GEMS: Asia China
Technology Hardware & Equipment
19 October 2006
Industry consolidation is accelerating
Michael Feng
Research Analyst (+86) 21 3896 2834 michael.feng@https://www.doczj.com/doc/402809372.html,
Eugene Yeoh
Research Analyst (+852) 2203 6181 eugene.yeoh@https://www.doczj.com/doc/402809372.html,
Gree: Winner of the industry consolidation
We are launching coverage on the air conditioner industry as we believe it is the
Gree/Buy and Midea/Hold rating. We believe Gree will be the largest beneficiary of
the consolidation by gaining more market share while maintaining its profitability. Deutsche Bank AG/Hong Kong
All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
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DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1
Air Conditioner Industry
C o m p a n y R e s e a r c h
I n d u s t r y F o c u s
Accelerating consolidation and changing competitive environment
favourable to big players such as Gree, 2) competitive environment has changed with a focus on better product quality and service as well as distribution channels instead of low price, and 3) big players have been increasing their market shares. Gree is the largest beneficiary of the consolidation
reach the growth market. It will maintain strong sales growth, driven by the sales of higher-margin central air con and the international markets.
Initiating coverage on Gree with a Buy and Midea with a Hold
Gree’s TP of RMB11.3 is derived from the DCF model using 8.3% WACC and 2% terminal growth. Midea’s TP of RMB8.1 is derived from DCF model with 8.6% appreciation, int’l business risk, new environmental standards, and loss of clients. Figure 1: Central air conditioners market share in the domestic market
York 15%
5%
3%
11%
8%
Source: Deutsche Bank estimates
Table of Contents
Investment thesis (3)
Outlook (3)
Valuation (3)
Risks (3)
Valuation (4)
Target price of RMB11.3 on Gree based on DCF and target FY07E PER of 14.7x (4)
Industry trend (7)
Industry consolidation is accelerating (7)
Domestic market (8)
Growth to moderate going forward (9)
Export market (11)
Export growth also expected to moderate (12)
Industry cost structure (13)
Pricing (15)
RMB appreciation and new environmental standards (16)
Competition (17)
Gree to benefit as competition squeezes smaller players (17)
Gree vs. Midea (19)
Growth – Gree should grow faster than Midea (19)
Exports (21)
Domestic market share (22)
Margins (23)
Working capital (26)
ROE - Gree’s ROE expected to improve (27)
Risks (28)
Margin erosion due to higher cost and price competition (28)
Industry overview (29)
China is the largest air conditioner manufacturer (29)
Market players (30)
Gree (31)
Midea (36)
Page 2 Deutsche Bank AG/Hong Kong
Investment thesis
Outlook
We believe it’s time to take a look at the players who have come through the industry
consolidation with growing sales and stable margins, especially after a number of companies
have exited the market. We believe: 1) the accelerating industry consolidation due to
moderate sales growth and higher cost pressures is becoming more favorable to the big
players such as Gree as a result of their huge economies of scale and better pricing power, 2)
competitive environment has changed with a greater focus on better product quality and
service as well as distribution channels instead of the low price, as evidenced by declining
market shares of the low-price competitors this year, and 3) big players have certainly been
increasing their market shares, while many foreign companies have been losing share in the
domestic market; not to mention many small/mid-sized ones exiting the market.
We believe industry leaders such as Gree are the largest beneficiaries of this consolidation;
we initiate coverage on Gree with a Buy and Midea with a Hold. Gree stands out because:
It has been increasing its market share while improving profitability, as more small
players have been exiting the market.
Gree’s self-owned 2,500 branded stores is an outstanding figure compared to its peers,
which will not only help Gree reach the markets apart from the major cities but also
maintain bargaining power.
It will likely maintain high sales growth rate with a 25% CAGR in top line in the next 2
years, mainly driven by the higher-margin central air conditioner segment and sales in the
international market.
Finally, Gree’s positioning is sustainable, in our view, because of its: 1) focus on air
conditioning to emerge as the #1 air conditioner vendor in the world, 2) profit-first strategy
supported by high quality/better service to compete with low-price competitors.
