 Top global power generation companies (2010 orders, bn)25 Other 24% Shanghai Electric 30% 23.7

bn

20 15.8 15 9.9 10

9.57.7

6.6

5.6

4.9

4.7 1.9

5 Harbin Power 20% Dongfang 26%Source: Company data, SG estimates

0

MHI

Doosan

BHEL

Harbin

GE

Shanghai

Source: Company data

Shanghai Electric Strong cooperation with SiemensShanghai Electric (SEG) is the largest of the three Chinese power generation players, with revenues from the power generation segment of CNY43bn (4.8bn) in FY2010, or 65% of group sales. Its order backlog in this segment amounted to CNY154bn (17bn) at year-end 2010, or 3.5x revenues. The group received CNY44bn in power orders in 2010, primarily reflecting the groups success in foreign EPC (Engineering, Procurement and Construction) markets. Shanghai Electric Power Generation (active in the manufacture and sale of power generation equipment and auxiliary products) is 40%-owned by Siemens.Revenue and margin history9080 70

Revenue breakdown by product, 201010%9% 8%

CNY Rmb bn bn

Other 4% Industrial Equipment 28%

6050 40

7%6% 5%

Dongfang

Siemens

T hermal Power 40%

4%3% 2%

3020 10 0 2006 2007 2008 2009 2010 2011e 2012e

1%0%

Services 19%

Revenues

EBIT margin (%, RHS)

Wind & Nuclear 9%

Source: Company data, IBES

Source: Company data

Shanghai Electrics strategy is to consolidate its market share in China and accelerate its internationalisation. The group has a leading position in thermal power equipment in China with a 55% market share in large-scale units (1,000MW). The group also plans to expand its technologies in clean and efficient thermal power equipment, for example by developing carbon capture technology: it is currently the main equipment supplier for Chinas first IGCC project in Tianjin. SEG is refocusing on the wind and nuclear energy equipment businesses (10% of revenues in 2010). It still lags behind Dongfang Electric in these two businesses in terms of sales and orders but is expected to catch up thanks to large investment in R&D and43

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Andritz

Alstom

Capital Goods

partnerships/JVs with Siemens and Toshiba-Westinghouse in China, which allow it to quickly adopt new technologies. Finally, the group aims to further accelerate its development in export markets, which already represented 19% of its 2010 sales. This notably reflects large contract wins for coal-fired plants in Iraq, India, Africa and Vietnam.Shanghai Electric Main export contracts booked over 2009-2011Contract details Country Value Date

2x610MW coal-fired power plants 125x2MW onshore wind turbines 66x660MW steam turbine and generator sets 2x600MW coal-fired power plants 2x600MW coal-fired power plantsSource: SEG

Iraq India India Vietnam Botswana

$1,000m $8,291m $1,380m $1,956m

Apr-11 Apr-11 Oct-10 Oct-09 Mar-09

Dongfang Electric the first mover into nuclear and wind marketsDongfang Electric is a pure player in the power generation market, with total revenues of CNY37.6bn (4.2bn) in 2010, up 15% yoy. The group has an estimated market share of 26% in China, with power generation equipment output capacity of 34GW in 2010. In 2010, 54% of sales were still generated by thermal, 25% by wind and nuclear, 8% by hydro and 13% by construction and services related to EPC contracts.Revenue and margin history60 50 40 306%

Revenue breakdown by product, 201014%12%

CNY RMB bn bn CNY bnbn CNY

Construction & Services 13%Hydro Power 8%

10%8%

20 10-

4% 2% 0%

T hermal Power 54% Wind & Nuclear 25%

2006

2007

2008Revenues

2009

2010

2011e

2012e

EBIT margin (%, RHS)

