socgen - china losing it shine
TRANSCRIPT
Macro Commodities Forex Rates Equity Credit Derivatives
11 January 2012
Equity
Sector Review
www.sgresearch.com
Capital Goods China losing its shine
Neutral China entering the danger zone. China’s 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.
Do not expect another infrastructure stimulus package. The debt burden of China’s 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.
Four new major themes should drive industrial companies’ growth in China. 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 China’s rebalancing efforts; 2) healthcare equipment, driven by
China’s ageing population; 3) automation, as high wage inflation calls for increased
productivity; 4) energy efficiency, becoming one of the government’s key priorities, with
investments of >$430bn in renewable energies, smart grids and electric mobility planned
over 2011-15.
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 government’s strategic priorities such as healthcare.
Short infrastructure/mining, long automation/energy efficiency. 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 China’s 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.
Stock selection
Preferred
Siemens
Least preferred
Atlas Copco
Sébastien Gruter
Gaël de Bray, CFA
(33) 1 42 13 47 22 (33) 1 42 13 84 14
[email protected] [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.
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Contents
4 Investment summary
8 Key recommendations
11 China – Entering the ‚danger zone‛
19 China – Rebalancing is key
31 Other long-term themes driving China’s 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 summary
The purpose of this report is to review China’s 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 country’s 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 zone
Chinese leading indicators have deteriorated for a number of months with PMI at or below 50.
China’s 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, China’s two key customers,
are facing a tougher macro environment. This also reflects the reduced competitiveness of
China’s 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 remote
Obviously, 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 country’s already high level of debt. China’s incremental capital output
ratio is already at a record high, suggesting that any new investment is likely to yield non-
performing 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 People’s
Bank of China has on the overall financing system.
Rebalancing – a game changer for capital goods companies
Even 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
0 2500 5000 10000 15000 20000 25000 30000 35000 40000
Co
ns
um
pti
on
in
ten
sit
y (
pe
r c
ap
ita
)
GDP per capita $
Steel
Cement
Investment driven economy
Consumption driven economy
BR
IC
co
un
trie
s
De
ve
lop
pe
dc
ou
ntr
ies
Oil
Source: SG Cross Asset Research
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New emerging growth drivers
We 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, China’s 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 world’s 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
Consumer-related industries
Healthcare AutomationEnergy
efficiency
Rebalancing of the economyAgeing
Population
Wage Inflation
CO2 emissions
PhilipsSKF
PhilipsSiemens
Smiths Group
ABBInvensysSiemens
Schneider
SchneiderSiemens
ABB
Atlas Copco
Macro trend
Sectorimpacted
Top picks
Construction & Mining
Atlas Copco SandvikVolvo
Source: SG Cross Asset Research
Competitive landscape should get tougher
Similar 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 5 5 5 2 2 4 3 2 2 1 1
Customer consolidation 5 5 4 2 2 4 2 2 2 2 1
Ticket size 5 5 4 4 4 3 2 1 3 1 1
OE vs aftermarket/distribution 4 2 3 4 2 2 3 3 1 2 2
Chinese players 5 5 4 4 5 2 2 2 2 2 2
Total 24 22 20 16 15 15 12 10 10 8 7
Risk Very high Very high High Medium to
high
Medium Medium Medium Low Low Low Low
Source: SG Cross Asset Research / * 5 = highest risk, 1 = lowest risk
Portfolio based on ‘Chinese rebalancing’ theme
We 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 risk
Alstom
ABB
Siemens
Volv oScaniaMAN
Inv ensy s
Nexans
Smiths
Atlas Copco
Sandv ik
SKF
Schneider
Legrand
Assa Abloy
Philips
Vallourec
0
5
10
15
20
25
5 7 9 11 13 15 17 19 21 23 25
Ex
po
su
re t
o L
T g
row
th t
ren
ds
in C
hin
a
China competitiv e risks
Best positioning
Low growth but limited risk
High risk profile
High growth but competitive risks
Source: SG Cross Asset Research
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Key recommendations
These 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 China’s 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 selection
Geographical exposure
(US = +; Europe/China = -)
End-market exposure (energy
efficiency/automation = +;
infrastructure/mining = -)
China competition risks
(high =-; low = +)
Valuation
(high = -; low = +)
Ranking
Schneider = ++ + - ++
SKF - + + + ++
Siemens - ++ - ++ ++
Philips + ++ - = ++
Assa Abloy + = ++ -- +
Legrand -- = ++ = =
ABB = ++ - - =
Invensys + + - + =
Volvo = = - + =
Scania - = = = -
MAN - = = = -
Vallourec ++ -- - - --
Atlas Copco = - + -- --
Sandvik = - + -- --
Alstom - - -- + ---
Nexans - -- - = ----
Areva -- ++ -- --- -----
Source: SG Cross Asset Research
North America (as % of sales) Western Europe (as % of sales) China (as % of sales)
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
Sm
ith
s
As
sa
Ab
loy
Inve
ns
ys
Ph
ilip
s
Va
llo
ure
c
Sc
hn
eid
er
Sie
me
ns
Vo
lvo
Atl
as
Co
pco
Are
va
AB
B
Sa
nd
vik
SK
F
Ne
xan
s
Le
gra
nd
Als
tom
MA
N
Sc
an
ia
0%
10%
20%
30%
40%
50%
60%
70%
Are
va
Le
gra
nd
Sc
an
ia
Sie
me
ns
MA
N
Ne
xan
s
SK
F
Als
tom
As
sa
Ab
loy
Ph
ilip
s
AB
B
Sc
hn
eid
er
Vo
lvo
Inve
ns
ys
Sa
nd
vik
Atl
as
Co
pco
Va
llo
ure
c
Sm
ith
s
0%
2%
4%
6%
8%
10%
12%
14%
16%
Sc
an
ia
Le
gra
nd
Sm
ith
s
MA
N
Als
tom
Inve
ns
ys
Ne
xan
s
Sa
nd
vik
Ph
ilip
s
Sie
me
ns
As
sa
Ab
loy
Vo
lvo
Va
llo
ure
c
Atl
as
…
Sc
hn
eid
er
SK
F
AB
B
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 company’s best-in-
class 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 Copco’s organic growth since 2004,
contributing up to 60% of its growth. The new legs of growth brought by automation
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11 January 2012 9
(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 group’s organic growth since 2004 has been driven by China
either directly or through its mining equipment activity. Sandvik’s 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 group’s conglomerate structure and record
backlog in the energy division should help protect earnings. The group’s 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 China’s re-balancing. Its energy efficient and
state-of-the-art bearings should also prove key assets to benefit from China’s 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 group’s 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 group’s 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
group’s 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 zone‛
Weakening short-term indicators
Weakening PMI data should drive weaker IP growth in coming months
China 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 production Chinese official PMI – Inventory index vs backlog index
25
30
35
40
45
50
55
60
65
70
0%
5%
10%
15%
20%
25%
Jan-0
5
May-
05
Sep-0
5
Jan-0
6
May-
06
Sep-0
6
Jan-0
7
May-
07
Sep-0
7
Jan-0
8
May-
08
Sep-0
8
Jan-0
9
May-
09
Sep-0
9
Jan-1
0
May-
10
Sep-1
0
Jan-1
1
May-
11
Sep-1
1
IP growth yoy PMI
-20
-15
-10
-5
0
5
10
15
Jan-0
5
May-
05
Sep-0
5
Jan-0
6
May-
06
Sep-0
6
Jan-0
7
May-
07
Sep-0
7
Jan-0
8
May-
08
Sep-0
8
Jan-0
9
May-
09
Sep-0
9
Jan-1
0
May-
10
Sep-1
0
Jan-1
1
May-
11
Sep-1
1
Source: National Bureau of Statistics
Exports show signs of weaknesses
Driven 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.
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Chinese exports ($100 million) Chinese export growth vs PMI
0%
10%
20%
30%
40%
50%
60%
-
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
Jan-1
0
Feb-1
0
Mar-
10
Apr-
10
May-
10
Jun-1
0
Jul-
10
Aug
-10
Sep-1
0
Oct-
10
Nov-
10
Dec-1
0
Jan-1
1
Feb-1
1
Mar-
11
Apr-
11
May-
11
Jun-1
1
Jul-
11
Aug
-11
Sep-1
1
Oct-
11
Nov-
11
Export - $100m yoy chge
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
30
35
40
45
50
55
60
65
May-
04
Sep-0
4
Jan-0
5
May-
05
Sep-0
5
Jan-0
6
May-
06
Sep-0
6
Jan-0
7
May-
07
Sep-0
7
Jan-0
8
May-
08
Sep-0
8
Jan-0
9
May-
09
Sep-0
9
Jan-1
0
May-
10
Sep-1
0
Jan-1
1
May-
11
Sep-1
1
PMI - New export orders (SADJ) Exports - 3m chge yoy
Source: Datastream
Some weakness emerged in FAI growth due to real estate
Fixed 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 estate… …offset by slight uptick in infrastructure spending
-40%
-20%
0%
20%
40%
60%
80%
01/0
2/0
8
01/0
4/0
8
01/0
6/0
8
01/0
8/0
8
01/1
0/0
8
01/1
2/0
8
01/0
2/0
9
01/0
4/0
9
01/0
6/0
9
01/0
8/0
9
01/1
0/0
9
01/1
2/0
9
01/0
2/1
0
01/0
4/1
0
01/0
6/1
0
01/0
8/1
0
01/1
0/1
0
01/1
2/1
0
01/0
2/1
1
01/0
4/1
1
01/0
6/1
1
01/0
8/1
1
01/1
0/1
1
Total FAI FAI manufacturing FAI Real Estate
-100%
-50%
0%
50%
100%
150%
200%
250%
01/0
2/0
8
01/0
4/0
8
01/0
6/0
8
01/0
8/0
8
01/1
0/0
8
01/1
2/0
8
01/0
2/0
9
01/0
4/0
9
01/0
6/0
9
01/0
8/0
9
01/1
0/0
9
01/1
2/0
9
01/0
2/1
0
01/0
4/1
0
01/0
6/1
0
01/0
8/1
0
01/1
0/1
0
01/1
2/1
0
01/0
2/1
1
01/0
4/1
1
01/0
6/1
1
01/0
8/1
1
01/1
0/1
1
Road Railways
Source: National Bureau of Statistics
Housing prices start to decline, developers struggle
In 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.
F179665
Capital Goods
11 January 2012 13
% of cities with falling housing prices month-on-month Property sector cooling
0%
10%
20%
30%
40%
50%
60%
70%
80%
Jan-1
1
Feb-1
1
Mar-
11
Apr-
11
May-
11
Jun-1
1
Jul-
11
Aug
-11
Sep-1
1
Oct-
11
Nov-
11
New built Second hand
0
5
10
15
20
25
30
35
40
45
50
-40
-20
0
20
40
60
80
100
120
2005 2006 2007 2008 2009 2010 2011
Housing starts
Property sales vol
Property investment (RHS)
% yoy, 3mma
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 completed
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
Nov
-97
May
-98
Nov
-98
May
-99
Nov
-99
Ma
y-0
0
Nov
-00
Ma
y-0
1
Nov
-01
Ma
y-0
2
Nov
-02
Ma
y-0
3
Nov
-03
May
-04
Nov
-04
May
-05
Nov
-05
May
-06
Nov
-06
May
-07
Nov
-07
May
-08
Nov
-08
Ma
y-0
9
Nov
-09
Ma
y-1
0
Nov
-10
Ma
y-1
1
Nov
-11
Space floor under construction (12M rolling basis) / space f loor completed (12M rolling basis)
Source: National Bureau of Statistics
F179665
Capital Goods
11 January 2012 14
Mounting fears about the Chinese financing system
The 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
Local GVTsPublic
companies
Private
companiesHouseholds
Real estate
developers
- Low employment rate Under pressure: - High savings rate
- Low growth - Wage inflation - Hurt by inflation
- Low profitability - Lower export opportunities - <0 real deposit rates with banks
- Dependence on shadow banking
30-40% of local gvts' tax revenues coming from land sales
PBoC + Central GVT
Local GVT Financing Vehicles
(36% of GDP)BANKS
Shadow Banking
(32% of GDP)
RRR cut by 50 bps in Dec 11Loan to deposit ratio still at
75%
Source: SG Cross Asset Research
Mounting pressure on local governments’ debt as land sales fall
Although information on Chinese local governments’ debt is still quite limited, SG economists
estimate it represents at least 37% of GDP. With this heavy debt burden, the financing
situation of local governments is increasingly stretched at a time when land sales, contributing
to 30-40% of their revenues, have started collapsing. The FT reported (7 Dec 2011) that
Guangzhou had to cancel or drastically scale back its plans to auction land four times in
November 2011. The FT (5 Jan 2012) also reported that in 130 big cities land sales had fallen
by 13% in 2011, although most of the fall occurred in the last few months of the year. This
means that all else being equal, the contraction in land revenues seen in 2011 increased local
governments’ deficit by an additional 4-5%.
We have seen a number of local government funding vehicles in financial distress. The first
instance of financial distress came from Yunnan Highway Development Investment Ltd in April
2011. The highway builder announced at the time that it could only pay interest on its loans
and would not pay principal. The Yunnan Government injected CNY300m of new capital and
lent it another CNY2bn in debt. In its most recent statements, YHD had CNY100bn of debt,
and five-year accumulated profits of CNY800m. With a debt/equity ratio of 3.4x, YHD could
handle debt up to CNY14.3bn, meaning that YHD’s excess CNY85.7bn of debt would still
need to be restructured.
F179665
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11 January 2012 15
Local government debt grew 36-fold over 13 years!
0
2
4
6
8
10
12
0
5
10
15
20
25
30
35
1996 1998 2000 2002 2004 2006 2008 2010
CNY trn (RHS)
% of GDP
China local government debt
Source: NAO, IMF
Shadow banking system casts doubt on Chinese government’s control over
the economy
The issue of the Chinese shadow banking system is now well publicised. SG economists
estimate that the size of China’s shadow banking system is CNY14-15tr, i.e. >30% of GDP.
Underground banking, itself, is estimated to be about CNY3trn to CNY4trn in size, compared
to the c.CNY55trn currently extended by formal banks.
Negative real deposit rates have pushed individuals and even companies (mainly State Owned
Enterprises) to find more lucrative investments for their cash in the shadow banking system
where yields can vary between 20% and 100% per annum. In the meantime, while demand for
new loans kept growing, tightening rules prompted borrowers to find fresh money in the
shadow banking system. This is obvious when looking at property developers’ capital
sources. The property sector raised CNY5.5trn of capital between January and August. The
unclassified part accounted for nearly 20% of the total and increased 32% yoy. The
percentage of property funding from unclassified sources for the first time exceeded that from
formal bank loans. A significant chunk of shadow banking credit must have landed in the
hands of developers. According to the China Trustee Association, more than half of trusts
were invested in infrastructure and real estate projects.
Estimated size of China’s shadow banking system Property developers were looking everywhere for funding
Entrusted loan
3.95
Trust loan1.49Bank
acceptance
bill
5.26
Underground banking
3 ~4 ?
The size of China's shadow banking system
June 2011CNY 14~15trn
10%
12%
14%
16%
18%
20%
22%
24%
26%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
bank loans
self -raised: others
Capital sources of property investments
Source: PBoC, SG Cross Asset Research Source: National Bureau of Statistics
Real 1Y deposit rate
-5
-4
-3
-2
-1
0
1
2
3
4
5
Ja
n-0
4
Ju
n-0
4
No
v-0
4
Ap
r-0
5
Se
p-0
5
Fe
b-0
6
Ju
l-0
6
De
c-0
6
Ma
y-0
7
Oc
t-0
7
Ma
r-0
8
Au
g-0
8
Ja
n-0
9
Ju
n-0
9
No
v-0
9
Ap
r-1
0
Se
p-1
0
Fe
b-1
1
Ju
l-1
1
Source: SG Cross Asset Research, National
Bureau of Statistics
F179665
Capital Goods
11 January 2012 16
Key to assessing the potential impact of the shadow banking system is to understand how
widespread the system is in the overall Chinese economy. Some may argue that the system is
very local and as such any collapse would not have far-reaching consequences in China.