Valuation
Our target price for Gree is RMB11.3, derived from 8.3% WACC and 2% terminal growth
rate, and implies 14.7x 07E EPS. Our target price for Midea is RMB8.1, derived from 8.6%
WACC and 2% terminal growth rate, implying 10.5x 07E EPS. Our DCF-based valuation
suggests 37% upside potential for Gree.
Gree is trading at 11.6x 06E and 10.7x 07E EPS against 18.4x and 12.2x 06E and 07E industry
average. We believe the company is undervalued because the market has not fully adjusted
to the easing cost pressures and continued increasing market share.
Risks
The main risks for China air conditioner vendors are slowing demand, pricing pressure from
the channel and margin erosion, especially from increasing material costs. Other risks
include: RMB appreciation, high risk of operating businesses in different countries based on
different market systems and cultures, loss of main customers, new environmental
standards, and business transparency.
Deutsche Bank AG/Hong Kong Page 3
Valuation
Target price of RMB11.3 on Gree based on DCF and target FY07E
PER of 14.7x
Gree (000651 CH, Buy, RMB8.23) is currently trading at 10.7x 2007E EPS. Our 12-18 month
target of RMB11.3 implies a 37% upside. It is derived from our DCF model based on a
WACC of 8.3% and 2% terminal growth rate.
Midea (000527 CH, Hold, RMB8.83) is currently trading at 11.5x 2007E EPS. Our 12-18
month target of RMB8.1 implies 9% downside. It is derived from our DCF based on a WACC
of 8.6% and 2% terminal growth rate.
We believe that a discounted cash flow-based valuation for the China air conditioner players
represents fair value for the companies as they have strong growth potential and have
historically been profitable. We also use peer PER analysis to compare PE multiples of their
competitors. Historical PER trading range and PEG method have also been listed in Figure 2
for investors’ reference.
Figure 2: Valuation summary
Methodology Key Assumption Fair Value Implied 2007
RMB Target PE
Gree
DCF Cost of equity of 8.9% and cost of debt of 5.5% 11.3 14.7x
Comparison with peers12 month forward PER, peer average of 12.2x 9.4 12.2x
Historical PER range 12 month forward PER 5.91-10.14* 8.3x-13.9x**
PEG Model 2007 EPS, PEG of 1, 14.5% 06-08F EPS Cagr 11.1 14.5x
Midea
DCF Cost of Equity of 9.3% and cost of debt of 6.0% 8.1 10.5x
Comparison with peers12 month forward PER, peer average of 12x 9.4 12.2x
Historical PER range 12 month forward PER 4.36-9.35* 6.9x-12.3x**
PEG Model 2007 EPS, PEG of 1, 10.5% 06-08F EPS Cagr 8.1 10.5x
forward EPS
DCF valuation of RMB11.3 for Gree and RMB8.1 for Midea
Our DCF analyses indicate that the intrinsic values of Gree and Midea, based on DCF
forecasts from 2006 to 2008E, are RMB11.3 and RMB8.1, respectively. The fair value for
Gree suggests 37% upside potential.