Source: Company data, IBES

Source: Company data

Among the three Chinese leaders, Dongfang Electric was the first group to move into the nuclear and wind power equipment markets. Its total order backlog at the end of 2010 in power generation was CNY140bn (15.6bn), or 3.7x 2010 revenues, of which 63% attributable to thermal power generation, 16% to wind and nuclear, and 10% to hydro. In conventional thermal power generation, the group is well positioned in large-scale hydro and coal-fired power generation equipment. In 2011, momentum remained positive and the group expects to deliver a total of 38GW production capacity of power generation equipment, up 10% yoy. Beyond 2011, the construction of new thermal power generation units in China is however expected to decrease, which would severely affect the number of thermal orders for the group in the future. Dongfang Electrics strategy is to develop its overseas operations aggressively. The group plans to increase its share of overseas business to up to 30% of revenues over the next three years in order to offset the expected decline in the thermal equipment segment in China. In 2010-2011, the group officially entered the power markets of Brazil, Saudi Arabia and Bosnia. In particular, the Rabigh project in Saudi Arabia is the first 60Hz thermal power generation equipment made in China to be exported to the Middle East. The Brazil Jerry Project was also the order with the largest contract value for Chinese hydro power equipment. Dongfang

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Electric now intends to enhance its marketing efforts and explore new markets such as the Middle East, eastern Europe, South America and Africa, and gradually expand into the middleto high-end markets.Dongfang Electric - main export contracts in 2009-2011Products Country Value Date

Low pressure heater for nuclear power plants 10x660MW steam turbine and generators sets 166 units of 1.5MW wind turbines 300MW coal-fired power plant 1800MW hydro power plant 2x622MW coal-fired power plants 2x660MW coal-fired power plants (consortium with Kepco) 3,300MW hydro power plant equipmentSource: SG Cross Asset Research, company data

France India India Bosnia Ethiopia Vietnam Saudi Arabia Brazil

$2,500m $203m $700m $450m $1,400m $1,700m $400m

Jun-11 Dec-10 Nov-10 May-10 May-10 Mar-10 Mar-09 Nov-08

Dongfang Electric also has the greatest exposure to nuclear. Dongfang Electric was an early entrant in the Chinese nuclear power market (1996) and offers the longest track record of the Chinese groups, with more than 10 years of R&D experience. The company already has a track record with the CPR-1000 model (a Chinese version of Arevas Generation 2 design). This model is outright leader in China as out of 26 nuclear reactors under construction in China in 2011, 16 are CPR-1000. Dongfang also became the first company to manufacture simultaneously second-generation CPR-1000, third-generation AP1000, and EPR nuclear island and conventional island equipment, following a successful bid for the 1,000MW AP1000 project in Taohuajiang and the subcontracting contract for nuclear island equipment for Taishan EPR through the consortium formed with Areva and China Guang Dong Nuclear Power Company.

Harbin Power Highest exposure to a saturated Chinese coal marketHarbin Power is the third-largest power generation company in China with a market share of 25% for the local installed base and 2010 revenues of CNY28.8bn (3.2bn). Total output in 2010 was 17.9GW, down 14% yoy.Revenue and margin history35

Revenue breakdown by division, 20109%

Rmb bn CNY bn

30 2520 15 10 5

8%7% 6% 5% 4%

AC/DC motors and Ancillary others 9% equipment 3%Engineering services 18%

3%2% 1%

2004 2005 2006 2007 2008 2009 2010 2011e 2012eRevenues EBIT margin (%, RHS)

0%

Hydro power 8%

T hermal power 62%

Source: Company data, IBES

Source: Company data

Harbin has significant exposure to an increasingly saturated thermal power equipment market and was the leader in market for 300MW and 600MW steam turbines and generators in China in 2010. Harbin also leads the hydro power equipment market, with close to 50% of the domestic installed base. Finally, it has a small presence in the gas turbine market. Recent export successes have compensated for the declining domestic market in thermal power generation. Harbins order intake in 2010 was CNY42.4bn (4.7bn), of which 42% in thermal power equipment, 3% in hydro, 21% in engineering services, 26% in nuclear and 8% for others. Exports accounted for CNY18.4bn (2.0bn) or 43% of new orders, including large contract

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wins in India in 2010 (marking the groups first entry into the Indian market with its 600MW supercritical steam turbines and generators).Harbin Power Main export contractsProducts Country Value Date

6x660MW supercritical boilers units 16x660MW supercritical steam turbine and generators Thermal power equipment 750MW combined cycle power plantSource: Company data