However, some examples published in the press show a widespread system that can affect
many stakeholders in the Chinese economy. For instance, a Bloomberg article published in
October 2011 tells the story of Ausnutria Dairy Corp, a producer of baby formula that invested
roughly two years of profits in Yunnan International Trust which then used the money to buy
four loans from China Merchants Bank. Neither the trust nor Ausnutria hold any collateral
against a default. Also, the FT reported in December last year that Yangzijiang Shipbuilding
earned a third of its Q3 income from investment products and lending to small businesses.
Non-bank lending, largely unregulated, has grown from 4% of loans in 2002 to more than half
last year (source: National Bureau of Statistics).
The authorities have responded to this issue with specific easing measures. Banking
regulators are reportedly saying that banks should be more tolerant of SME defaults in order
to help them through difficult times. Initiatives such as collective issuance of SME bonds are
also seen as having increasing scope. However, if authorities can prevent an overall collapse
of the shadow banking system, this phenomenon reveals in our view Beijing’s lack of control
over the financing of the Chinese economy. The shadow banking system has surely delayed
the impact of monetary policy tightening in 2010-2011, which raises questions about the
efficiency of any monetary policy easing in 2012.
Chinese government facing debt and deficit issue
China has its own debt issue
SG economists estimate that the public debt in China amounted to CNY29trn, equivalent to
72% of GDP and nearly 200% of fiscal revenues at the end of 2010. This breaks down into
five main categories: central government debt representing 17% of GDP, local government
debt representing 37% of GDP, the debt of the Ministry of Railways (4.5% of GDP) and Policy
banks (8% of GDP) and debt from the previous bank restructuring costs (6% of GDP).
China’s government debt (% of GDP)
17
37
5
8
6
72
0
10
20
30
40
50
60
70
80
Ce
ntr
al g
ov
't
de
bt
Loc
al g
ov
't
de
bt
Min
istr
y o
f R
ailw
ay
s
Polic
y b
an
ks
Bank
restr
uctu
ring
costs
Tota
l debt
Source: CEIC, CBRC, NAO, MoR, Bloomberg, Dragonomics, SG Cross Asset Research
F179665
Capital Goods
11 January 2012 17
Some may argue that China’s debt is in fact much lower since this math ignores the huge FX
reserves China has accumulated over the years. The latest data shows that China’s FX
reserves were at $3.2trn (around 45% of GDP). Now the issue with FX reserves is that China
cannot really use this resource. Indeed, it will be hard for China to sell off some of its dollars
without undermining the value of its reserves (70% are in $), and no market will be large
enough to cope with this amount of money. It is important to understand that FX reserves are
not a treasure, but rather the asset side of PBoC’s balance sheet. Therefore PBoC cannot use
its reserves without increasing its indebtedness.
China’s fiscal deficit is larger than thought
China’s central government rolled out a stimulus package of CNY4trn (13% of 2008 GDP) in
2009 and 2010. Despite this spending spree, the official fiscal deficit figures for those two
years were 3.1% and 2.3%, respectively. However, there are various kinds of off-balance-
sheet revenues and expenditures. On the revenue side, land sale proceeds are the biggest
omission. On the expenditure side, off-balance-sheet spending and the investment of local
governments are not secrets anymore. Although it is almost impossible to estimate all these
grey items, we can still get an idea of the actual consolidated fiscal deficit from the change in
aggregate government debt levels. According to the National Audit Office, local government
debt increased from CNY5.6trn in 2008 to CNY9trn in 2009. These official numbers imply that
Chinese local governments were running a deficit of CNY3.4trn or 10% of GDP in 2009. In
addition, debt taken on by the Ministry of Railways (MoR) more than doubled between 2008
and 2010 to CNY1.9tr, which suggested one more deficit count of roughly 1.5% of GDP for
2009 and 2010. Therefore, the three parts together – the central government, local
governments, and the MoR – were running a deficit of 14% and 7.5% of GDP in 2009 and
2010, respectively. This was the face cost of bringing the Chinese economy to above 9%
growth.
China fiscal deficit in 2009 was at least 14% of GDP
-16
-14
-12
-10
-8
-6
-4
-2
0
2
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Central gov 't Local gov 't Ministry of Railway s
def icit, % of GDP
Source: CEIC, NOA, MoR, SG Cross Asset Research
Monetary easing has started, but do not expect another infrastructure plan
The People’s Bank of China cut the required reserve ratio by 50bp for all commercial banks.
This move came earlier than most expected. The cut will add around CNY390bn of liquidity to
the banking system, although it will not necessarily increase lending directly as banks are still
constrained by the 75% loan to deposit ratio. And the latest data show a decline in deposits,
with household deposits falling by CNY727bn in October. However, as all banks do not
China’s FX reserves ($bn)
-
500
1,000
1,500
2,000
2,500
3,000
3,500
Ja
n-9
3
Fe
b-9
4
Ma
r-9
5
Ap
r-9
6
Ma
y-9
7
Ju
n-9
8
Ju
l-9
9
Au
g-0
0
Se
p-0
1
Oc
t-0
2
No
v-0
3
De
c-0
4
Ja
n-0
6
Fe
b-0
7
Ma
r-0
8
Ap
r-0
9
Ma
y-1
0
Ju
n-1
1
Source: Datastream
F179665
Capital Goods
11 January 2012 18
approach the LDR limit, cutting RRR would help liquidity in the system somewhat. Our
economist expects four additional cuts to RRR that could free up another CNY1.6trn of fresh
liquidity into the system (i.e. around 3% of outstanding bank loans). In the meantime, the
Chinese government is taking different measures to reduce the weight of the shadow banking
system, like encouraging banks to lend to SMEs. If it works, the net effect of monetary easing
and the shrinking shadow banking system might be negative given the current weight of the
later.
Conclusion – The situation in China is worrying to say the least. Short-term indicators are
weakening as past monetary tightening starts to bite and the export model is threatened once
again by the risk of recession in Europe and the US. Data from the real estate industry show a
significant deterioration, with a clear break in the confidence that real estate prices always go
up. The debt burden of local governments and large ongoing deficits should prevent a large
stimulus plan similar to that of 2008. Monetary easing could bring some relief, although we
believe that Beijing lost some control of the financing system through the shadow banking.
F179665
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11 January 2012 19
China – Rebalancing is key
One of the greatest challenges China is facing is how to reshape its heavily investment-driven
mode of economic growth. The transition from an investment-driven economy to a
consumption driven economy is expected to have some major consequences on industrial
end-markets and their respective growth potential. We discuss below in details tomorrow’s
winners and losers of this necessary transition.
Fixed asset investment - a key pillar of growth
China’s economic growth over the past three decades has been heavily driven by investment.
From 2003, more than half of China’s GDP growth has been driven by investment growth as
shown on the left hand side chart. With gross fixed capital formation representing nearly 50%
of GDP, China stands well ahead of other BRIC countries where the same ratio stands
between 17% and 31%.
Breakdown of China’s GDP growth GDP by expenditures in different countries (2010)
13,663
17,232
13,834
1,954
46,683
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
45,000
50,000
GD
P 2
003
Gro
ss c
apital
form
ation
Consum
ption
Net exp
ort
GD
P 2
011e
48
31 2922 21 20 17 16
3658
54
53 60 58 6271
0
10
20
30
40
50
60
70
80
90
100
China India Korea Russia Japan Euro Area Brazil United States
Gross fixed Household consumption
Source: National Bureau of Statistics, SG Cross Research Source: World Bank, SG Cross Asset Research
Fixed asset investment increased more than six-fold between 2003 and 2011e and should
reach c.75% of GDP in 2011e vs 41% back in 2003. Key drivers of FAI growth were higher
investments in construction with real estate contributing to 26% of the overall FAI growth and
infrastructure 21%. Capex in manufacturing activities contributed 36% to FAI growth as China
became the world’s factory.
Breakdown of FAI growth by industry (2003-2011e) Breakdown of FAI by industry (end of October 2011)
56
74
60
114
42
345
0
50
100
150
200
250
300
350
400
FA
I 2003
Real esta
te
Infr
astr
uctu
re
Manufa
ctu
ring
/min
ing
oth
ers
FA
I 2011e
Real estate25%
Infrastructure /utilities
27%
Mining4%
Manufacturing34%
Others10%
Source: National Bureau of Statistics, SG Cross Asset Research Source: National Bureau of Statistics, SG Cross Asset Research
F179665
Capital Goods
11 January 2012 20
Almost 50% of FAI in China is directed towards construction, a third to manufacturing and
less than 5% to mining as shown on the right-hand side chart. However, we believe that at
least a third of manufacturing capex is related indirectly to construction through the steel or
the construction equipment industries. So overall, it is fair to estimate that at least two-thirds
of Chinese fixed asset investment is related to construction.
We see two main threats to fixed asset investment growth going forward:
Overheating of construction – As we discussed later in this report, this stands to be the
biggest short-term threat for FAI growth. The pace of construction activity in real estate and
infrastructure is already high, sufficient in our view to cope with the expected increase in the
country’s urbanisation rate.
Status of world’s factory increasingly called into question – Offering abundant and low-cost
labour as well as a cheap currency, China has been and remains the world’s factory. However,
this status is increasingly called into question by many corporates, as predictability of the cost
base in China is jeopardized by a labour shortage (notably in coastal areas), wage inflation and
Yuan revaluation. We have seen a number of companies (even Chinese companies) invest in
neighbouring countries like Malaysia and Vietnam, most notably for low value added products.
Let’s take the example of a US company that decided back in 2006 to set up a factory in
China to produce manufacturing goods for the US market. While back in 2006 the same
company calculated an IRR of c.25% on this investment based on fixed yuan/$ rate and 10%
wage inflation, the same investment today at the current FX rate and 20% wage inflation
would yield only 11% IRR. Lately, Emerson was quite vocal about cost inflation in China
where it has nearly a third of its total workforce. At its Q2 conference call, Emerson’s CEO
said that ‚the Chinese economy is going into a more costly mode and we are going to have to
refix where we’re manufacturing.‛
Rebalancing the growth model towards consumption
Our SG economist expects FAI growth to slow down materially in 2012 to 14.5% vs 24.2% in
a bumpy landing scenario. For the first time in China’s recent history, growth in retail sales
should outpace FAI growth.
SG forecasts (yoy change, %)
2008 2009 2010 2011e 2012e 2013e 2014e 2015e 2016e
GDP 9.6 9.2 10.4 9.2 8.1 7.7 7.4 7.2 7.0
FAI 25.9 30.0 23.8 24.2 14.5 13.0 12.5 12.0 11.5
IP 12.9 12.3 14.4 13.8 10.3 9.0 8.0 7.5 7.0
Retail sales 21.7 15.5 18.4 16.7 15.1 14.0 13.0 13.0 13.0
Source: SG Cross Asset Research
Why China needs to rebalance its growth model
Why does China need to rebalance its growth model? A report issued by the Bank of Japan
highlighted four main reasons:
Benefits of growth to capital – Under the current model of growth, benefits of growth have
been biased towards corporates and not sufficiently received by households, with household
disposable income growing much slower than GDP per capita.
Employment in urban areas – Consumption rhymes with services which are by nature labour
intensive. To boost employment in urban areas, China needs to grow its tertiary sector.
Yuan vs US$ and euro
60
70
80
90
100
110
120
Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10
Yuan to Euro Yuan to US$
Source: Datastream
F179665
Capital Goods
11 January 2012 21
Slowdown in productivity growth – Overinvestment and excess capacity in some industries
have led to a slowdown in productivity growth.
Environment and energy efficiency – Investment-driven growth is highly energy intensive and
reducing pollution in megacities has become one the Chinese government’s priorities.
The Chinese government is fully aware of the need for China to rebalance its economic growth
towards domestic consumption, but several relevant measures that have been put into place
have failed to deliver on the target. Back in April 2011, President Hu Jintao stated that “China
has made remarkable achievements in development […] but there is a lack of adequate
balance, coordination or sustainability in our development”.
The Japanese experience – A warning signal for China?
In the mid-1970s, Japan re-balanced its growth model, moving from an investment-driven
economy to a consumption-driven economy. However, as seen in the following chart, this
transition has not been without any impact on the country’s GDP growth. While Japan
achieved GDP growth in the 8-12% range between 1955 and 1970, the growth rate declined
to 4-5% on average between 1975 and 1990. The slowdown in productivity growth in the
capital can explain this rebalancing, but so can wage inflation and the diminishing return on
capital as shown on the right-hand side chart.
Despite the slowdown observed in GDP growth, Japan successfully managed the transition
towards a consumption-driven economy. Real GDP growth post the rebalancing slowed down
but remained healthy until the bursting of the construction bubble at the end of the 1980s.
China must go through this transition phase, although the challenge looks even greater than
for Japan in the 1970s as China’s dependence on investment is much higher and the country
is also experiencing a housing bubble that Japan had to face only 15 years after its
rebalancing.
Japan –
Gross fixed capital formation as % of GDP vs real GDP growth Japan –
Return on capital (%)
0
2
4
6
8
10
12
14
20
22
24
26
28
30
32
34
36
38
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Gross Fixed Capital Formation Real GDP growth
0
5
10
15
20
25
30
35
40
45
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
Source: SG Cross Asset Research, World Bank Source: Bank of Japan
Diminishing returns and overcapacity loom in China
Naturally, any economy or company investing a lot faces the risk of diminishing returns. This is
the case of China, where we have seen a sharp deterioration in its incremental capital output
ratio (ratio of investment to growth which is equal to 1 divided by the marginal product of
capital). A normal ICOR is in the region of 3, but in China ICOR increased from about 3 in 2007
to close to 6 in 2011e. This surge in ICOR is undoubtedly the result of the latest stimulus plan
F179665
Capital Goods
11 January 2012 22
directed towards large infrastructure projects (which typically yields low returns in the short
term).
If we were to assume an ICOR of 3x for China over the last ten years, GFCF would have
reached CNY15trn vs CNY23trn expected in 2011, meaning that currently one-third of the
capital stock is not efficient and yields low or even negative returns.
Declining investment efficiency and rising asset inflation
-4
-2
0
2
4
6
8
10
2
2.5
3
3.5
4
4.5
5
5.5
6
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Incremental Capital Output Ratio
GDP def lator (% y oy , RHS)
Source: CEIC, SG Cross Asset Research, Economics
We have tried to verify this downward trend in returns, looking at the financial statements of
industrial companies within the Shanghai 50 index. Our first observation is that these top
industrial companies have gradually reduced their capex. In 2001, capex represented 25% of
annual sales and declined to less than 10% of sales in 2010. This contrasted with the overall
Chinese economy, where FAI growth as a % of GDP increased from 34% of GDP in 2001 to
70% in 2010. This relative wisdom on the pace of investment did not prevent these top
industrial companies from reporting declining ROCE…and this is our second observation.
Average pre-tax ROCE peaked in 2006-2007 at 22-23% but fell sharply in 2008 and 2009 and
recovered slightly in 2010.
Industrial companies within Shanghai 50 –
Capex as a % of sales Industrial companies within Shanghai 50 –
Pre-tax ROCE (%)
0%
5%
10%
15%
20%
25%
30%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
16%
13% 13%
16%
20%21%
23%22%
15%
13%
17%
0%
5%
10%
15%
20%
25%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: SG Cross Asset Research, Datastream, Company data
F179665
Capital Goods
11 January 2012 23
It is not unusual to hear stories about overcapacity in China, although they are often hard to
verify due to the lack of statistical data. We list below several Chinese industries which are
suffering from significant overcapacity:
Steel industry – Total steel capacity in China is estimated at 800 million tons with a utilization
rate of only 75%. According to ABB, there more than 6,000 steel companies in China and the
production capacity per blast furnace is comparably smaller than in other countries. The
director of the China Iron & Steel Association said at the end of last year that the profit
margins from 77 steel mills tracked by the Association dropped to a record-breaking low.
Weakening export demand and the current slowdown in housing/infrastructure construction
reduced expected sales development, while input costs (notably iron ore) remained high. A
consolidation process is driven by the government.