In our view, Gree is currently being valued under the fair value method because the market
has not fully adjusted to the easing cost pressures and continued increasing market share. Page 4 Deutsche Bank AG/Hong Kong
Figure 3: Gree DCF valuation table
2006F2007F2008F2009F 2010F 2011F2012F
Free Cash Flow (104.7)(28.1)742.4 969.6 936.9 791.7 644.4
Terminal Value 10,367.0
Total Cash Flow (104.7)(28.1)742.4 969.6 936.9 791.7 11,011.4
Discount Factor 0.961 0.887 0.819 0.755 0.697 0.644 0.594
Present Value -100.6 -24.9 607.6 732.6 653.3 509.6 6,541.9
Enterprise Value 8,919.5
Cash on Handset 572.70
Outstanding Debt 381.32
Equity value 9,110.82
Number of Shares 805.41
Value per share 11.3
Figure 4: Midea DCF valuation model
2006F2007F2008F2009F 2010F 2011F2012F
Free Cash Flow 170.4 40.3 343.5 456.6 717.1 18.8 335.6
Terminal Value 5,216.4
Total Cash Flow 170.4 40.3 343.5 456.6 717.1 18.8 5,552.0
Discount Factor 0.960 0.884 0.814 0.750 0.691 0.636 0.586
Present Value 163.5 35.6 279.8 342.5 495.5 12.0 3,255.0
Enterprise Value 4583.9
Cash on Hand 1244.7
Outstanding Debt 704.2
Equity value 5,124.4
Number of Shares 630.4
Value per share 8.1
Figure 5: Key assumptions table for DCF calculation
Gree Midea
Risk Free Rate of Return 5.0% 5.0%
Beta 0.80.9
Market premium 4.8% 4.8%
Cost of equity 8.9%9.3%
Cost of debt 5.5% 6.0%
Debt / (Debt + Equity) 12.3%18.7%
Effective tax rate 19.4%8.8%
WACC 8.3%8.6% Deutsche Bank AG/Hong Kong Page 5
Page 6
Deutsche Bank AG/Hong Kong
PER multiple
Our RMB11.3 target price for Gree implies 14.7x 2007E EPS, a 20% premium to the industry average but a 14% discount to the 2006 industry average based on 06E EPS. We believe the premium for Gree is fair, reflecting its growth potential and relatively high ROE. Our RMB8.1 target price for Midea implies 10.5x 2007E EPS, a 14% discount to the industry average to reflect its slower growth potential.
Figure 6: Comps table
Bloomberg Price* Market car
EPS CAGR PER(X) PEG
ROE Company Ticker Rating 17-Oct 20052006E 2007E 2008E 06--082005 2006E 2007E 2005
Gree 000651 CH Buy 8.23 6.50.61 0.71 0.77 0.95 16%13.1x 11.6x 10.7x 0.7x 18.7%Midea 000527 CH Buy 8.83
5.50.61
0.67
0.77
0.82
10%
14.5x
13.1x
11.5x
1.3x 1
2.5%
LG Electronics 066570 KS
Buy 59500 893937972539692510614104%15.7x 23.4x 8.6x 0.2x 10.6%Daikin 6367 JP NR 3470 970.880.816519122116%42.9x 21.0x 18.2x 1.3x
9.3%
Trane ASD US Hold 43.28 8.2 2.56 2.78 3.2 3.512%16.9x 15.6x 13.5x 1.3x 60.0%Whirlpool WHR US NR 86.93 6.8 6.71 6.088.710.4931%13.0x 14.3x 10.0x 0.5x 25.0%Haier 600690 CH
NR 5.48
5.30.24
0.31
0.5
N.A.
61%
22.8x 17.7x 11.0x 0.3x
6.7%
Average
22.3x
18.4x
12.2x
Gree is currently trading at a discount of 12% and 36% to the 2007E and 2006E industry average PER of 12.2x and 18.4x, respectively, in spite of its position of relatively high growth potential among peers and the profitability Gree has realized for its shareholders.
Peer PER band analysis
The historical PE band chart for China’s air conditioner industry in Figure 7 indicates that the industry has historically traded at 6.9x-30.7x forward earnings. Assuming near-term slower sales growth and higher cost pressure, the industry is now trading at valuations of 10.2x-11.1x.
Figure 7: Competitors’ PE comparison
510152025301/2/04
7/2/04
1/2/05
7/2/05
1/2/06
7/2/06
Gree
Midea
Haier
Source: Deutsche Bank estimates, Bloomberg
PEG valuation
Based on Gree’s 14.5% CAGR of 06E-08E EPS, PEG of 1.0x and 2007E EPS, the PEG valuation methodology derived RMB11.1 as the TP for the company. For Midea, the target price is RMB8.1 based on a 10.5% CAGR of 06E-08E EPS, PEG of 1.0x and 2007E EPS. Our PEG of 1.0x is in line with the low interest rate environment and China’s stable economic growth.
Deutsche Bank AG/Hong Kong Page 7
Industry trend
Industry consolidation is accelerating
The ongoing industry consolidation is accelerating and will be more favourable for industry leaders. Several factors including moderate sales growth, higher raw material costs, pricing pressure from retailers, RMB appreciation and new environmental standards, discussed in detail from this page to page 18 are accelerating consolidation.