India India Vietnam Pakistan

$1,060m $1,470m $162m $400m

Jan-11 Sep-10 Feb-10 Sep-09

Chinese players increasingly looking overseasChinese companies already have significant market shares globally, especially in hydro and steam turbines, where they account for about 36% and 38% of the market respectively. This mainly reflects their strong positioning in the large Chinese and Indian markets, where the abundance of coal resources and the urgency to address a tight power supply situation led to the quick expansion of coal-fired power plants as the preferred source of power during the past decade. In the wind segment, the largest Chinese vendors are now also ranked in the top world positions, with Sinovel and Goldwind in the #2 and #4 spots respectively. Thanks to design support and component supplies from Western companies such as AMSC, they have rapidly moved up the value chain and developed large-size turbines as well as offshore turbines. Given their critical mass, the Chinese companies now look ready for rapid international expansion. In contrast, the gas turbines market is still dominated by Western players (GE, Siemens, MHI and Alstom).Steam turbines market share, 2009-2010Others 16% Shanghai 20%

Hydro turbines market share, 2008

Other 16%

Harbin 20%

Toshiba 4% MHI 4% GE 4% Alstom 4% Siemens 4%

Andritz 10% Dongf ang 16% VoithSiemens 12%

Dongfang 19%

BHEL 6%Harbin 19%

Alstom 26%

Source: Platts Global Power Plants database

Source: Andritz, Alstom

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Gas turbines market share, 2009-2010Hitachi BHEL 1% 1% Ansaldo 3% Tuga 6% MHI 10%

Wind turbines market share, 2010Other 17%

Other 8%

Sinovel 11%Goldwind 9%

GE 38%

Siemens 6% Gamesa 7% Dongfang 7% Guodian United Power 4% Suzlon 7% Vestas 15%

Alstom 12%

Enercon 7% GE 10%Source: BTM

Siemens 21%Source: Platts Global Power Plants database

The only way to compete is via partnerships with Chinese playersGiven their limited access to the Chinese market (often due to temporary import restrictions or local buying preferences), the only way that Western companies can compete is to create JVs with existing local players. In this respect, Shanghai Electric has been the most responsive Chinese company. Shanghai Electric has a 60%-40% JV with Siemens (Shanghai Electric Power Generation Equipment) which enables Siemens to participate indirectly in the Chinese power equipment market. Siemens is also outsourcing the production of thermal power equipment to Shanghai

Electric, effectively using the Chinese player as a low-cost provider of components for its EPC contracts in emerging markets. We note that Siemens has imposed export restrictions on its Chinese partner: Shanghai Electric Power cannot sign order contracts in Europe and the US involving equipment that uses Siemens technology. In December 2011, Shanghai Electric and Siemens announced the creation of two new JVs in the offshore wind area. In each of the JVs, Siemens will have a stake of 49% and its Chinese partner 51%. The first JV will be engaged in R&D and production of wind turbine equipment (nacelles and hubs) for the Chinese market and for Siemens' global supply network. The second JV will be responsible for wind turbine equipment sales, marketing, project management and execution as well as service in China.

Shanghai Electric has agreed to team up with Alstom. The combined entity looks set to be the global leader in boilers, with estimated sales of 2.5bn. The 50-50 JV should control around one-third of the global boiler market. Alstom also brings its ECS (Environmental Control Systems) operations in China to the JV. By joining forces with Shanghai, Alstom has managed to find an exit for this business which is highly commoditised and brought only a limited contribution to earnings.

Generally, we consider that these JVs make sense since they give foreign companies indirect access to the Chinese market and provide them with more competitive component supplies to support their turnkey operations in international markets. That said, these deals are clearly defensive and further highlight how competitive the power markets have become over the past few years since they often involve transferring technologies and gradually losing control of the product manufacturing base.