Shipbuilding industry – China’s shipbuilding capacity reached 19m compensated gross tons
(CGT) in 2010. As the authorities tagged the shipbuilding industry as strategic, domestic
capacity increased c.16x, from just 1.2m CGT in 2000. China has now almost 40% of global
capacity. Although capacity is almost fully booked for 2012, a lot of spare capacity exists for
2013, notably in the medium and small yards.
Wind energy – As of 2011, China had more than 80 wind turbine makers capable of
producing over 40GW vs less than 2GW back in 2006. However, annual domestic demand
was only 15GW last year, meaning that utilization rates were below 40%. This overcapacity
has led to material pricing pressure in the wind energy industry.
LED manufacturing – In 2011, China represented 75% of the world market for MOCVD
reactors, the main machine used to deposit light emitting semiconductor material on top of
wafers. This huge investment has been mostly driven by government subsidies. Utilization
rates of MOCVD machines in China are in the 20-30% range and 50-60% range in Taiwan and
South Korea.
The winners of China’s rebalancing policy
The likely re-balancing of the Chinese economy towards consumption will have some major
consequences on the growth potential of capital goods. The key winners of today’s Chinese
investment-driven economy are likely to become tomorrow’s relative losers.
US history can, in our view, provide good insight into industrial activities which may be the
beneficiaries of China’s rebalancing. Obviously, in the early cycle phase of its development
process, a country will consume a lot of commodities to build infrastructures and housing
stock. Typically, this phase lasts until GDP per capita reaches $5,000-10,000 (China likely to
be at c.$8,500 in 2011 on a PPP basis). In this early phase of development, the consumption
intensity of main commodities surges as the US example shows.
The second phase of development should see the emergence of mass consumption. With
increasing disposable income, households start buying cars, electrical appliances, etc. In this
second phase, all industries directly exposed to household consumption outperform. In the
US, car consumption intensity increased by more than half between 1970 and 2010. Also,
electricity consumption intensity increased by almost 70% in the same timeframe.
F179665
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11 January 2012 24
US steel consumption per
capita (kg/year)
US copper consumption per
capita (kg/year)
US number of cars per 1,000
people
US electricity consumption per
capita (MW/year)
0
100
200
300
400
500
600
19
00
19
06
19
12
19
18
19
24
19
30
19
36
19
42
19
48
19
54
19
60
19
66
19
72
19
78
19
84
19
90
19
96
20
02
20
08
0
2
4
6
8
10
12
14
16
19
00
19
05
19
10
19
15
19
20
19
25
19
30
19
35
19
40
19
45
19
50
19
55
19
60
19
65
19
70
19
75
19
80
19
85
19
90
19
95
20
00
20
05
0
100
200
300
400
500
600
700
800
900
19
00
19
06
19
12
19
18
19
24
19
30
19
36
19
42
19
48
19
54
19
60
19
66
19
72
19
78
19
84
19
90
19
96
20
02
20
08
0
2
4
6
8
10
12
14
19
50
19
53
19
56
19
59
19
62
19
65
19
68
19
71
19
74
19
77
19
80
19
83
19
86
19
89
19
92
19
95
19
98
20
01
20
04
20
07
Source: SG Cross Asset Research
The following chart shows a simplified map of consumption intensity of some
commodities/products depending on the level of development.
Development process – Consumption intensity vs GDP per capita
0 2500 5000 10000 15000 20000 25000 30000 35000 40000
Co
ns
um
pti
on
in
ten
sit
y (
pe
r c
ap
ita
)
GDP per capita $
Steel
Cement
Investment driven economy
Consumption driven economy
BR
IC
co
un
trie
s
De
ve
lop
pe
dc
ou
ntr
ies
Oil
Source: SG Cross Asset Research
The key winners of this transition are obviously capital goods industries which are directly or
indirectly related to the consumption theme. We have also identified a few industries where
consumption intensity grows at least in line with GDP per capita like healthcare, automotive
and civil aerospace.
In the following table, we show a breakdown of revenues of capital goods companies by end-
markets which are supportive in an economy driven by consumption or investments. The
companies within our universe, which should be the main beneficiaries of China’s rebalancing,
are Philips, SKF and Siemens.
F179665
Capital Goods
11 January 2012 25
Consumption-related manufacturing vs infrastructure/construction-related exposure as a % of
sales
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Ph
ilip
s
SK
F
Sm
ith
s
Inv
en
sy
s
San
dv
ik
Atla
s C
op
co
Sie
me
ns
Sch
ne
ider
Ne
xa
ns
AB
B
Vallo
ure
c
Assa
Ablo
y
Legra
nd
Als
tom
Are
va
Consumption-related manuf acturing Construction and inf rastructure
Source: SG Cross Asset Research
The losers of China’s rebalancing policy
Construction spending – As good as it gets!
As we have long argued (Chinese construction bubble – Preparing for a potential burst, June
2011) the current pace of real estate and infrastructure construction in China is sufficient to
meet the long-term challenge of urbanization. Excess capacity has emerged in construction,
both in real estate and infrastructure.
Clear excess supply in real estate – The real estate sector has been booming over the last
few years in China and all data points to excess supply. Last year, China built nearly 2bn sqm
of new housing, enough to accommodate 60m people, while only 20m people are moving to
the cities each year. Floor space per capita stands at 31sqm per capita and this standard is
much closer to developed countries than emerging countries. This excess supply is mainly
due to the fact that Chinese people see real estate as the only available investment vehicle
offering protection against inflation (provided that housing prices keep going up).
Consequently, a large chunk of these newly built housing remains empty. The recent fall in
housing prices could prompt Chinese households to sell their investments in order to protect
their capital gains. If so, the housing bubble could collapse within the next few months.
Supply of new housing exceeds urbanisation Floor space per capita (sqm) vs GDP per capita
0
10
20
30
40
50
60
70
80
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011e
New housing supply (million people)
Increase in urban population (million people)
Austria
Bulgaria
DenmarkFinland
France
Germany
Italy
Netherlands
Romania
Sweden
Spain
Hungary
India
UK
Japan
US
China
0
10000
20000
30000
40000
50000
60000
0 10 20 30 40 50 60 70
GD
P p
er
capita (P
PP
, $ 2
010)
sqm per capita
Source: SG Cross Asset Research, National Bureau of Statistics Source: World Bank, IMF
F179665
Capital Goods
11 January 2012 26
Infrastructure – Contrary to common perception, China’s infrastructure is at a relatively
mature stage of development. With 60 meters of paved roads per car, China stands two to
three times above the standard of developed countries. At current production rates, it will take
20 years for China to come back into world standards. The length of the Chinese expressway
network is on par with that of the US while the two countries have largely the same area. The
Chinese high speed railway network is by far the longest globally and should reach almost
10,000km by 2015.
Paved roads per car (meters) Expressway network (km) High speed railway network (km)
-
10
20
30
40
50
60
70
China Spain France US Germany Italy
-
10,000
20,000
30,000
40,000
50,000
60,000
70,000
80,000 1
99
0
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
-
2,000
4,000
6,000
8,000
10,000
12,000
Ch
ina
Sp
ain
Ja
pa
n
Fra
nc
e
Oth
ers
Ge
rma
ny
Ita
ly
Be
lgiu
m
In operation In construction
Source: SG Cross Asset Research, CIA Factbook Source: National Bureau of Statistics Source: International Union of Railways
The most striking example of an over-exuberant Chinese construction market can be found in
the country’s cement consumption. In 2011, Chinese cement consumption is likely to have
exceeded 2,000 million tonnes, representing more than 55% of global cement consumption.
Per capita, the picture looks even crazier with average consumption of 1,500kg per head,
nearly 5x higher than the world average ex-China. Within the last 10 years China has
consumed roughly the same cement per capita as the US over the past 100 years!
All countries where cement consumption per capita exceeded 1,200kg for a few years have
experienced a construction crisis sooner or later. The latest example of this rule of thumb is
Spain.
Cement consumption per capita (kg)
-
200
400
600
800
1,000
1,200
1,400
1,600
1901
1904
1907
1910
1913
1916
1919
1922
1925
1928
1931
1934
1937
1940
1943
1946
1949
1952
1955
1958
1961
1964
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
US China Spain France
Source: SG Cross Asset Research, Cembureau, US geological survey
F179665
Capital Goods
11 January 2012 27
Mining equipment - the hardest hit
Given China’s huge appetite for commodities which fed through its construction boom over
the last decade, a hard landing in China and the bursting of the construction bubble would
have material consequences on the global mining industry.
Commodity/Mining – it’s only about China
The significant upcycle in mining capex witnessed over the last decade has been primarily
driven by China as the country put in place the necessary infrastructure for its long-term
development.
Over the last ten years, 133% of the increase in global copper consumption has been driven
by China, 85% for coal, 85% for iron ore and 108% for nickel as the following charts show.
Without China the global consumption of commodities would have hardly increased over the
last decade, and therefore assessing where Chinese consumption of raw materials is headed
is key for helping to determine mining capex for this decade.
Key drivers of coal consumption Key drivers of copper consumption
2,400
976
206 26
3,556
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
Cons. 2000
Chin
a
Oth
er
EM
Deve
lopped
Cons. 2010
15,219
4,358
1,178 2,255
18,499
0
5,000
10,000
15,000
20,000
25,000C
ons. 2000
Chin
a
Oth
er
EM
Deve
lopped
Cons. 2010
Source: SG Cross Asset Research, BP Source: SG Cross Asset Research
Key drivers of crude steel consumption Key drivers of nickel consumption
845,051
461,883
223,133 144,288
1,385,779
0
200,000
400,000
600,000
800,000
1,000,000
1,200,000
1,400,000
1,600,000
1,800,000
Cons. 2000
Chin
a
Oth
er
EM
Deve
lopped
Cons. 2010
1,111
388
25 54
1,470
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
Cons. 2000
Chin
a
Oth
er
EM
Deve
lopped
Cons. 2010
Source: SG Cross Asset Research, World Steel Association Source: SG Cross Asset Research
A long history of global steel consumption shows clearly the impact China had on the steel
industry overall. While global steel consumption hovered between 600m and 800m tons from
1970 to 2000, it soared by 600m tons to reach c.1,400m tons in 2010. China is responsible for
85% of global steel consumption growth over the last ten years.
F179665
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11 January 2012 28
Global steel consumption (million tons) Growth in global steel consumption – 5-year moving average
-
200
400
600
800
1,000
1,200
1,400
1,600
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
World ex-China China
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
7%
8%
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
2011
Source: World Steel Association, SG Cross Asset Research
Overcapacity as demand stalls?
Driven by the demand surge coming from China, miners have significantly increased their
capex spending to increase commodity output. We estimate that global mining capex reached
$140bn in 2011, nearly three times higher than the annual capex between 1990 and 2004.
Global mining capex – $bn
46 44 42 40 43
53 5661
51 4842
3337
43
59
72
92
108116
79
118
140
0
20
40
60
80
100
120
140
160
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011e
Source: SG Cross Asset Research, Metso
A large portion of mining capex over the last few years has been directed towards growth
projects. From 2005 to 2010, capex for the top 20 miners stood more than 2.5 times higher
than depreciation. As the lead time on new mining projects can be long (up to 5-7 years), the
surge in capex spending since 2005 will really start impacting commodity output this decade.
In one of its latest investor presentations, Rio Tinto showed that global commodity output
should rise 5.8% annually through 2015 in a best-case scenario. A more probable scenario
would see CAGR of 3.5%, which is still twice as strong as the average growth rate registered
between 2005 and 2010.
F179665
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11 January 2012 29
Capex vs depreciation – top 20 miners ($bn) Commodity output
0
10
20
30
40
50
60
70
80
2003 2004 2005 2006 2007 2008 2009 2010
Capex Depreciation
14000
16000
18000
20000
22000
2005 2006 2007 2008 2009 2010 2011e 2012e 2013e 2014e 2015e
Production Forecast Highly probable Probable Possible
Industry capacity
Source: PWC Source: Rio TInto
All miners are clearly ‚China believers‛ and assume that China’s increasing urbanisation rate
will require more intense consumption of the main commodities. However, as we argue earlier
in this report, construction intensity has probably peaked in China, meaning that it is difficult
to expect pent-up demand for commodities to come from China. A standstill or collapse in the
Chinese construction market should push many commodities in excess capacity; 60% of
global steel consumption goes to China and 60% of this steel is used in construction,
meaning that one-third of global steel production goes to the Chinese construction industry
and 50% of the increase in global steel consumption was due to the Chinese construction
boom. Likewise, China accounts for 40% of global copper consumption and about a third of
that goes to construction, meaning that nearly 15% of global copper production goes to the
Chinese construction industry and 45% of the increase in global copper consumption
stemmed from the Chinese construction boom. Bearing in mind that iron ore, coal and copper
represent more than 60% of global mining capex, it is easy to understand that the outlook for
Chinese construction is key to commodity demand.
What If the commodity bubble collapses?
Our assessment of the risk to mining equipment companies is as follows:
Mining capex falls back towards depreciation / 60% cut to OE revenues – The bursting of the
Chinese construction bubble would materially impact commodity demand, and it is thus fair to
assume that all growth projects would be cancelled by miners. This means that mining capex
would be more closely aligned with depreciation charges. We estimate mining capex faces a
maximum 60% cut in a worst-case scenario.
Aftermarket revenues initially cut by 10% – Driven by de-stocking and a slowdown in
production rates to avoid excessive overcapacity, we assume that the aftermarket activities of
mining equipment companies would also be hurt and discount a 10% cut in aftermarket
activities.
Factoring these assumptions into our Atlas Copco and Sandvik earnings models, we find that
a collapse of commodity demand driven by the bursting of Chinese construction bubble would
cut Sandvik and Atlas Copco earnings by 35% and 20%, respectively. Sandvik’s higher
sensitivity is due to its lower share of aftermarket revenues (projects and OE sales = 53% of
mining revenues) and its lower margin.
Mining capex by commodity
Iron ore
21%
Coal
21%
Copper
19%
Gold
13%
Nickel
9%
Aluminium
5%
Fertiliser
5%
Platinum
3%
Zinc
1%
Others
3%
Source: PWC
F179665
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11 January 2012 30
We do not factor in this analysis any pricing pressure likely to arise if capex plans from miners
remain at depressed levels for a number of years and mining equipment manufacturers are
late to cut capacities.
Sensitivity of sales and EBIT to a collapse in mining capex
-14%
-9%
-35%
-20%
-40%
-35%
-30%
-25%
-20%
-15%
-10%
-5%
0%
Sandv ik Atlas Copco
Sales impact EBIT impact
Source: SG Cross Asset Research
F179665
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11 January 2012 31
Other long-term themes driving China’s growth
If rebalancing its growth model towards consumption represents a major challenge for China,
the country has to face three other challenges that may provide industrial companies new legs
of growth. One of these challenges is the country’s ageing population, providing great
prospects to the healthcare industry. Another challenge stems from wage inflation, driven by
economic growth as well as by a growing labour shortage. Finally, the latest challenge China
faces is environmental protection.
Which industrial companies will be tomorrow’s winners and losers of these emerging trends?
Ageing population and rising demand for medical devices
China will face an ageing of its population. Due to its one child policy, the Chinese population
is now materially imbalanced with 15-64 old people representing 72% of the total today vs
c.55% in the 1960s. In 2010, citizens over 65 years of age rose to 8% of the whole population.
The rapid decrease in China’s birth rate, combined with stable or improving life expectancy,
has led to an increasing proportion of elderly people and an increase in the ratio between
elderly parents and adult children. According to a World Bank study, over 23% of China’s
citizenry is expected to be over age 65 by 2020.
The main consequence of this trend is a likely surge in healthcare expenditures in China.
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 catches
up with the world average of $1,000 per capita by 2020 (a relatively cautious scenario),
healthcare expenditures in China will soar from $0.4trn to $1.3trn, for a CAGR of 15%.