Although every manufacturer in the industry has been affected, we believe industry leaders such as Gree will benefit from this consolidation as small players are forced to leave the market.
Figure 8: Top ten players’ domestic market share
Figure 9: Number of active brands in domestic market
64%
68%
72%
76%
2004
2005
20
406080
1001Q05
1Q06
Source: Gome
Source: GFK
We believe larger players including Gree will continue to expand their market shares despite slower industry growth. Statistics from market research firms indicate that top players have been increasing their market shares in the first half of 2006, as we highlight in Figure 10. Considering that the numbers from research firms are mainly derived from mid/large-sized retail stores located in urban areas, we think Gree’s market share should be larger than the numbers announced by them as only 30% of its products are shipped to big retailing chain stores.
Figure 10: 2006 1H top three retailers‘ market shares
Market Share*
YoY Growth
Gree 21.1%+3.7%Midea 18.3%+1.1%Haier 11.2%+0.4%Total
50.6%
+5.3%
Source: Sino: * market share is based on monitoring of 2300 big/middle sized retailing stores in 175 city
We believe large players will further increase their exports to the international markets by squeezing the smaller players as: 1) internal manufacturing processes change over time to meet the new environmental standards, and 2) higher bargaining power with retailers as evidenced by Gree’s over-160% increase in exports during the first 7 months of calendar year 2006.
Page 8
Deutsche Bank AG/Hong Kong
Figure 11: 2006 1H top three in international sales
Sales(RMBb) 20061H YoY Growth
Gree 3.984+76.67%Midea 5.367+14.29%
Haier
1.90
+50.00%
Domestic market
Between 2001 and 2006, domestic volumes grew at a CAGR of 10%. This has been driven by the new demand from Chinese urban areas, supported by the consumers’ increased purchasing power, low air conditioner penetration rate, and urbanization across the country. Figure 12: Domestic sales (m units) and growth rate in freezing year
10
20
30
2001
2002
2003
2004
2005
2006
-15%
0%
15%
30%
45%
Source: https://www.doczj.com/doc/402809372.html,
The purchasing power of Chinese consumers living in the urban areas has improved largely during the past several years, as evidenced by an 11% CAGR of disposable income per capita from 2000 to 2004 (see Figure 13). The consumption expenditure has also increased at a 9% CAGR during the same time period.
Figure 13: Increasing purchasing power of urban consumers
RMB/Capita
2000 2001 2002 2003 2004 CAGR Urban Disposable Income(Per Capita) 6,280 6,860 7,703 8,472 9,422 11% Urban Consumption Expenditure(total)(Yuan)
4,998
5,309
6,030
6,511
7,182
9%
Source: National Bureau of Statistic
The penetration rate of air conditioners in Chinese urban areas was only 0.3 units per household in 2000, relatively low compared with other major countries such as Japan, where over 86% of households owned air conditioners at the time Figure 14: Air conditioner penetration rate in urban areas
Unit/Household 2000 2001 2002 2003 2004 2005E Urban Penetration rate
0.3
0.4
0.5
0.6
0.7
0.8
Even though there are no statistics available on the total number of urban households in China, we estimate that the number has increased gradually as a result of the 4% CAGR of the urban population during 2000 to 2004 and a -1% CAGR of continued decline in the average household size, as illustrated in Figure 15.
Increasing purchasing power
Low penetration rate of air conditioners
Urbanization boom in China
Deutsche Bank AG/Hong Kong Page 9
Figure 15: Total number of households and an average family size
2000 2001 2002 2003 2004 CAGR Urban Population(000) 458,440 480,640 502,120 523,760 542,830 4% Urban household
size(Capita/Household) 3.1 3.1 3.04 3.01 2.98 -1% Total household number
340,120
346,763
354,551
361,448
367,709
2%
Growth to moderate going forward
We believe domestic air conditioner sales volumes will grow at a slower pace over the next two years following a 10% sales decline in 2006. We believe there are several factors that will influence the domestic air conditioner sales, other than the weather.