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Rail transportationChinese competition risks VERY HIGHThe Ministry Of Railways controls market access to the railway sector and Chinese policy makes it impossible for foreign companies to produce complete trains in China, forcing them to enter into partnerships with local companies CNR and CSR and requiring substantial technology transfers. Both CSR and CNR have already reached critical scale thanks to the size of their domestic market. They now intend to increase exports of their rolling stock and are likely to bid for major metro, locomotives and high-speed train projects in the future in international markets.Rail transportation Chinese competition risksKey criteria Score (out of 5) Comments

Strategic industry Customer consolidation Ticket size Aftermarket/Distribution Chinese players TotalSource: SG Cross Asset Research

5 5 5 4 5 24

Strategic industry, often controlled by governments Very high Municipalities, governments Very large ticket items Limited aftermarket business 2 large players, controlling 100% of their domestic market Very high risk Chinese players already larger in size than traditional players

Rail infrastructure investments in China peaked in 2010The rail transportation market is expected to grow from 45bn in 2010/2011 to 51bn in 2015/2016 according to the latest data from UNIFE and Bombardier. This would imply 2.3% CAGR over the period. This is a marked slowdown compared to the 2005-2009 period during which the industry experienced 6% CAGR, mainly driven by the Chinese boom. Europe is still the largest region with 39% of the total, but the size of the Chinese market has increased substantially over the past five years, now accounting for 33% of the global market.Global rolling stock market by region, 2010Latin America India 4% 5% Asia-Pacif ic 5%

Global rail transportation market share by player, 2010Invensys 2% Ansaldo STS 3% KHI 3% Others 9% CSR 16%

CIS 7%

Europe 36%

CAF 3% TMH 4% CNR 15%

North America 10%

GE 6%

Siemens 11%

Bombardier 15%

China 33%Source: UNIFE

Alstom 13%Source: Company data, Bombardier, UNIFE

Under the Chinese mid- and long-term railway network plan, investments in railway infrastructure have grown rapidly, with a peak in 2010 at around CNY700bn. However, 2011 was a turning point for spending on infrastructure following the dismissal of the Ministry of Railway (MOR) due to corruption charges and the collision between two high speed trains in July, killing some 43 passengers. This was the worlds first fatal train accident on a dedicated

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high-speed line. Facing financing constraints and increased losses, the MOR then decided to cut spending on infrastructure to an expected CNY470bn in 2011 and CNY400bn in 2012, 43% lower than the peak. It is clear that the MOR faces a declining rate of return on new projects and many new lines appear to be under-utilised.High speed rail (km)12,000

Chinese railway infrastructure spending (CNY bn)In operation In construction

800 707 700 623

-43%

10,000

600

Bn Y uans

8,000

500 400 300 337

469 400

6,000

4,000

200 89 100

155

179

2,000

0

2011e

China Spain Japan France Others Germany Italy BelgiumSource: MOR Source: International Union of Railways

Rolling stock investments usually lag rail infrastructure investments by 2-3 years. Therefore, the decline in infrastructure spending from 2011 on should be followed by a similar trend for rolling stock investments. As shown in the graph below, based on recent data from UNIFE, mentioned by Alstom, the Chinese rolling stock market should decline by at least 20% in 2014-2015 vs the 2008-2010 peak.Chinese rolling stock market likely to decline after 2013e9 8 7 6 5 4 3 2 1 0 2008-10 High SpeedSource: UNIFE 2010, Alstom, SG Cross Asset Research

bn

8.4

8.3

6.6

2011-13e Regional Locos Metro

2014-16e LRV

Chinese players have a monopoly on their local marketThe Ministry of Railways (MOR) controls market access to the railway sector and supervises the purchase and pricing of rolling stocks. Each railway administration has to submit its request to the MOR, which centrally purchases equipment and allocates orders through bidding processes with CSR (China South Locomotive and Rolling Stock) and CNR (China Northern Locomotive and Rolling Stock), the two leading companies. CSR had 51% of the market in 2010, while CNR had the remaining 49%. The bids are not entirely based on market prices as the MOR may provide guidance for the pricing of a new type of train by referring to11 January 2012 49

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2007

2008

2009

2010

2005

2006

Capital Goods

the prices and cost structure of similar products and profit margins. The MOR is also responsible for testing, formulating technical standards and safety specifications and delivering production licences. CNR and CSR were formed from the break-up of China Locomotive & Rolling Stock Corporation in 2000 and today provide a full range of rail transportation equipment, including locomotives, freight wagons, passenger carriages, multiple units and urban railways.