Breakdown of Chinese population by age Healthcare expenditures per capita (PPP, $ 2005)
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
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
Population ages 0-14 Population ages 15-64 Population ages >65
-
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
India
Chin
a
Bra
zil
Worl
d
Russia
Japan
UK
Euro
are
a
Fra
nce
OE
CD
mem
bers
Germ
any
US
Source: World Bank
Stocks exposed to the ‚ageing population‛ theme
Although 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, in-
vitro diagnostics laboratory equipment, hearing instruments and healthcare IT. Asia/Australia
F179665
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11 January 2012 32
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 automation
Although 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 China Labour force in China (m)
0%
5%
10%
15%
20%
25%
2006 2007 2008 2009 2010 9M2011
720
740
760
780
800
820
840
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
2030
Source: National Bureau of Statistics Source: Economist Intelligence Unit
F179665
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11 January 2012 33
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 China’s 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 world’s 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?
How many industrial robots to produce 100,000 vehicles?
-
50
100
150
200
250
300
350
400
Chin
a
UK
Nort
h A
meri
ca
Fra
nce
Spain
Italy
Germ
any
Japan
South
Kore
a
-
500
1,000
1,500
2,000
2,500
3,000
3,500
Chin
a
UK
Spain
Nort
h A
meri
ca
Fra
nce
South
Kore
a
Germ
any
Japan
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 group’s flagship automation system is 800xA, which is a
F179665
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11 January 2012 34
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 world’s 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. Schneider’s 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 efficiency
With 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), China’s 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 GDP
0.21
0.29
0.36
1.27
0.790.72
0.510.46
Japan Germany US China India Middle East Brazil World
World average
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 11th five-year plan. In the 12th 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.
Key picks on the ‚energy efficiency‛ theme
ABB estimates that energy efficiency is a primary buying criteria for around 45% of its sales.
The group’s 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. Schneider’s 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 group’s 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.
Siemens’s 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 landscape
Over the last decade, the story on China for industrial companies has been mainly focused on
two main features: benefiting from China’s low cost base to improve returns and targeting
China’s 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 5 5 5 2 2 4 3 2 2 1 1
Customer consolidation 5 5 4 2 2 4 2 2 2 2 1
Ticket size 5 5 4 4 4 3 2 1 3 1 1
OE vs aftermarket/distribution 4 2 3 4 2 2 3 3 1 2 2
Chinese players 5 5 4 4 5 2 2 2 2 2 2
Total 24 22 20 16 15 15 12 10 10 8 7
Risk Very high Very high High Medium to
high
Medium Medium Medium Low Low Low Low
Source: SG Cross Asset Research / * 5 = highest risk, 1 = lowest risk
Where Chinese firms have caught up with global players
In 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)
27x
22x
18x
13x
10x9x
7x
4x 4x 3x
1x 1x
0
5
10
15
20
25
30
Min
ing
eq
uip
ment
Healthcare
Cuttin
g tools
Low
voltag
e
Air
com
pre
ssors
Beari
ng
s
T&
D
Constr
uction
Eq
uip
ment
Pow
erg
en
Tru
cks
Win
d turb
ine *
Rail
Tra
nsport
ation
Source: SG Cross Asset Research, Company Data * Based on GW
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Growing Chinese competition in ‚strategic‛ big-ticket
industries
We 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
country’s infrastructure (power installed base, grid network, transportation network),
associated capital goods industries are strategic for the country’s 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
Pricing power
Industries most at risk
Hig
h
LowHigh
Fossil Power Generation
TransportationNuclear
Wind Power
T&D
Cable
Auto Equipment
Automation
BearingsTooling
Mining equipment
Medical Equipment
Lo
w
Compressors
Co
ns
oli
da
tio
n o
f th
e c
us
tom
er b
as
e
Size of each contract
Ultra - low Voltage
Locks
Attractive but volatile
Pricing risks
Source: SG Cross Asset Research
China’s 12th 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.
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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 new-
energy 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 curve
For 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 China’s 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 China’s 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 bachelor’s 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 key
To 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 group’s flagship products
is the Somatom Spirit Computed Tomography (CT) system, a multi-slice scanner for the entry-
level 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, mid-
segment 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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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
China competition risks –
Industry profiles
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Power generation
Chinese competition risks – VERY HIGH
We 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 Electric’s major contract wins in
India and Vietnam over the past two years.
Power Generation – Chinese competition risks
Key criteria Score (out of 5) Comments
Strategic industry 5 Highly strategic industry, often controlled by governments
Customer consolidation 5 High customer consolidation – a couple of utilities by country
Ticket size 5 Very large ticket items (EPC contracts, etc.)
Aftermarket/Distribution 2 Very profitable aftermarket business
Chinese players 5 3 large players, already controlling 80% of the domestic market
Total 22 Very high risk – Chinese players already very active overseas in the coal-fired and hydro markets
Source: SG Cross Asset Research
China remains the largest power market worldwide
Chinese utilities have been adding power generation capacity at an extraordinary pace over
the past ten years. China’s 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 1970
0
50
100
150
200
250
300
19
70
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
CHINA
Asia ex-China
LATAM
AFRICA / M-E
EUROPE
N AMERICA
Source: Platts Global Power Plants database
But activity is now declining from its highs
A 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
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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 China’s capacity additions are past the peak.
Power generation installed base in China Capacity additions are past the peak (GW)
392440
517
625
713
792
876
962
1040
0%
5%
10%
15%
20%
25%
0
200
400
600
800
1000
1200
2003 2004 2005 2006 2007 2008 2009 2010 2011e
Installed base (GW) Growth rate (%, RHS))
24 20
16
28
40
68
100 101
83 88 90
68
0
20
40
60
80
100
120
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 IEA 2010-2020
Source: Platts Global Power Plant Database Source: IEA
Nuclear and wind are taking share from coal
Coal 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 country’s 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, 2010 New capacity additions by fuel, 2011-2020e
Coal74%
Hy dro17%
Gas4%
Wind2%
Nuclear1%
Other2%
Coal40%
Hy dro20%
Gas8%
Wind20%
Nuclear8%
Other4%
Source: Platts Global Power Plants Database Source: IEA
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Three Chinese companies control the domestic market
Three 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)
Shanghai Electric
30%
Dongfang26%
Harbin Power20%
Other24%
23.7
15.8
9.9 9.5
7.7 6.6
5.6 4.9 4.7
1.9
0
5
10
15
20
25
GE
Sie
mens
Als
tom
MH
I
BH
EL
Shang
hai
Dong
fang
Doosan
Harb
in
Andri
tz
€bn
Source: Company data, SG estimates Source: Company data
Shanghai Electric – Strong cooperation with Siemens
Shanghai 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 group’s 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 history Revenue breakdown by product, 2010
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
0
10
20
30
40
50
60
70
80
90
2006 2007 2008 2009 2010 2011e 2012e
Revenues EBIT margin (%, RHS)
Rmb bnCNY bn
Thermal Power40%
Wind & Nuclear
9%
Services19%
Industrial Equipment
28%
Other4%
Source: Company data, IBES Source: Company data
Shanghai Electric’s 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 China’s 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 and
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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 2009-2011
Contract details Country Value Date
2x610MW coal-fired power plants Iraq $1,000m Apr-11
125x2MW onshore wind turbines India - Apr-11
66x660MW steam turbine and generator sets India $8,291m Oct-10
2x600MW coal-fired power plants Vietnam $1,380m Oct-09
2x600MW coal-fired power plants Botswana $1,956m Mar-09
Source: SEG
Dongfang Electric – the first mover into nuclear and wind markets
Dongfang 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 history Revenue breakdown by product, 2010
CNY bn
0%
2%
4%
6%
8%
10%
12%
14%
-
10
20
30
40
50
60
2006 2007 2008 2009 2010 2011e 2012e
Revenues EBIT margin (%, RHS)
RMB bnCNY bnCNY bn
Thermal Power54%
Wind & Nuclear
25%
Hydro Power8%
Construction & Services
13%
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 Electric’s 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 middle-
to high-end markets.
Dongfang Electric - main export contracts in 2009-2011
Products Country Value Date
Low pressure heater for nuclear power plants France - Jun-11
10x660MW steam turbine and generators sets India $2,500m Dec-10
166 units of 1.5MW wind turbines India $203m Nov-10
300MW coal-fired power plant Bosnia $700m May-10
1800MW hydro power plant Ethiopia $450m May-10
2x622MW coal-fired power plants Vietnam $1,400m Mar-10
2x660MW coal-fired power plants (consortium with Kepco) Saudi Arabia $1,700m Mar-09
3,300MW hydro power plant equipment Brazil $400m Nov-08
Source: SG Cross Asset Research, company data
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 Areva’s 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 market
Harbin 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 history Revenue breakdown by division, 2010
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
-
5
10
15
20
25
30
35
2004 2005 2006 2007 2008 2009 2010 2011e 2012e
Revenues EBIT margin (%, RHS)
Rmb bnCNY bn
Thermal power62%Hydro power
8%
Engineering services
18%
Ancillary equipment
3%
AC/DC motors and
others9%
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. Harbin’s 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 group’s first entry into the Indian market with its 600MW
supercritical steam turbines and generators).
Harbin Power – Main export contracts
Products Country Value Date
6x660MW supercritical boilers units India $1,060m Jan-11
16x660MW supercritical steam turbine and generators India $1,470m Sep-10
Thermal power equipment Vietnam $162m Feb-10
750MW combined cycle power plant Pakistan $400m Sep-09
Source: Company data
Chinese players increasingly looking overseas
Chinese 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, 2009-2010 Hydro turbines market share, 2008
Shanghai20%
Dongfang19%
Harbin19%
BHEL6%
Siemens4%
Alstom4%
MHI4%
GE4%
Toshiba4%
Others16%
Harbin 20%
Dongf ang 16%
Alstom 26%
Voith-Siemens 12%
Andritz 10%
Other 16%
Source: Platts Global Power Plants database Source: Andritz, Alstom
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Gas turbines market share, 2009-2010 Wind turbines market share, 2010
GE38%
Siemens21%
Alstom12%
MHI10%
Tuga6%
Ansaldo3%
Hitachi1%
BHEL1%
Other8%
Sinovel
11%
Goldwind9%
Dongfang7%
Guodian United Power
4%
Suzlon7%
Vestas15%
GE10%
Enercon7%
Gamesa7%
Siemens6%
Other17%
Source: Platts Global Power Plants database Source: BTM
The only way to compete is via partnerships with Chinese players
Given 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 transportation
Chinese competition risks – VERY HIGH
The 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 risks
Key criteria Score (out of 5) Comments
Strategic industry 5 Strategic industry, often controlled by governments
Customer consolidation 5 Very high– Municipalities, governments
Ticket size 5 Very large ticket items
Aftermarket/Distribution 4 Limited aftermarket business
Chinese players 5 2 large players, controlling 100% of their domestic market
Total 24 Very high risk – Chinese players already larger in size than traditional players
Source: SG Cross Asset Research
Rail infrastructure investments in China peaked in 2010
The 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, 2010 Global rail transportation market share by player, 2010
Europe36%
China33%
North America
10%
CIS7%
Asia-Pacif ic5%
Latin America5%
India4%
CSR 16%
CNR 15%
Bombardier 15%
Alstom 13%
Siemens 11%
GE 6%
TMH 4%
CAF 3%
KHI 3%
Ansaldo STS 3%
Invensys 2% Others 9%
Source: UNIFE 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 world’s 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) Chinese railway infrastructure spending (CNY bn)
-
2,000
4,000
6,000
8,000
10,000
12,000
China Spain Japan France Others Germany Italy Belgium
In operation In construction
89
155179
337
623
707
469
400
0
100
200
300
400
500
600
700
800
2005
2006
2007
2008
2009
2010
2011e
2012e
Bn
Yu
an
s
-43%
Source: International Union of Railways Source: MOR
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 2013e
0
1
2
3
4
5
6
7
8
9
2008-10 2011-13e 2014-16e
High Speed Regional Locos Metro LRV
8.3
6.6
8.4€bn
Source: UNIFE 2010, Alstom, SG Cross Asset Research
Chinese players have a monopoly on their local market
The 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 to
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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 company
CSR 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 history CSR - Revenue breakdown by segment, 2010
23 27
35
46
64
86
0%
1%
2%
3%
4%
5%
6%
7%
-
10
20
30
40
50
60
70
80
90
2006 2007 2008 2009 2010 2011e
Revenues (Rmb bn) EBIT margin (%, RHS)
Locomotiv e28%
High Speed trains
23%Freight wagon
11%
Metro11%
Passenger carriage
7%
Others20%
Source: Company data, Bloomberg Source: Company data
CNR is the second major player, leading the locomotive segment
CNR’s 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 history CNR - Revenue breakdown by segment, 2010
21
26
35
41
62
84
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
-
10
20
30
40
50
60
70
80
90
2006 2007 2008 2009 2010 2011e
Revenues (Rmb bn) EBIT margin (%, RHS)
Locomotiv e
24%
High Speed trains
19%
Freight wagon13%
Metro8%
Passenger carriage
6%
Others30%
Source: Company data, Bloomberg Source: Company data
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Well positioned to expand market share in foreign markets
Both 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 absorbed
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 (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 high-
powered 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 China
Seller Model Buyer Date Commercial
speed (km/h)
Chinese
name
Units Contract size
(€m)
Alstom Pendolino CNR 2004 200 CRH-5 60 660
Kawasaki Shinkansen E2-1000 CSR 2004 200 CRH-2 60 na
Siemens Velaro ICE-3 CNR 2005 300 CRH-3 60 669
Bombardier Zefiro CSR 2007 250 CRH-1 40 413
Siemens Velaro CNR 2009 350 CRH-3 100 750
Bombardier Zefiro CSR 2009 380 CRH-1 80 700
Source: Company data
Locomotives – technology transfers to China
Company Partner Model Characteristics
CSR Siemens EuroSprinter 8-axle and 9600kw
CSR Siemens EuroSprinter 6-axle and 9600kw
CSR Siemens EuroSprinter 6-axle and 7200kw
CNR Alstom Prima 6-axle and 9600kw
CNR Alstom Prima 8-axle and 9600kw
CNR Toshiba SSJ3&EH500 6-axle and 9600kw
CNR Bombardier IORE Kiruna 6-axle and 7200kw
Source: Company data
Critical size and 30% cost advantage
In 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 models
35.0
30.830.0
28.6
22.1
20.0
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
40.0
Alstom Bombardier Siemens Alstom CNR CSR
AGV Zef iro Velaro TGV Duplex CRH3 CRH1
€m
Source: Company data, Railway Gazettte, Brazil TAV project – Capital Cost report (2009)
Rail transport market share - 2002 Rail transport market share - 2010
Bombardier21%
Alstom17%
Siemens15%
GE7%
Ansaldo4%
GM4%
CSR3%
CNR3%
Japanese8%
Others18%
CSR 16%
CNR 15%
Bombardier 15%
Alstom 13%
Siemens 11%
GE 6%
TMH 4%
Ansaldo 4%
CAF 4%
KHI 3%
Others 9%
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 5 additional EMUs CSR na Sep-11
Turkmenistan 60 freight locomotives CSR €64m Sep-11
Middle East Metro vehicles CSR €280m Aug-11
Iran ZK1-E wagon bogies CNR €23m Apr-11
Georgia 5 EMUs CSR €24m Mar-11
Mongolia Locomotives CNR €22m Jan-11
New Zealand 300 wagons CNR €22m Dec-10
Australia Locomotives CSR €12m Sep-10
Saudi Arabia 10 mainline locomotives CSR na Jul-10
Malaysia Urban rail vehicles CSR €454m Jul-10
India Metro/subway CSR na Jun-10
Belarus Locomotives CNR €76m Mar-10
Argentina Metro/subway CNR €343m Jan-10
Pakistan Coaches CNR €78m Jan-10
Source: Company data
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Transmission & Distribution
Chinese competition risks – HIGH
We 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 China’s 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 risks
Key criteria Score (out of 5) Comments
Strategic industry 5 Strategic industry
Customer consolidation 4 High – Grid operators, utilities, energy-intensive industries
Ticket size 4 Products and Systems (large HVDC contracts, bulk tenders)
Aftermarket/Distribution 3 Limited service business
Chinese players 4 New players emerging and gradually taking share in their domestic market
Total 20 High risk – Chinese players already gaining share in China and India
Source: SG Cross Asset Research
CAGR of 14% in China power grid spending over 2010-15e
According to the International Energy Agency (IEA), total investment in electricity infrastructure
over 2010-2020 should reach $6.8trn overall, of which close to $3.2trn or 45% of the total
should be dedicated to the Transmission and Distribution grids. By region, China appears as
the largest country by far, representing 30% of global investment over the period. Overall,
emerging countries should account for more than 60% of total investment.