As we indicated earlier, we believe the fast-increasing air conditioner penetration rate in urban areas is one of the major drivers of air conditioner sales growth in the domestic market. However, after the penetration rate reached a level of 0.80 units per household in 2005, we believe it will have less power to further drive the sales growth in the future, based on our research on the sales growth trend of major durable goods in urban households and a comparison with the trend in other countries.
As illustrated in Figure 16, the penetration growth rate of other major home appliances in urban households declined to a single digit after the penetration reached 0.8 units per household. For example, the growth rate for penetration of TV slowed to 6% in 1993 after the penetration rate reached 0.8 units and never returned to a double-digit growth rate again. Japan’s air conditioner penetration rate, even if it is not directly comparable with that of China’s, also indicates the penetration rate will lose momentum once it reaches a level near 80%.
Figure 16: Major home appliances’ penetration rates and their growth rates
Major Home Appliances’ penetration rate 1989 1990 1991 1992 199319941995199619971998199920002001 2002 2003 200420052006E Washing Machine 0.8 0.8 0.8 0.8 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 1.0 Growth rate 3% 4% 2% 4%1%2%1%-1%2%1%-1%2% 1% 2% 2%TV
0.5 0.6 0.7 0.7 0.8 0.9 0.9 0.9 1.0 1.1 1.1 1.2 1.2 1.3 1.3 1.3 Growth rate 15% 15% 11% 6%8%4%4%7%5%6%5%3% 5% 3% 2%Refrigerator 0.4 0.4 0.5 0.5 0.6 0.6 0.7 0.7 0.7 0.8 0.8 0.8 0.8 0.9 0.9 0.9 Growth rate
16% 15%
8%
8%
9%
7%5%5%4%2%3%2% 7% 2% 2%Air Conditioner(Urban) 0.1
0.1 0.2 0.2 0.2 0.3 0.4
0.5
0.6
0.7
0.8 Growth rate 44%
40%
23%
22%
26%
16% 43% 21% 13%16%
Air Conditioner(rural) 0.01 0.02 0.02 0.03 0.05
Growth rate
29% 35% 51% 36%
We believe the demand from the rural market, supported by the low penetration rate, will maintain the high growth rate than urban areas, but will still account for less than 10% of total new demand in the domestic market in 2008 due to the relatively less powerful purchasing power of consumers in the rural areas.
High penetration rate will have less power to drive the sales growth
Growing but still small demand from rural market
Page 10 Deutsche Bank AG/Hong Kong
Figure 17: Income per capita (RMB 000): comparison between urban and rural areas
2468102000
2001200220032004
Source: Nation Bureau of Statistic
An air conditioner can be used for around 10 years on an average. We estimate that the replacement demand for air conditioners will be relatively small before 2008 as a large number of air conditioners has been sold after 2000.
To summarize, we believe the domestic market will achieve 5% and 13% growth in 2007 and 2008, respectively, with relatively stable growth from the urban market, continued strong growth in the rural market and the replacement demand kicking in mainly from 2008. Figure 18: Forecast for domestic market and key assumptions
2006E 2007E 2008E Urban Penetration(Unit) 0.89 0.96 1.03 Growth rate 10%8% 7%Rural Penetration 0.07 0.08 0.10 Growth rate 25%
20%
20%
Urban Population(000) 573,654
589,143
603,871
Growth rate
3%
3%
3%
Rural Population(000) 737,804
728,365
719,047
Growth rate -1%-1%
-1%
Urban average family (member/household) 2.93 2.91 2.89 Rural average family member 4.00 3.95
3.91
Urban household member (000) 195,565 202,438
209,144 Rural Household member 184,673 184,236
183,799
Total Urban A/C(000 unit) 174,249 194,802 215,342 Total Rural A/C 12,477 14,937
17,882
New demand from Urban(000 unit) 21,367 20,553 20,541 New demand from rural 2,472 2,460 2,945 Replacement demand 2,094 4,887 Total demand 23,839 25,107 28,372
Growth rate
-10%
5%
13%
Replacement demand may kick in after 08
The market will have a 5% and 13% growth in 07and 08, respectively
Deutsche Bank AG/Hong Kong Page 11
Export market
The export of air conditioners is another growth engine for the industry. Export volumes grew at a 39% CAGR from 2001 to 2006. The fast growth of Chinese air conditioner exports is an evidence that air conditioner vendors in China have some advantages compared with their peers in other countries, including cost competitiveness, the entire value chain, and improved quality control.