CSR is the leading Chinese rail transportation equipment companyCSR recorded sales of CNY63.9bn in 2010 (7.1bn), representing an increase of 40% over the previous year. CSR is the leader in the high-speed train segment. CSR has received to date total orders for 680 high-speed trains, representing around 60% of total orders allocated by the MOR, of which 242 trains have already been delivered. CSR directly controls around 40% of the high-speed train market, being the manufacturer of CRH2 trains (based on Kawasaki technology) while its 50/50 JV with Bombardier has about 20% of the market, supplying CHR1 trains (based on Bombardier technologies). Before the train crash in July and the budget cuts from the MOR, CSR had set up aggressive development targets in export markets (up to 15% of revenues from only 4% in 2010).CSR - Sales and EBIT margin history90 80 64 70 60 50 46 35 23 27 2% 1% 0% 2006 2007 2008 2009 2010 2011e 5% 4% 3% 86 7% 6%

CSR - Revenue breakdown by segment, 2010Others 20%Locomotiv e 28%

4030 20 10 -

Passenger carriage 7%

Metro 11%High Speed trains 23%

Revenues (Rmb bn)

EBIT margin (%, RHS)

Freight wagon 11%

Source: Company data, Bloomberg

Source: Company data

CNR is the second major player, leading the locomotive segmentCNRs sales totalled CNY62.2bn (6.9bn) in 2010 with similar business lines to CSR. The group controls 40% of the high-speed train market to date and is the major supplier of CRH3 trains (based on Siemens Velaro technology). CNR is the industry leader in the locomotives segment, gradually gaining share over CSR in high-powered electric locomotives. CNR also has aggressive development plan for export revenues.CNR - Sales and EBIT margin history90 80 5.0% 70 60 50 40 30 20 1.0% 35 41 62 4.0% 3.0% 2.0% 84 6.0%

CNR - Revenue breakdown by segment, 2010Others 30% Locomotiv e 24%

2621

10 2006 2007 2008 2009 2010 2011e

Passenger carriage 6% Metro 8%

High Speed trains 19% Freight wagon 13%

0.0%

Revenues (Rmb bn)

EBIT margin (%, RHS)

Source: Company data, Bloomberg

Source: Company data

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Well positioned to expand market share in foreign marketsBoth CSR and CNR intend to increase exports as a percentage of their revenues in order to face the impending slowdown of the Chinese rail market. CSR is the most aggressive, targeting to grow export revenues tenfold until 2015e, with export revenues growing from 4% to 15% of sales.

Best-in-class technologies already absorbedChinese policy makes it impossible for foreign companies to produce complete trains in China, forcing them to enter into partnerships with local companies. CNR and CSR (via their many subsidiaries) are the only two companies authorized to sell complete trains in China. Contracts won by foreign companies were therefore systematically obtained through partnerships or JVs and involved substantial technology transfers. For example, by importing foreign EMU (Electrical Multiple Units) technologies, the Chinese rail equipment manufacturers CSR and CNR have successfully introduced EMUs with operating speeds exceeding 300km/h as of 2007. The 350km high-speed EMUs independently developed by CSR began mass production in 2009. This surprisingly quick ability to master high-speed train and highpowered electric locomotive manufacturing was achieved on the back of the technological transfers shown in the two tables below. In December 2011, CSR unveiled an ultra-high-speed test train, intended to give Chinese engineers the opportunity to research train and track behaviour at speeds up to 500km/h! This train was developed with the support of the Ministry of Railways and the Ministry of Science & Technology.Electrical Multiple Units (EMU) technology transfers to ChinaSeller Model Buyer Date Commercial speed (km/h) Chinese name Units Contract size (m)