Global T&D spending breakdown by region/country Chinese investments in power grid construction
North America17%
W. Europe14%
Developed Asia8%
China 30%
India10%
Other Asia6%
E. Europe / Russia
6%
MEA5%
LatAm4%
150
214245
289
390345
367
427
497
579
675
0
100
200
300
400
500
600
700
800
2005
2006
2007
2008
2009
2010
2011e
2012e
2013e
2014e
2015e
CAGR 14%
CAGR 18%
Source: International Energy Agency, World Energy Outlook Source: China Electricity Council
The 12th five-year plan, covering the 2011-2015 period, targets a continued increase in
Transmission and Distribution investments with CNY510bn ($75bn) per year expected over the
period, against CNY345bn ($51bn) invested in 2010. Based on more detailed data from the
China Electricity Council, we note that the key investment areas will be in UHVDC with
expected investment of CNY100bn per year (20% of total) and in the Smart Grid segment with
another CNY100bn spending targeted per year.
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The UHVDC (Ultra High Voltage Direct Current) technology allows transport of very high
amount of power over long distances with minimum losses compared to AC systems
(Alternating Current). Siemens, ABB and Alstom remain the only companies to truly master
this technology at this stage. However, Chinese players are gradually moving up the learning
curve.
Large HVDC projects awarded in China since 2007
Date Winner Project name Amount
($m)
kV km MW Client Product
Apr-11 ABB Jinping-Sunan 120 800 2,090 7,200 State Grid Valves, control system
Apr-11 ABB Jinping-Sunan 165 800 2,090 7,200 State Grid Transformers
Apr-11 Siemens Xiluodu-Guangdong 175 500 1,286 6,400 Southern Grid Valves, control system
Apr-11 Siemens Nuozhadu-Guangdong 175 800 1,451 5,000 Southern Grid Valves, transformers
Apr-09 ABB Ningxia-Shandong 140 660 1,350 4,000 State Grid Transformers
Jun-08 ABB Shenyang-Liaoning 70 500 920 3,000 State Grid Transformers
Apr-08 Siemens Xiangjiaba-Shanghai 208 800 2,000 6,400 State Grid Transformers
Feb-08 Siemens Guizhou-Guangdong 130 500 1,225 3,000 Southern Grid Valves, control system
Dec-07 ABB Xiangjiaba-Shanghai 440 800 2,000 6,400 State Grid Substations, systems
Jun-07 Siemens Yunnan-Guangdong 390 800 1,400 5,000 Southern Grid Substations, systems
Source: SG Cross Asset Research
Local players are gaining market share vs Western
manufacturers
Unlike in the rail transportation and power generation markets, Chinese T&D players are still
relatively small compared to global leaders. Nevertheless, the competitive environment has
already become much more challenging over the past couple of years. The largest Chinese
player TBEA had revenues of around $2.6bn in 2010 and claims to hold the world’s number
three position in terms of transformer capacity behind ABB and Siemens.
Global T&D players (2010 revenues)
16.6
11.9
5.9 5.4
3.9
2.6 1.9 1.5 1.4 1.1 0.8 0.7 0.7
0
2
4
6
8
10
12
14
16
18
AB
B
Sie
me
ns
Sc
hne
ider
Als
tom
To
sh
iba
TB
EA
XD
E
lec
tric
Hy
os
un
g
CG
Pow
er
TW
BB
BH
EL
SP
X
GE
$bn
Source: Company data, SG Cross Asset Research
‘Buy China’ attitude. State Grid Corporation of China is the main grid operator in China
accounting for 80% of grid investment in 2010. This behemoth (2010 revenues of CNY1.5tr, or
$230bn, with more than 1.5m employees) has put in place a centralised bidding procedure for
T&D products (transformers, circuit breakers, switchgears, etc) in order to improve its
purchasing efficiency and reduce costs. Every two months, SGCC pools the needs for
electrical equipment from several provinces and calls for a bulk tender. This has sent prices
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lower and enabled local players to gain market share from Western manufacturers over the
past years on low and medium segment products (such as transformers up to 500kV). We
show market share trends for transformers over 2007-2011 in the graphs below.
Market share transformers China - 2007 Market share transformers China - 2009 Market share transformers China – 2011
TBEA20%
XD Electric10%
Baoding6%
ABB17%
Areva3%
Siemens5%
Others39%
TBEA31%
XD Electric12%
Baoding4%
ABB9%
Areva4%
Siemens1%
Others39%
TBEA27%
XD Electric13%
Baoding11%
ABB6%
Areva2%
Siemens3%
Others39%
Source: State Grid Corporation of China Source: State Grid Corporation of China Source: State Grid Corporation of China
Increasing dependence on State Grid. State Grid Corp. is the largest utility in the world and
ranked #8 in the Fortune Global 500 in 2010. It is the largest buyer of T&D equipment in the
world, with annual spending of close to $30bn. On top of building the largest power grid to
serve 88% of the national territory (one billion people), State Grid is targeting the mastery of
core UHV technologies and aims to become a leading player in this field internationally. For
instance, as part of the eleventh 5-year plan, it was granted 457 UHV patents. State Grid’s
ambition is also to accelerate breakthroughs in smart grid’s technologies and, again, take the
lead internationally in these areas.
State Grid Corporation of China – Key performance indicators
KPI End of the ‘10th 5-year plan’ End of the ‘11th 5-year plan’ By the end of the ‘12th 5-year
plan’
Transmission lines (km) 381,764 618,837 Over 1,000,000
Transformation capacity (MVA) 983,380 2,131,930 Over 4,000,000
Electricity sales (TWh) 1,500 2,689 3,800
Revenue (CNY bn) 750 1,543 Over 2,000
Cumulative patents 866 6,528 -
Source: State Grid
State Grid is looking to expand internationally and already operates the National Grid
Corporation of Philippines (acquired in 2009) and 7 transmission lines in Brazil. According to
SinoCast, State Grid is also in discussions with the UK National Grid to acquire 4 natural gas
networks and a 10% stake in the company. Interestingly, State Grid owns 60% of XJ Group
and 100% of Pinggao and Speco, three of the largest Chinese T&D equipment companies.
So, the group’s ambition to export its power grid technology will likely help these subsidiaries
displace traditional players in overseas markets.
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State Grid Corporation of China
SGCC100%
CET
XJ
Pinggao
30%XJ Electric
Pinggao Elec
Speco
25%
Pinggao Toshiba
JV 50%
Sales: 3.9bn RmbGIS/Circuit breaker
CZ-Toshiba
Sales:2.5bn RmbTransformer
Sales: 1bn Rmb(Equity-accounted)
HV sw itch
Sales:1.1bn RmbTransformer
Sales:5.1bn Rmb
Sales:13.1bn Rmb
Sales: 2bn RmbGIS/Circuit breaker; HV sw itch
Source: SG Cross Asset Research
Partnerships and JVs required to increase market access. ABB recently highlighted that
strategic partnerships or JVs were often the only way to improve market access in China. In
the HVDC system market (>$1bn), ABB expects to qualify for a JV with a local established
player by 2012, which could double its accessible market size. The official approval for
another JV is also expected in early 2012 which would increase its accessible market threefold
for T&D control and protection (>$1.5bn).
The latest example came from China Electric Power Equipment and Technology (CET), a
subsidiary of SGCC, which recently announced a JV agreement with Alstom to develop
converter stations for 800kV and 1,100kV HVDC lines, in order to supply SGCC directly with
local products.
Overview of the main domestic vendors
TBEA (Tebian Electric Apparatus) is the largest T&D player in China with CNY18bn in 2010
($2.6bn). TBEA manufactures and exports mainly transformers as well as electric wire and
cables. It has a leading market share with SGCC, with 27% market share of transformer
orders. The group has also already built a strong overseas presence with 20% of sales
generated outside China in 2010, mainly in the Middle East, Africa, but also in the US.
Revenue (CNYm) and margin history & forecasts Breakdown of revenues by segment, 2010
0%
2%
4%
6%
8%
10%
12%
14%
0
5,000
10,000
15,000
20,000
25,000
2004 2005 2006 2007 2008 2009 2010 2011e 2012e
Revenue Operating margin (%, LHS)
Transformer57%
Wire and Cable20%
Solar Silicon Wafers
15%
Electrical Contractors
5%
Other3%
Source: Company data, Bloomberg Source: Company data, Bloomberg
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XD Electric is the second largest T&D player with sales of CNY12bn in 2010. Its main products
are transformers and switchgears, but the group also manufactures rectifiers, insulators and
capacitors. The group had limited success so far outside China, with export revenues stable
at around 8% of revenues over the past three years.
Revenue (CNYm) and margin history & forecasts Breakdown of revenues by product, 2010
0%
2%
4%
6%
8%
10%
12%
14%
0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
2006 2007 2008 2009 2010 2011e 2012e
Revenue Operating margin (%, LHS)
Transformers41%
Switchgear35%
Rectifying Device
9%
Insulator & Lightning Arrester
5%
Capacitor4%
Other6%
Source: Company data, Bloomberg Source: Company data, Bloomberg
Baoding Tinawei Baobian Electric (TWBB) is the third largest player in China with revenues of
CNY8bn in 2010. The group focuses mostly on transformers, which accounted for close to
80% of group sales in 2010. TWBB decided to diversify into renewable energies in 2008 and
now derives 10% of sales from wind turbines and 7% from solar PV. These businesses have
been loss making, which partly explains the decline in the group’s operating margin since
2009. Profitability of the core transformer business is also under pressure falling from a peak
of 16% in 2008 to only 10% in 2010, highlighting the extent of competition in this business.
Revenue (CNYm) and margin history & forecasts Breakdown of revenues by product, 2010
-1%
1%
3%
5%
7%
9%
11%
13%
15%
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
2006 2007 2008 2009 2010 2011e 2012e
Revenue Operating margin (%, LHS)
Transformer79%
Wind Energy10%
Photovoltaics7%
Others4%
Source: Company data, Bloomberg Source: Company data, Bloomberg
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Healthcare
Chinese competition risks – MEDIUM
The healthcare industry is a relatively new addition to the Chinese government’s priority list. The
government has recently favoured domestic companies in the tenders for rural areas and its
support for R&D (>$9bn over 2009-2011) could change the playing field over time, leading to
growing price pressure. Foreign companies have, however, been very reactive to the country’s
changing requirements and have already developed locally produced offerings tailored to the
booming entry-level market segments. This more comprehensive presence should make it
harder for local competitors to capture market share from Western companies well-established
in premium markets as it forces these local competitors to compete on their home turf.
Healthcare – Chinese competition risks
Key criteria Score (out of 5) Comments
Strategic industry 4 New addition in the Chinese government’s priority list
Customer consolidation 4 Increased share of government tenders
Ticket size 3 Medium
Aftermarket/Distribution 2 Services and upgrades offering a recurring and profitable stream of revenue
Chinese players 2 Domestic competitors still small in size
Total 15 Medium risk – Increasingly challenged
Source: SG Cross Asset Research
Strong market growth expected, driven by insurance coverage
Healthcare expenditure accounts for 5% of GDP in China versus 15% in the US, 11% in
France and 10% in Germany. China consumes around 80 times less healthcare expenditure
per capita than the US. By 2025, the number of people in China aged 65 or more is expected
to double to c.200m. China should continue to represent a substantial growth engine for
foreign medical equipment suppliers given the ageing population, the government’s new focus
on expanding medical coverage to the bulk of the population and the low penetration of
common medical equipment in Chinese hospitals. The Chinese medical imaging device
industry has already witnessed rapid growth in recent years (CAGR of 11% over 2006-2010)
and Philips expects the China market to double over 2010-2015. Similarly, GE expects its
healthcare revenue in China to rise 20% annually through 2015 while Siemens estimates that
purchases of CT scanners in China will exceed the US unit volume by that time.
Total national spending on healthcare (2000-2010) Government spending on healthcare (2000-2011e)
476 515568
658759
866
1097 1129
1454
17541800
0
200
400
600
800
1000
1200
1400
1600
1800
2000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
RMB bn
14% CAGR (2000-10)
49 57 6478 85
104132
199
276
399
480
0
100
200
300
400
500
600
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
RMB bn
25% CAGR (2000-10)
Source: Mindray, MOH Source: Mindray, MOH
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Density of MR Imaging systems per m people Population (m)
0
5
10
15
20
25
30
35
40
45
Japan
US
A
Sw
itzerl
and
Germ
any
Austr
ia
Kore
a
UK
Italy
Bra
zil
Chin
a
India
OECD Av erage ~15
0
100
200
300
400
500
600
700
800
900
1000
1100
1200
1300
1400
Japan
US
A
Sw
itzerl
and
Germ
any
Austr
ia
Kore
a
UK
Italy
Bra
zil
Chin
a
India
in million
Source: Siemens Source: Siemens
Prior to 2008, 70-80% of the government healthcare budget was focused on urban areas. In
2009, the Chinese government initially committed CNY850bn ($124bn) over 2009-2011 to
develop the country’s healthcare system and, in early-2011, announced an increase of its
funding to CNY1trn. The government has committed to the construction of thousands of
hospitals, healthcare centres, and clinics to create a platform for universal healthcare access
for all by 2020. This should inevitably lead to spending on medical devices and equipment at
an unprecedented rate in a relatively short period of time.
The government’s priorities include the construction and renovation of around 2,000 county-
level hospitals, so that each county will have at least one such facility. County-level hospitals
are usually the best-equipped hospitals in the country and must have at least 250 beds.
The central government will also fund the construction of 29,000 township hospitals, and
the upgrading of another 5,000. It has also allocated funds for the construction of village
clinics in remote areas so that every village will have at least one unit by the end of 2011.
In H1 2011, the central government spent CNY245m ($38bn) on healthcare, an increase of
~60% yoy. Almost half of the spending went to improving insurance coverage and facilities, in
particular in rural areas. China’s basic insurance programmes today cover around 90% of the
population, while only 56% of urban and 25% of rural citizens had insurance in 2008.
Foreign healthcare companies increasingly targeting China’s
80,000 community hospitals
China’s massive hospital network has historically been poorly equipped and the market for
foreign companies has traditionally been limited to the top quartile in urban areas (around 3,600
hospitals), with the sale of high technology devices. In many first-class hospitals, the products
most in demand are often the most advanced, in order to serve their wealthier clients. Chinese
consumers tend to trust Western brands over domestic ones and are ready to pay 20% more
for foreign medical devices. Local players will likely continue to struggle before they can
penetrate the premium market, in our view.
Considering the fact that China’s healthcare funding now focuses on the basic medical
institutions, most of the major medical equipment companies have decided to expand into the
low- and mid-end ranges for the rural areas. The rise in domestic companies such as Mindray
and Wandong, supported by the healthcare reform, is also putting pressure on foreign
companies to accelerate their development and consolidate their positions in China.
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GE, Siemens and Philips have invested heavily in building up their own facilities in China over
recent years. JVs were formerly the preferred way of penetrating the Chinese medical market;
but, more recently, greenfield projects (including R&D centres) have become more popular as
a way of both serving local needs and providing a low-cost global sourcing base.
GE Healthcare today derives $1bn in sales from China, with six manufacturing centres and
10% of its global workforce in the country. In 2008, GE formed a 49%-51% JV with Shinva
Medical focusing on diagnostic X-ray equipment, which enabled the group to gain access to
Shinva’s network in underdeveloped areas and sell devices at more affordable prices, without
devaluing the GE brand. In July 2011, GE decided to move the headquarters of its x-ray
business from the US to Beijing.
Philips has tripled its workforce in China since 2007 (today China accounts for 10% of the
group’s global healthcare workforce) and estimates that its addressable market share has
increased from 16% in 2006 to 19% in 2010. After the creation of a JV with Neusoft in 2004,
Philips acquired Goldway in 2008, the second-largest domestic manufacturer of patient
monitoring products, and has since outgrown Mindray in the Chinese market.
Siemens recently indicated that 1 out of 4 MRIs and 1 out of 2 CTs sold by the group globally
are already manufactured in China. A couple of years ago, Siemens launched its SMART
strategy (Simplicity, maintenance-friendly, affordable, reliable and timely-to-market) aimed at
supplying products tailored to the entry-level market segments. A good example, that has
proved successful, is Siemens SOMATOM Spirit scanner, which offers basic CT features at a
competitive price. Most of the development work was carried out in Shanghai and each unit is
completely assembled in China, with 90% of the components sourced from China. As of 2010,
some 600 SOMATOM Spirits had been installed in China, primarily in rural areas.
No national champion but competitive pressure likely to build up
China’s medical imaging device industry is today dominated by six foreign companies; GE,
Siemens, Philips, Hitachi, Toshiba, and Shimadzu. These companies hold market share of
over 50% overall, and over 90% in the high-end device market.
China medical instrument market, 2010
GE23%
Siemens11%
Philips10%
Shimadzu6%
Toshiba5%
Hitachi4%
Omron2%
Aloka2%
Others37%
Source: Sinotes Consulting
There is no real national champion. China’s 3,000 domestic producers of medical equipment
mainly occupy the low end of the market and no more than 200 have annual sales of over
$20m. The largest local company is Mindray Medical which is around three times smaller than
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GE Healthcare in China. Other players are much smaller and include Wandong Medical and
Neusoft Medical Systems (see next section for details), Anke Medical (first MRI equipment in
China in 1989, first proprietary MRI equipment with complete independent IP rights launched
in May 2011, with an annual capacity of 80 units), Xingaoyi (specialising on open permanent
magnet MRI equipment), Chison (annual capacity of 8,000 ultrasound system units), Perlong
Medical (specialising in X-ray equipment), and Belson (JV between US-based company Bell
and Chinese Hengsheng for manufacturing ultrasound scanners and care devices such as
stethoscope and blood pressure monitors).
Ultrasound systems In-vitro diagnostics Patient monitoring & anaesthesia
Foreign brands
77%
Mindray14%
Other domestic
brands9%
Foreign brands
50%
Mindray16%
Other domestic
brands34%
Foreign brands
50%
Mindray31%
Other domestic
brands19%
Source: Mindray, 2009 Source: Mindray, 2009 Source: Mindray, 2009
Given that healthcare has become a specific investment priority for the Chinese government,
hospitals are increasingly influenced by public authorities in their purchasing decisions. The
Ministry of Health has tightened controls on purchases of high-priced medical devices (MRI,
CT and PET costing more than CNY5m) and, in turn, encourages the purchase of X-ray
machines, patient monitoring devices and ultrasounds for rural areas. The government is also
offering subsidies that favour locally made, low-cost products – this is part of the same ‘Buy
China’ attitude that foreign suppliers have already experienced in the Power and T&D
industries. Competition for government tenders has intensified in recent years, creating
greater pricing pressure. For instance, Wandong Medical won over 50% of the public bidding
on rural medical devices in 2009. With the government behind them, domestic suppliers
should artificially grow in size in the rural areas, which should eventually help them reach
critical mass, spend more on innovation and catch up with foreign brands.
Through the 2009-2011 stimulus package, the central government is expected to have spent
around CNY63bn ($9.2bn) in technology R&D, which, on an annual basis, represents around 3x
the R&D spending of Philips or Siemens. Government support for R&D will likely change the
playing field over time and help many Chinese firms become global players. A few local
companies such as Mindray have gradually bridged the gap with foreign companies in
product function and quality at a cost basis 30% lower. Chinese companies also have obvious
advantages in the sale of low- and middle-end products in their home country as they provide
user-friendly versions for Chinese doctors, which present no cultural difference. Mindray has
also already started to expand internationally. The economic recession and the ongoing
pressure to reduce their public health expenditures have encouraged most developed
countries to look for more affordable medical imaging devices, such as alternatives from low-
cost manufacturers. This ‘trading down’ shift in the mix is both helping the development of
Chinese companies in overseas markets and putting pressure on foreign companies to
expand their production base in China to export more affordable products back to developed
countries.
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Overall, we believe foreign companies should continue to enjoy strong growth and
profitability in China for another five years. However, once demand matures, pricing in
the industry look set to deteriorate sharply.
In the imaging systems business, the initial equipment revenue is just the first step, as it is
the prerequisite to the second step of building up recurring revenue and profit in
aftermarket/service operations. For example, Siemens’ installed base reached >4,000 units in
China in 2010, with a CAGR of 10% over 2005-2010. Its service and upgrade sales business
has now just started to accelerate, growing 20% p.a. since 2008, as once the warranty period
is over, the highly profitable aftermarket business comes into action.
There is no national champion and we believe foreign companies have been reactive
enough in the build-up of their distribution networks. They began to sign multi-year
distribution agreements with some key distributors and to enter agreements that effectively
prevent distributors from selling competitors’ products. For instance, over 2006-2010,
Siemens increased the number of its distributors at a CAGR of 40% and its sales staff at a
CAGR of 12%. In 2010 only, Philips increased its penetration in lower tier hospitals and
regions by 20%. Displacing the existing relationships may be difficult and time-consuming for
new entrants.
Overview of the local competition
We focus here on the progress achieved over the past few years by the three largest local
companies; Mindray Medical, Wandong Medical and Neusoft Medical Systems.
Mindray – already a global player in Medical Mindray was founded in 1991 and achieved total
revenues of $704m with an EBIT margin of 22% in 2010. Mindray sells patient monitoring
products, in-vitro diagnostics products and ultrasound systems. Mindray’s Chinese sales
grew 35% yoy in Q3 2011, while its international sales grew 26%, accounting for 57% of
group sales.
Mindray: sales and EBIT margin development over 2004-2011e
0%
5%
10%
15%
20%
25%
30%
0
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010 2011e
Sales (million $) Operating Margin
Source: Mindray, Bloomberg
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Mindray: breakdown of sales – 2003 Mindray: breakdown of sales – 2010
China75%
Emerging markets (ex
China)12%
Developed markets
8%
Others5%
China42%
Emerging markets (ex
China)32%
Developed markets
25%
Others1%
Source: Mindray Source: Mindray
Mindray already has one of the largest sales networks in China, with 1,500+ sales and service
staff and 2,400 distributors (including 1200+ exclusive distributors). Mindray estimates that its
products sell at a 30% discount versus international players and at a 20% premium to
domestic players. The group invests around 10% of sales p.a. in R&D and has demonstrated
strong product development capabilities over the past five years.
Wandong Medical– The second-largest listed Chinese medical equipment manufacturer Set
up in 1997, Wandong Medical manufactures in X-ray equipment, MRI, dental units, patient
monitors etc. It has an annual capacity of 6,000 sets of X-ray equipment and 100 sets of MRI.
Wandong remains the #2 player amongst the Chinese manufacturers, well behind Mindray,
and has historically generated a significant portion of revenues from government tenders
sales. As shown in the following graph, Wandong’s revenues from government tender sales
dropped significantly in 2010 as government spending was reduced after almost doubling in
the first year of the healthcare reform in 2009.
Wandong: sales and EBIT margin Wandong: breakdown of sales by geography
0%
2%
4%
6%
8%
10%
12%
0
100
200
300
400
500
600
700
800
2003 2004 2005 2006 2007 2008 2009 2010 2011e
Sales (in million Yuan) Operating Margin
Domestic 94%
Overseas6%
Source: SG Cross Asset Research
Neusoft Medical Founded in 1998, Neusoft Medical is a wholly owned subsidiary of Neusoft.
It is a supplier of imaging systems, including CT, MRI, X-ray machines and ultrasound system
scanners, with annual sales of around CNY800m in 2010. In 2004, Philips formed a 51%-49%
JV with Neusoft Medical, focusing on the economy and mid-end ranges (CT and X-ray), with
the aim to feed both Neusoft Medical and Philips’ separate sales channels and export half of
its production after three years. The first exports took place in 2006 but, since then, we
understand that the JV has failed to deliver on its promises. In Q3 2011, Philips reported that
its order growth in China was penalised by a reorganisation of the Neusoft JV, initiated by their
partner, which cost around 500bp of growth.
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Construction equipment
Chinese competition risks – Medium to High
We score the Construction Equipment industry at 16/25 in our Chinese competition risk scale.
Driven by the construction boom, some large Chinese players capable of competing
internationally have emerged over the past few years. The bleak outlook we anticipate for the
Chinese construction sector should accelerate the international deployment of Chinese
players. Zoomlion’s CEO recently claimed that the Chinese CE market was overcrowded and
the path to growth was abroad.
Construction equipment – Chinese competition risks
Key criteria Score (out of 5) Comments
Strategic 2 Not strategic but construction industry is or has been
Customer consolidation 2 Thousands of customers globally
Ticket size 4 Significant investment for contractors
OE vs Aftermarket/Distribution 4 Independent dealers can provide entry points into new markets
Chinese players 4 Large domestic market and 3-4 large players
Total 16
Source: SG Cross Asset Research
Chinese CE market and its main players
We estimate that the Chinese construction equipment market (CE) represents more than 40%
of the global CE market in volume (25-30% in value), mostly dominated by Chinese players
(i.e. 65% market shares). The top three Chinese players (Sany Heavy, XCMG and Zoomlion)
control 30% of the Chinese CE market while the share of non-Chinese manufacturers stands
at roughly 35%.
Geographical breakdown of CE market (volumes, 2010) China CE market shares (based on 2010 revenues)
China; 42%
Europe; 12%
North America; 16%
Latin America; 6%
Asia ex China; 14%
RoW; 10%
Caterpillar
9%
Volvo7% Komatsu
5%
Hitachi4%
Kobelco1%
Hunan Sunward
1%
Liugong5%
Lonking4%
Sany Heavy11%
Shantui4%
XCMG8%
Zoomlion11%
XGMA3%
Other Chinese18%
Others9%
Source: Volvo Source: SG Cross Asset Research, Company Data
Sany Heavy Industries – The Chinese leader
Sany Heavy Industries is the leading Chinese player in the construction equipment industry,
with revenues likely to exceed CNY50bn in 2011. Key products include concrete machinery
(54% of sales), excavators (19% of sales) and crane machinery (13% of sales). Sany Heavy is
the largest player in the domestic excavator industry with nearly 10% market share. Sany is
also the most developed Chinese player on the international scene with manufacturing and
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R&D bases in the US, Germany and India. In 2010, the company derived 7% of its sales from
overseas.
Revenue (CNYm) and margin history Revenue breakdown by product, 2010
0%
5%
10%
15%
20%
25%
-
10,000
20,000
30,000
40,000
50,000
60,000
2004 2005 2006 2007 2008 2009 2010 2011e
Revenues EBIT %
Concrete machinery
54%
Excavator19%
Truck crane8%
Rotary drilling6%
Crawler crane5%Road
machinery4%Spare parts
3%
Others1%
Source: Company Data, IBES Source: Company Data
Zoomlion – The most ambitious in terms of international expansion
Zoomlion is the second largest Chinese player in the construction equipment industry, with
leading positions in concrete (44% of sales) and crane (35% of sales) machineries. Zoomlion
revenues are likely to reach CNY45bn in 2011, just behind Sany Heavy Industry. The company
derives 6% of its revenues from overseas but is targeting 35% by 2015. The company will
start production in its new manufacturing facility in Brazil and is building a new site in India.
Back in 2008, Zoomlion bought CIFA, the third largest player in the global concrete machinery
industry, providing a good foothold in Europe.
Revenue (CNYm) and margin history Revenue breakdown by product, 2010
10%
12%
14%
16%
18%
20%
22%
-
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
45,000
50,000
2006 2007 2008 2009 2010 2011e
Revenue EBIT %
Concrete machinery
44%
Crane machinery
35%
Road construction
4%
Excavators2%
Material Handling
1%
Financial leases
3%Others
11%
Source: Company Data, IBES Source: Company Data
XCMG – The leading player in crane machinery
XCMG revenues should exceed CNY30bn in 2011. Representing more than 60% of its total
revenues, crane machineries are the group’s key product. XCMG derives around 9% of its
sales from overseas and this percentage is set to grow as the company is massively investing
in new capacities abroad. The company is spending $200m capex in Brazil to sell its full
product range in LatAm and the US.
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Revenue (CNYm) and margin history Revenue breakdown by product, 2010
0%
2%
4%
6%
8%
10%
12%
14%
16%
-
5,000
10,000
15,000
20,000
25,000
30,000
35,000
2008 2009 2010 2011e
Revenues EBIT %
Crane62%
Scraper15%
Compaction machinery
7%
Spare parts6%
Concrete machinery
4%Pavement
construction machinery
3%Fire-fighting machinery
1%Others
2%
Source: Company Data, IBES Source: Company Data
Development of Chinese competition
Moving up the value chain – US/EU standards in sight
Even though engine emission standards in China are still a long way below those of Europe or
the US (China is implementing Tier III standards vs Tier IV in the US/EU), Chinese CE players
are quickly moving up the value chain. The Chinese excavator industry is a good example of
how fast this process is developing. The hydraulic equipment used in excavators subjects
hydraulic fluid to extremely high pressure, which requires strong expertise and precision
machinery. Since China is a relative newcomer to this field, foreign companies have
historically dominated the Chinese market for excavators. According to CCMA 2010 data,
foreign brands had 70% of the Chinese excavator market in terms of volume. However, it is
worth noting that this market share has been on a downward trend for the past few years.
Their market shares rose from 22% in 2006 to above 30% in 2010 as the chart on the right-
hand side shows. Data for the first nine months of 2011 show an acceleration of this trend,
with the share of Chinese manufacturers increasing to almost 40%. Chinese companies like
Sany have successfully entered the excavator market by: 1) entering the small- to medium-
size excavator market, and 2) importing hydraulic components from Rexroth (part of Bosch
group) or Kawasaki. Sany Heavy has thus seen its market share grow from less than 2% in
2006 to more than 8% in 2010, just behind Kobelco.
Excavators – 2010 market shares (units) Excavators – Evolution of market shares
Komatsu14%
Doosan13%
Hyundai11%
Hitachi11%
Kobelco9%
Sany Heavy Industry
9%
Caterpillar6%
Volvo5%
Yuchai5%
Liugong Machinery
3%
Futian Lovol3%
Hunan Sunward
3%
JCM2%
Xiagong2%
Sumitomo2%
Other3%
77.4% 78.1% 73.7% 71.8% 69.5%
22.6% 21.9% 26.3% 28.2% 30.5%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2006 2007 2008 2009 2010
Foreign Chinese
Source: CCMA Source: CCMA
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A relative lack of success internationally…so far
The Chinese construction equipment companies are still relatively undeveloped on a global
scale. The top three Chinese manufacturers have each reported only between $250-350m
revenues outside China as the following table shows. Sany Heavy has been the most
successful in increasing its non-domestic revenues from c.$220m to c.$325m between 2009
and 2010. However, it is interesting to note that the non-domestic revenues of these
companies are similar to their 2007 level. Clearly the export potential has shrunk during the
downturn, although we could have expected Chinese companies to outperform the broader
market. This relative lack of success in our view stems from the focus of Chinese companies
over the past few years on the strength of their domestic market.
Non-domestic revenues of the top three Chinese companies ($m)
202
610
383272
239
577
218326
458
641
273 323
0
200
400
600
800
1000
1200
1400
1600
1800
2000
2007 2008 2009 2010
Zoomlion Sany XCMG
Source: Company Data
Slowing domestic market should accelerate global deployment
Fully aware that the sharp volume growth enjoyed over the last few years is unlikely to go on
forever, Chinese companies are looking abroad to be able to maintain their strong growth
trajectory. In 2010, China’s exports of construction machinery reached $9.3bn (up 35% from
2009, albeit still 25% down vs 2008), with the majority being components and low to medium-
end products. However, a portion of these exports was accounted for by non-Chinese
companies which are manufacturing parts or complete equipment in China and then shipping
them abroad.