Alstom Kawasaki Siemens Bombardier Siemens BombardierSource: Company data

Pendolino Shinkansen E2-1000 Velaro ICE-3 Zefiro Velaro Zefiro

CNR CSR CNR CSR CNR CSR

2004 2004 2005 2007 2009 2009

200 200 300 250 350 380

CRH-5 CRH-2 CRH-3 CRH-1 CRH-3 CRH-1

60 60 60 40 100 80

660 na 669 413 750 700

Locomotives technology transfers to ChinaCompany Partner Model Characteristics

CSR CSR CSR CNR CNR CNR CNRSource: Company data

Siemens Siemens Siemens Alstom Alstom Toshiba Bombardier

EuroSprinter EuroSprinter EuroSprinter Prima Prima SSJ3&EH500 IORE Kiruna

8-axle and 9600kw 6-axle and 9600kw 6-axle and 7200kw 6-axle and 9600kw 8-axle and 9600kw 6-axle and 9600kw 6-axle and 7200kw

Critical size and 30% cost advantageIn 2002, the Chinese players had about 6% of the global market while Bombardier, Alstom and Siemens had 53% of the market. In 2010, their global market share increased to 21%, leaving only 39% for the three big traditional players, primarily reflecting the strong expansion of the protected Chinese railway market. CSR and CNR have now reached critical mass, with annual turnover in excess of their Western peers. While it might be too early to assess the negative impact the train accident in China will have on the credibility of Chinese technology and whether it could hamper development overseas, we know that CSR and CNR can export more aggressively in theory, with their strong 30% price advantage against Western competition.

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Price comparison between main high-speed train models40.0 35.0 30.830.0 30.0

m 35.0

28.6

25.0 20.0 15.0 10.05.0

22.1 20.0

0.0 Alstom AGV Bombardier Zef iro Siemens Velaro Alstom TGV Duplex CNR CRH3 CSR CRH1

Source: Company data, Railway Gazettte, Brazil TAV project Capital Cost report (2009)

Rail transport market share - 2002Others 18% Bombardier 21%

Rail transport market share - 2010Others 9% KHI 3% CAF 4% Ansaldo 4% CSR 16%

Japanese 8% CNR 3% CSR 3% GM 4% Ansaldo 4%

TMH 4%

CNR 15%

GE 6%

Alstom 17%Siemens 11%

Bombardier 15%

GE 7%

Siemens 15%

Alstom 13%

Source: UNIFE 2010, Bombardier Transport, Companies data, SG Cross Asset Research

Chinese manufacturers have already expanded their presence overseas, as illustrated by some recent contracts awarded to CSR and CNR in emerging markets, primarily for metro carriages and locomotives.CNR and CSR Main recent contracts abroad (2010-2011e)Country Product Supplier Value Date

Georgia Middle East Iran Georgia Mongolia New Zealand Australia Saudi Arabia Malaysia India Belarus Argentina Pakistan

5 additional EMUs Metro vehicles ZK1-E wagon bogies 5 EMUs Locomotives 300 wagons Locomotives 10 mainline locomotives Urban rail vehicles Metro/subway Locomotives Metro/subway Coaches

CSR CSR CSR CNR CSR CNR CNR CSR CSR CSR CSR CNR CNR CNR

na 64m 280m 23m 24m 22m 22m 12m na 454m na 76m 343m 78m

Sep-11 Sep-11 Aug-11 Apr-11 Mar-11 Jan-11 Dec-10 Sep-10 Jul-10 Jul-10 Jun-10 Mar-10 Jan-10 Jan-10

Turkmenistan 60 freight locomotives

Source: Company data

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Transmission & DistributionChinese competition risks HIGHWe believe the T&D industry is a story of two halves. On the one hand, demand is expected to continue growing at a higher pace than GDP, supported by Chinas massive investment program over 2010-2015, primarily in the high-end segments (HVDC, UHVDC and Smart Grid). On the other hand, the preference for buying locally has created new competition and pricing pressure in the traditional AC segment has now become a fact of life for Western manufacturers.T&D Chinese competition risksKey criteria Score (out of 5) Comments

Strategic industry Customer consolidation Ticket size Aftermarket/Distribution Chinese players TotalSource: SG Cross Asset Research

5 4 4 3 4 20

Strategic industry High Grid operators, utilities, energy-intensive industries Products and Systems (large HVDC contracts, bulk tenders) Limited service business New players emerging and gradually taking s