Export of construction & mining equipment ($m) Breakdown of exported construction & mining equipment by
value
-
2,000
4,000
6,000
8,000
10,000
12,000
14,000
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Excavator
4%
Loader9%
Bulldozer3%
Crane11%
Fork-lift truck5%
Grader / leveller3%
Road roller / tamping machine
3%
Lifting / handling machine
3%
Earth moving / grading machine
5%
Concrete machine
4%
Elevator / escalator
10%
Component35%
Other5%
Source: CCMA Source: CCMA
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We expect the largest Chinese manufacturers to become much more aggressive
internationally over the next few years, especially in emerging markets like India or Brazil.
Zoomlion raised equity last year to finance its international expansion. The group aims to
derive more than 35% of its revenues internationally by 2015 (vs only 6% in 2010). In 2012,
Zoomlion expects to start building a factory for making concrete machinery in India and to
start production of its new plant in Brazil. In Japan, it will build a factory after winning an order
in the country for 30 truck-mounted concrete pumps in September 2011. XCMG invested
$200m in Brazil to start manufacturing full-series construction equipment for LatAm and the
US markets. Sany also announced an additional investment in the US and plans to invest in 30
countries as globalization has become an important part of the group’s growth story.
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Heavy and medium duty trucks
Chinese competition risks – Medium
We view the heavy and medium duty truck industry as having a mid- to high-risk profile.
Although Chinese players are large in size, the importance of aftermarket/distribution network
remains a major impediment for an aggressive international expansion. However, this barrier
to entry can be easily removed, should a Chinese player acquire one of the mid-sized EU/US
players (Iveco, Navistar or Paccar).
Heavy and medium duty truck – Chinese competition risks
Key criteria Score (out of 5) Comments
Strategic 2 Not strategic
Customer consolidation 2 Highly fragmented customer base
Ticket size 4 High for customers
OE vs aftermarket/distribution 2 Great importance – capital turnover key for customer’s profit generation
Chinese players 5 Among the largest players
Total 15
Source: SG Cross Asset Research
A huge domestic market with large players
The truck market has experienced a large shift in demand over the past decade. Developed
markets represented more than two-thirds of worldwide volume demand before 2000, but in
2011 we estimate this level had fallen to slightly more than 25%. This material shift in demand
away from developed markets is explained by the strong increase in Chinese demand over the
past decade, with China now representing almost half of the truck market by volume (about
25% in value terms) against 15-20% a decade ago.
Geographical breakdown of deliveries in 1998 Geographical breakdown of deliveries in 2010
Western Europe
22%Af rica
1%
Asia-Pacif ic31%
Eastern Europe
2%
North America
39%
South America
5%
Western Europe
8%
Af rica1%
Asia-Pacif ic68%
Eastern Europe
5%
North America
11%
South America
7%
Source: SG Cross Asset Research, JD Power
This shift in demand has led to a major redistribution of global market shares. With little
access to the Chinese truck market, the main European and US truck manufacturers have lost
ground globally. For instance, we estimate Daimler has seen its global market share fall from
c.20% in 1998 to less than 10% today.
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Market share 1998 (medium and heavy duty trucks) Market share 2010 (medium and heavy duty trucks)
DMC8%
CNHDTC1%
FAW7%
Ashok Leyland1%
Daimler 19%
Ford 7%
GM3%
Hyundai 1%
Navistar9%
Isuzu 3%
IVECO 4%
MAN 4%
Other5%
Paccar7%
Tata 5%
Toyota2%
Volvo 12%
Scania3%
DMC7%
SHAANXI AUTO
4%
CNHDTC8%
FAW11%
BEIQI FUTIAN4%
Ashok Leyland3%
Daimler 8%
Ford 3%
GM0%
Hyundai 1%
Navistar3%
Isuzu 1%
IVECO 2%
MAN 4%
Other22%
Paccar3%
Tata 8%
Toyota1%
Volvo 5%
Scania2%
Source: SG Cross Asset Research, JD Power
Overview of the main Chinese players
Dongfeng is by far the market leader in China with one-third of the medium truck market and
20% share of the heavy truck market. FAW and CNHTC (i.e. Sinotruk) follow, with respectively
21% (leader in the heavy truck segment) and 16% market shares. It is worth noting that the
top three players are losing ground.
Market share medium duty trucks (2010) Market share heavy duty trucks (2010)
FAW15%
CNHTC7%
JAC11%
Sichuan Nanjun10%
Qingling6%
Dongfeng32%
Other19%
FAW23%
CNHTC19%
Foton11%
SHAANXI AUTO11%
CHONGQING HEAVY
3%
JAC2%
North Benz4%
Dongfeng20%
Other7%
Source: SG Cross Asset Research, JD Power
Western truck manufacturers have been historically reluctant to enter the Chinese truck
market as the demand was mainly concentrated in the low-end segment with 85% of truck
demand priced at less than $45,000 per unit.
However, this market segmentation is changing with product offering moving up the value
chain. The technological gap between Chinese trucks and US/EU trucks is narrowing as China
will officially move to Euro IV in 2010 and Euro V in 2012. This and other factors such as rising
energy prices, improved infrastructure and demand in the high-load capacity segment are
pushing the Chinese truck market toward higher-end products, and this clearly represents an
opportunity for US and European truck manufacturers.
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Market share distribution by truck prices in China
0%
5%
10%
15%
20%
25%
30%
35%
40%
<3
0,0
00
30-3
7,0
00
37-4
5,0
00
45-5
2,0
00
52-6
0,0
00
60-6
7,0
00
67-7
5,0
00
75-9
5,0
00
95-1
50
,000
>150,0
000
Chinese players Japanese players European players
Source: Daimler
The Chinese truck market has thus become increasingly appealing for Western truck
manufacturers, although their late entry into this huge market means that they struggle to take
market shares. Therefore, Western truck manufacturers have formed JVs with Chinese players
to produce high-end trucks. The following chart below shows the current main relationships
between Chinese truck makers and their European or US counterparts.
Connections between US/EU truck manufacturers and Chinese truck manufacturers
Chinese manufacturers (market share in China) Deal type Western manufacturers
Dongfeng (22%) Joint Venture Volvo
Sinotruk (16%) 25% ownership
SHAANXI AUTO (9%) Joint Venture
SAIC (3%) Joint Venture Iveco
Foton (8%) Joint Venture Daimler
Qingling (2%) Joint Venture Isuzu
Sichuan Nanjun (2%) Joint Venture Hyundai
Jianghuai Auto (4%) Joint Venture Navistar-Caterpillar
MAN
Source: Company data, SG Cross Asset Research
Chinese competition entering emerging markets
Although stringent regulations and the importance of aftermarket/distribution network mean
that US and European truck markets remain relatively protected at the moment, the Chinese
truck manufacturers are targeting other emerging markets to increase their global market
shares. For instance, Sinotruk, which is the largest heavy duty truck exporter among Chinese
players, should export almost 20,000 trucks in 2011. To put this number into context, Sinotruk
has around of 1.5% market share of the global market ex-China. More than half of Sinotruk
exports are directed to Africa and LatAm, while the remainder goes to other Asian countries
and Eastern Europe.
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The latest data from the China Association of Automobile Manufacturers show that exports of
Chinese truck increased by 40% through the first ten months of 2011, well exceeding the
market growth ex-China.
Sinotruk’s heavy duty truck export volume and market share Export of light, medium and heavy duty trucks (volume)
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
1.4%
1.6%
-
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
18,000
20,000
2004 2005 2006 2007 2008 2009 2010 2011e
Volume Market share
-
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
Dec-0
9
Jan-1
0
Feb-1
0
Mar-
10
Apr-
10
May-
10
Jun-1
0
Jul-
10
Aug
-10
Sep-1
0
Oct-
10
Nov-
10
Dec-1
0
Jan-1
1
Feb-1
1
Mar-
11
Apr-
11
May-
11
Jun-1
1
Jul-
11
Aug
-11
Sep-1
1
Oct-
11
Source: Company Data Source: China Association of Automobile Manufacturers (CAAM)
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Automation
Chinese competition risks – Medium
We believe the automation industry is safe for now in terms of emerging market competition.
The Chinese automation market remains underdeveloped and the vast majority of the industry
is controlled by a handful of multinational companies. China’s shift from a developing country
to one of the world’s leading manufacturers of industrial and consumer goods and the rising
cost of labour should inevitably translate into growing demand for more efficient and reliable
manufacturing processes. It also means that the automation industry could increasingly
become strategic for the government, given its growth potential and China’s growing focus on
high-end equipment manufacturing and energy efficiency.
Automation – Chinese competition risks
Key criteria Score (out of 5) Comments
Strategic industry 3 Growing government focus on energy efficiency and high-tech manufacturing
Customer consolidation 2 Scattered end-customer base
Ticket size 2 Low- to medium-ticket items (PLC, DCS, actuators, instruments, robots)
Aftermarket/Distribution 3 Various channels (OEMs, systems integrators, distributors)
Chinese players 2 Emerging market competitors still very small
Total 12 Medium risk – High barriers to entry but likely to become strategic
Source: SG Cross Asset Research
The Chinese automation market is still underdeveloped
The Chinese automation market has grown at a CAGR of 16% over the past 10 years, far
above GDP growth, and is expected to reach over $26bn in 2011e. The Chinese automation
market has gradually gained scale, with all product categories now being represented and
application fields expanding. The number of suppliers has also increased and channels have
become more mature. Despite this strong growth, the Chinese market accounts for only 12%
of the global automation market, estimated at around $200bn globally. This highlights the
relative underdevelopment of this market in China so far and its growth potential over the
medium term.
Automation market by region (2010) Automation market in China (1999-2013e)
EMEA36%
Germany9%USA
19%
Other Americas
6%
China12%
Other Asia18%
0
5
10
15
20
25
30
35
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011e
2012e
2013e
$bn
CAGR 16%
CAGR 12%
Source: Siemens Source: Gonkong China Industrial Control
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Wage inflation should drive accelerated growth in automation
China’s demographics appear to be tightening the available labour supply and boosting
wages. The one-child policy and demand from labour for a greater share of benefits from
China’s economic growth are contributing to this pattern. Moreover, government policy is also
to accommodate wage pressures, consistent with China's desire to move toward higher
value-added manufacturing and domestic demand-led growth. The current five-year plan calls
for doubling the average minimum wage by 2015. With double-digit annual wage inflation, a
strengthening CNY, competition for skilled labour and increasingly onerous restrictions on
overtime hours (max. 36 hrs/month), China is no longer a low-cost country. This should force
all Chinese industries to utilise automation systems to gradually replace manual workers.
We believe that the robotics segment offers one of the most obvious examples of the growth
opportunity for automation companies. According to the International Federation of Robotics
(IFR), China only accounted for 4% of the global installed base of industrial robots in 2010, far
behind Japan (29%), North America (15%) and Germany (13%). ABB is the leader in China
with an estimated 20% market share, while Japanese players Fanuc and Yaskawa are not far
behind with 15% market share each. There is limited local competition.
Industrial robots installed base by country, 2010 Market share of robotics in China, 2009
Japan29%
North America15%
Germany13%
Korea8%
Italy6%
China4%
France3%
Spain3%
Taiwan2%
UK1%
Other 16%
ABB20%
Fanuc15%
Yaskawa15%Kuka
9%
OTC18%
Panasonic15%
Other8%
Source: IFR Source: ABB
Limited local competition so far
The Chinese automation market is skewed towards process industries. As illustrated by the
charts below, the chemical, power generation, petrochemical and oil & gas sectors account
for around 65% of the total automation market.
Chinese automation market by product Chinese automation market by sector
PLC7%
DCS6%
IPC4%
HMI3%Other controls
2%
LV drives18%
MV drives5%
Other drives3%
Control valve18%
Other actuators5%
Instrument & Sensor
15%
Motion control8%
Other6%
Chemical18%
Power Generation
17%
Petrochemical14%Metallurgy
11%
Building Material5%
Oil & Gas4%
Other31%
Source: Gonkong China Industrial Control Source: Gonkong China Industrial Control
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ABB and Emerson, which have historically ranked in the top two positions in the DCS and
control valves segments, have recently encountered more of a challenge, with Invensys and
Siemens steadily taking share as they gradually opened up new industries (nuclear for
Invensys and food/beverage and pharmaceutical for Siemens). Domestic DCS manufacturers
such as Hollysys, Supcon and Xinhua Control have also appeared, benefiting from the
development of numerous small refinery and chemical projects.
As China rebalances from an infrastructure-led-economy towards a consumer-oriented
economy in the coming years, we expect demand for discrete automation systems such as
PLCs to enjoy superior growth rates given their lower relative penetration rates. Siemens, as
the largest supplier of PLC products with a market share of 35%, holds a safe lead in the
Chinese market which remains dominated by foreign brands, including Rockwell, Schneider
and Mitsubishi.
The drive market should also be supported by the Chinese government’s growing focus on
energy conservation and environmental protection. Industrial motors use around 25% of all
electricity generated and motor-drive combinations can cut energy costs by up to 70%, with
average payback period on investment in drives of around two years. ABB leads the drive
market in China, followed by Siemens, Yaskawa and Fuji. Sanch, the largest Chinese
company has market share of <2% in the country.
As shown in the right-hand graph below, the Chinese automation market is largely dominated
by Western manufacturers (75% market share). Automation & control products branded in
Europe and the US are viewed as premium quality products. By fitting components and
products manufactured by US or European suppliers, Chinese machine builders can enhance
perceived quality of a machine and therefore make it more marketable. For instance, some
machine builders in China offer machinery with the option of components manufactured
locally or, for a price premium, components manufactured in the US or Europe.
Global automation market shares, 2010 Chinese automation market shares, 2010
Siemens
15%
ABB Automation12%
Emerson Process
7%
Rockwell5%
Schneider5%Mitsubishi
4%Danaher
4%Yokogawa
3%
Honeywell3%
GE3%
Supcon0.4%
Hollysys0.2%
Other39%
Siemens
10%
ABB8%
Emerson6%
Honeywell5%
Yokogawa3%
Schneider2%
Rockwell2%
Invensys1%
Other EU, US, Japan39%
Supcon1%
Hollysys1%
Other Chinese22%
Source: Control Global Source: SG Cross Asset, Company data, ARC
The market can be divided into three categories.
European and American brands occupy the medium and high segments of the market,
generally characterised by project purchasing and direct sales to end-users or to system
integrators. The main players include Siemens, ABB, Emerson, Schneider, Rockwell, Invensys
and Honeywell. Western manufacturers are also constantly developing mid-end products so
as to open up new growth areas and to prevent local players from moving up the value chain.
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Japanese brands tend to hold the medium segment of the market, generally selling to
distributors and OEMs (machine tools, textile machinery, cranes, etc…). The main player is
Yokogawa, followed by Mitsubishi, Omron and Yaskawa.
Local players like Hollysys, Supcon or Xinhua Control focus on the entry-level market,
mainly competing on prices and primarily active in areas driven by governmental support
(railway, power, petrochemical, water processing).
Hollysys Technologies: leading Chinese player in DCS
Hollysys Technologies (3,500 employees) is amongst the largest Chinese automation players
with total revenues of $262m in FY 2011 (end-June). Hollysys claims to have an 11% market
share in DCS systems in China and believes that the quality of its DCS systems is today
comparable to those of foreign suppliers: the group has recently been qualified as a potential
DCS vendor by BASF. The group is guiding for sales growth of 35% in FY 2012.
Hollysys - Revenue and margin history Hollysys - Revenue breakdown by division
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
-
50
100
150
200
250
300
350
400
2007 2008 2009 2010 2011 2012e 2013e
Revenues ($m)
EBIT margin (%, RHS)
Industrial Automation
52%
Rail automation
28%
Subway automation
18%
Nuclear automation
2%
Source: Company data, Bloomberg Source: Company data, Bloomberg
Hollysys derives 52% of sales from industrial automation, with a historical focus on DCS (used
in the industries involving continuous flow of material handling) and more recently with a
development in PLC (used in discrete control). The group also derives 28% of sales from the
High-Speed Rail market, where it provides train control and protection systems, and 18% of
sales from SCADA systems to China’s subway market. Finally, the company supplies control
systems used in conventional islands of nuclear power plants and expects its proprietary
nuclear island automation system to be commercialised in 2012 or 2013, when the total
automation and control for nuclear stations will be fully localised in China.
Hollysys has said it plans to aggressively expand its business to exploit the anticipated
growing demand for automation and control in areas favoured by government policy such as
clean energy and infrastructure industries. The group is also preparing for international
expansion, following on the acquisition of Concord in May 2011 which will provide Hollysys
with a distribution channel for DCS and PLC outside of China.
Risk of new entrants: the example of Foxconn
Foxconn is a leading consumer electronics subcontractor in China, assembling mobile
phones, tablet PCs and other electronic devices for Western firms like Apple. It is also the
largest private employer in China with more than one million employees. The company has
recently announced its willingness to replace a large part of this workforce with up to 1 million
robots over the next three years, which would imply over 300,000 units per year. ABB was
already a supplier of Foxconn for robots and could have benefited from this development, but
Foxconn decided to set up a robots production unit in Taiwan to manufacture its own robots.
If other large Chinese companies decide to produce their own automation products to fulfil
their increasing needs, then Western companies could miss part of this huge potential market.
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Bearings, cutting tools and compressors
Chinese competition risks – Low
We view the bearing industry as relatively safe with regard to Chinese competition. Its
fragmented customer base, its non-strategic profile and the relatively small scale of Chinese
players should reduce competition risks in the mid term.
Bearings – Chinese competition risks
Key criteria Score (out of 5) Comments
Strategic 2 Energy efficient devices have become strategic
Customer consolidation 2 Fragmented customer base except in the auto industry
Ticket size 1 Small-ticket item, sale on value added not on price
OE vs Aftermarket/Distribution 3 Large distribution network required
Chinese players 2 Only small-sized players
Total 10
Source: SG Cross Asset Research
We view the cutting tools industry as a relatively safe haven with regard to Chinese
competition. On almost all criteria, the industry scores relatively low, meaning that risks remain
subdued for the time being.
Cutting tools – Chinese competition risks
Key criteria Score (out of 5) Comments
Strategic 1 Not strategic
Customer consolidation 2 Fragmented customer base
Ticket size 1 Small-ticket item, sale on value added not on price
OE vs Aftermarket/Distribution 2 Very efficient distribution network required
Chinese players 2 Only small-sized players
Total 8
Source: SG Cross Asset Research
We view the stationary air compressor industry as relatively well protected against Chinese
competition. The biggest entry barrier for the industry is the importance of aftermarket and
distribution networks.
Stationary air compressors – Chinese competition risks
Key criteria Score (out of 5) Comments
Strategic 2 Energy efficient devices have become strategic
Customer consolidation 2 Fragmented customer base
Ticket size 3 Mid-ticket item, sale on value added not on price
OE vs Aftermarket/Distribution 1 Aftermarket is key to avoid production shutdowns
Chinese players 2 Only small-sized players, Chinese market dominated by foreign brands
Total 10
Source: SG Cross Asset Research
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China is a key market for general engineering activities
China accounts for 20% to 30% of the global market for bearings, cutting tools and industrial
air compressors. China has therefore become a key market for most general engineering
activities.
Global bearing market Global cutting tool market Global industrial air compressor market
Asia ex-
China-Japan
4%
China28%
Japan15%
Europe ex-Germany
20%
Germany10%
North America
20%
South America
3%
China22%
Europe33%
US26%
Other Asia14%
LatAm5%
US27%
Europe27%
China 23%
India5%
Other Asia9%
Latin America
9%
Source: SKF Source: SG Cross Asset Research Source: SG Cross Asset Research
Still highly fragmented Chinese competition…
For these activities, Chinese competition remains heavily fragmented and mainly focused on
the low- to mid-end segments. In addition, these engineering activities are often vertically
integrated into large, state-owned enterprises.
For instance, according to the China Machinery Industry Federation, they are more than 1,500
bearing companies operating in China and 90% of them recorded less than CNY100m
revenues in 2010. The top 10 bearing players (including foreign brands) have less than 35%
market share.
Number of companies operating in the bearing
industry in China
Revenues and market shares of top 10 bearing
companies in China
0
200
400
600
800
1000
1200
1400
1600
1800
2001 2002 2003 2004 2005 2006 2007 2008
Nb. of companies with sales > 100 Million Yuan
Nb. of companies with sales < 100 Million Yuan
0%
5%
10%
15%
20%
25%
30%
35%
40%
0
5
10
15
20
25
30
35
2000 2001 2002 2003 2004 2005 2006 2007 2008
TOP 10's sales (CNY bn) as %
Source: China Machinery Industry Federation
We list in the following tables the main Chinese players in each industry.
Key Chinese players in the Bearing market
Bearings Estimated revenues
(CNYbn)
Comments
LYC Bearing Corporation 6,000 Leading Chinese bearing manufacturer, less than 5% of revenues derived from export
Harbin Bearing Group 4,000 Acquired by AVIC in 2008, very focused on bearings for railway and aerospace sectors
Wafangdian 2,500 State-owned enterprise but SKF has 19.7% of shares
Source: SG Cross Asset Research, Company Data
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Key Chinese players in the Cutting Tool market
Tooling Estimated revenues
(CNYbn)
Comments
Zhuzhou Cemented Carbide 1,200 The most advanced cutting tool manufacturer in China. Sales offices in Europe and in the US
Shanghai Tool Works 600 Regional player only, mostly in the low-end segment
Source: SG Cross Asset Research, Company Data
Key Chinese players in the stationary air compressor market
Stationary air compressors Estimated revenues
(CNYbn)
Comments
Fusheng Industrial 3,000 Owned by private equity, 70% of sales made in China
Kaishan 1,600 Regional player only, mainly reciprocating compressors
Source: SG Cross Asset Research, Company Data
…mainly focused on the low- to mid-end segments
In most general engineering activities, Chinese manufacturers are still very focused on the
low- to mid-end segments where competition is all about pricing. However, Chinese
manufacturers will continue to move up the value chain and the low-end segments should
progressively disappear to the benefit of the mid- to high-end segments. It is therefore key for
engineering companies to have a presence in the mid-end segment.
Among engineering companies, Atlas Copco looks to be the best positioned thanks to its
multi-brand strategy. SKF is targeting development of its mid-end segment PEER brand to
expand in the Chinese mass bearing market. Sandvik is still heavily focused on the premium
market.
Chinese competitive landscape
Premium
Medium
Low-end
Ch
ine
seb
ran
ds
Fo
reig
nb
ran
ds
CHINA TODAY CHINA TOMORROW
Ch
ine
sea
nd
fo
reig
n b
ran
ds
Premium
Medium
Source: SG Cross Asset Research
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Low voltage
Chinese competition risks – LOW
We believe the low-voltage industry offers a resilient and low-risk profile with regard to
emerging market competition. The market has a local structure with high entry barriers
(differences in local norms, end-users’ habits and aesthetic preferences in each country, local
players’ strong relationships with distributors). Demand is also characterised by a regular flow of
small-ticket items. Low-voltage products only represent a small cost component of building
projects, which limits deflationary patterns. According to a Sonepar survey, price is ranked only
seventh in terms of end-users’ priorities.
Low voltage – Chinese competitin risks
Key criteria Score (out of 5) Comments
Strategic industry 1 Below the radar screen
Customer consolidation 1 Very fragmented and scattered end-customer base
Ticket size 1 Very low ticket items (switches, sockets, etc)
Aftermarket/Distribution 2 Distribution network, a prerequisite for success
Chinese players 2 Local market structure preventing Chinese to expand overseas successfully
Total 7 Low risk – High barriers to entry (norms, standards, access to distribution)
Source: SG Cross Asset Research
The Chinese competitive landscape is already well structured
The low voltage market in China was estimated at around CNY60bn (€6.7bn) in 2010. The
chart below shows the main players in the market based on their positioning.
Main low voltage companies in China
CHINTDelixi
Tengen...
Low -end market:
33bn Yuan
Mid-end market:
15bn Yuan
High-end market:
12bn Yuan
Chang
Nader
Renming
ABBSchneider
Noark(CHINT)
Siemens
Price
Market positioning
Source: AEG, Nader
The high-end market, accounting for about 20% of the total, is targeted by foreign brands
such as Schneider (30% estimated market share), ABB and Siemens. Amongst local
competitors, only Chint, with the launch of its Noark brand, has recently made some inroads
in the premium segment.
Chinese players (Chint, Legend, Tengen, etc) remain focused on the low and mid-end
segments, for which the leading player is Chint. Foreign companies have also tried to
penetrate the space through local partnerships. For instance, in 2007, Schneider created a 50-
50 JV with Delixi to offer a different value proposition from its existing premium offering,
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11 January 2012 81
independently marketed through a specific network of more than 1,000 retail outlets. The JV
was expected to generate revenues of around €220m in 2007. Schneider-Delixi now claims a
market share of around 20% in the ‘value’ segment in China, just behind Chint.
Chint: leading Chinese player with 10% market share
Chint is the largest Chinese player in the low-voltage segment, with an estimated 10% share
of the local market. The group had revenues of CNY6.3bn (€0.7bn) in 2010, with an EBIT
margin of 13.5%. Exports accounted for 7% of revenues in 2010 but the group’s target is to
lift this figure to 10-20% within the next five years. The group established its Noark subsidiary
in 2011, targeting the high-end market to compete with Western manufacturers.
Chint – Revenue and margin history Chint – Revenue breakdown by division (2010)
4%
6%
8%
10%
12%
14%
16%
18%
20%
-
2
4
6
8
10
12
2006 2007 2008 2009 2010 2011e 2012e
Revenues (in RMB m) EBIT margin (%, RHS)
Power Distribution
34%
Terminal devices
31%
Power Control
25%
Power Supply
7%
Other3%
Source: Company data, Bloomberg Source: Company data, Bloomberg
Below the radar in terms of strategic importance
The low voltage market remains relatively protected from Chinese competition, in our view.
We have long argued that Chinese competition is a key risk in so-called ‘strategic’ sectors.
The Chinese government, through the implementation of its five-year plans, has supported the
development of local champions in sectors that have strategic importance for the
development of the country: power generation, rail transportation, T&D, healthcare, etc. Low
voltage products are not considered strategic and their growth potential leaves them well
below the government’s radar. As a result, Chinese players have not benefited from any real
government support so far, which explains their relatively small size versus traditional Western
players and their relative absence from the high-end segments.
Market share with local distributors is key
The customer base in the low voltage industry is highly fragmented, with hundreds of
thousands of individual customers in each country. In such scattered markets, the required
commercial network to address all electricians is a key competitive advantage compared with
new entrants like Chint and Legend for which it is very time-consuming and expensive to build
up the appropriate relationships with distributors, panel builders, contractors and specifiers.
In 2010, Schneider had a network of 16,000 sales outlets all over the world, including
wholesalers, local and professional distributors and home improvement chains. Schneider’s
latest acquisition in China illustrate the group’s strategy to constantly increase the capillarity
of its network: Schneider entered into a partnership with NVC Lighting to expand its market
penetration in smaller cities in China by using NVC Lighting’s diffused channels (3,000 retail
outlets, half of which are located in smaller cities and townships).
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APPENDIX
COMPANIES MENTIONED
ABB (ABBN.VX, Hold)
Alstom (ALSO.PA, Hold)
Apple (AAPL.OQ, Buy)
Areva (AREVA.PA, Sell)
Assa Abloy (ASSAb.ST, Hold)
Atlas Copco (ATCOa.ST, Sell)
BASF SE (BASFn.DE, Hold)
Bombardier (BBDb.TO, Buy)
CRH (CRH.L, Buy)
Daimler (DAIGn.DE, Hold)
Emerson (EMR.N, Hold)
Invensys (ISYS.L, Hold)
Legrand (LEGD.PA, Buy)
MAN (MANG.DE, Buy)
National Grid (NG.L, No Reco )
Nexans (NEXS.PA, Sell)
Philips (PHG.AS, Buy)
Rio Tinto (RIO.L, Buy)
Rockwell (ROK.N, Sell)
Sandvik (SAND.ST, Sell)
Scania AB (SCVb.ST, Hold)
Schneider (SCHN.PA, Hold)
Siemens (SIEGn.DE, Buy)
SKF (SKFb.ST, Buy)
Smiths Group (SMIN.L, No reco)
Vallourec (VLLP.PA, Hold)
Volvo (VOLVb.ST, Hold)
ANALYST CERTIFICATION
The following named research analyst(s) hereby certifies or certify that (i) the views expressed in the research report accurately
reflect his or her personal views about any and all of the subject securities or issuers and (ii) no part of his or her compensation
was, is, or will be related, directly or indirectly, to the specific recommendations or views expressed in this report: Sébastien
Gruter, Gaël de Bray, CFA.
SG RATINGS
BUY: expected upside of 10% or more over a 12 month period.
HOLD: expected return between -10% and +10% over a 12 month
period.
SELL: expected downside of -10% or worse over a 12 month
period.
Sector Weighting Definition:
The sector weightings are assigned by the SG Equity Research
Strategist and are distinct and separate from SG research analyst
ratings. They are based on the relevant MSCI.
OVERWEIGHT: sector expected to outperform the relevant broad
market benchmark over the next 12 months.
NEUTRAL: sector expected to perform in-line with the relevant
broad market benchmark over the next 12 months.
UNDERWEIGHT: sector expected to underperform the relevant
broad market benchmark over the next 12 months.
Ratings and/or price targets are determined by the ranges
described above at the time of the initiation of coverage or a
change in rating or price target (subject to limited management
discretion). At other times, the price targets may fall outside of
these ranges because of market price movements and/or other
short term volatility or trading patterns. Such interim deviations
from specified ranges will be permitted but will become subject to
review by research management.
Equity rating and dispersion relationship
50%
38%
12%
49%
43%
36%
0
50
100
150
200
250
300
Buy Hold Sell
Companies Covered Cos. w/ Banking Relationship
Source: SG Cross Asset Research
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IMPORTANT DISCLOSURES
Areva SG acted as joint bookrunner in Areva's bond issue.
Areva SG acted as offer's sponsorof the conversion of Areva's investment certificates into shares.
Areva SG is acting as financial advisor to Areva
Daimler SG acted as joint lead manager in Daimler Finance North America LLC' senior high grade bond issue.
Daimler SG acted as co manager in Daimler Finance North America LLC' senior high grade bond issue.
Dong SG acted as joint deal manager and joint bookrunner in Dong Energy's tender offer (7.75% 01/06/3010
EUR).
Honeywell SG acted as co-manager in Honeywell's bond issue.
Legrand SG acted as sole bookrunner in the disposal of Wendel & KKR's stakes into Legrand.
Legrand SG acted as joint bookrunner in legrand's bond issue (4.375% 21/03/18 EUR).
National Grid SG acted as joint bookrunner of KEYSPAN 's bond issue. (Subsidiary of National Grid)
National Grid SG acted as joint deal manager in National Grid's Tender offer.
Schneider SG acted as joint bookrunner in Schneider's bond issue (Eur500mm long 7yr).
Vallourec SG acted as joint bookrunner in Vallourec's bond issue (Maturity: 14/02/2017).
Director: A senior employee, executive officer or director of SG and/ or its affiliates is a director and/or officer of Alstom.
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ABB, Alstom, Apple, Assa Abloy, BASF SE, Bombardier, CRH PLC, DONG, Daimler, Emerson, Honeywell, Invensys, Legrand,
MAN, National Grid, Nexans, Philips, Rio Tinto, Sandvik, Schneider, Siemens, Vallourec, Volvo.
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11 January 2012 84
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