Figure 19: International sales (m units) and growth rate in freezing year 0
102030
2001
2002
2003
2004
2005
2006
-20%
20%
60%
100%
Source: https://www.doczj.com/doc/402809372.html,
Lower cost of labor is one of the key advantages for China’s air conditioner industry. While no comparable statistics are available, we believe that China’s labor cost in the air conditioner industry is less than 1/10 of Japan’s. One of the major Chinese air conditioner vendors told us that the average salary of his/her staff was RMB3,670 per month (US$460) in 2005. Based on the data released by the Japanese government, the average monthly salary in the manufacturing industry was JPY369,000 (US$3,510) in 2004.
China also has a well-established air conditioner components industry, after decades of the air conditioner industry’s development. In fact, China is also the largest manufacturing nation of some key components, such as compressors. Besides, Chinese vendors have established strategic relationships with upstream suppliers, such as steel makers, for stable supplies of materials.
The level of quality control has improved largely recently. While Chinese vendors still focus on low/middle-end products in the marketplace, we believe that the products of the top-tier vendors is generally good, as evidenced by the 6-year guarantee plan implemented by them. Moreover, some Chinese air conditioner vendors are the OEMs for some Japanese companies catering to Japanese consumers, who are considered to be extremely strict on product quality Furthermore, some big players export their self-branded air conditioners to international markets and these have been selling well in the developing countries due to the products’ stable quality and competitive price.
Cost competitiveness: lower labor cost
Entire industry value chain
Improved quality control
Export growth also expected to moderate
Air conditioner exports increased 8% in 2006 as strong exports to the U.S. market partly
offset the shipment decline to the EU market where newly-introduced environmental
standards (a detailed discussion follows later) have severely impacted the enthusiasm of
many small exporters. Data from the Chinese Customs indicates the export to the EU market
from Guangdong province, the largest air conditioner manufacturing base in China, has
declined 33% in the first 7 months in calendar year 2006.
We believe the export market will witness a low growth rate next year, reflecting the impact
of similar environmental standards as that of EU that will likely come into effect in the North
American market in 2007 and continued RMB appreciation.
Figure 20: Assumptions for key markets
20052006YoY2007E YoY 2008E YoY
North. America 7,362,2229,735,69632%10,222,481 5% 9,711,357-5%
Pacific 598,755 441,834-26%397,651 -10% 477,18120%
Africa 750,5061,086,52045%1,412,476 30% 1,624,34715%
South America. 1,188,1072,347,58298%3,521,373 50% 4,753,85435%
Europe 7,537,4214,525,737-40%4,752,024 5% 5,702,42920%
Asia 7,247,0698,463,35817%9,309,694 10% 10,706,14815%
Total 24,684,08026,600,7278%29,615,698 11% 32,975,31511%
Source: Deutsche Bank estimates, https://www.doczj.com/doc/402809372.html,
Assumptions for key markets:
The North American market will grow less due to environmental standards likely to come
into effect in 2007.
The European market will be covered gradually partly due to the fact that the hot
summer in 06 cleared a large amount of inventory.
South America and Africa and parts of the Asian market will continue to see strong
growth, following the growth trend of the Chinese urban market.
In contrast to the OEM strategy adopted by many smaller exporters, major players are
building their own distribution channels in the fast-growing emerging markets with their own
brands – as evidenced by 100% of Haier’s exports to the international market consisting of
its own brand. Moreover, due to the differing capabilities of industry leaders and small/mid-
sized players to deal with new environmental standards, the export market has been
concentrating on the bigger players. Furthermore, we think the high concentration rate of big
players will further increase as other major Chinese export markets - including North America,
Japan, and some countries in the South-East Asia - are scheduled to introduce environmental
standards, similar to the ones introduced in the EU, in the near future. Press reports indicate
that unlike major players who have adjusted to the new environmental standards introduced
in the EU market, most small vendors are reluctant to change their internal manufacturing
processes to meet the new standards owing to the higher cost involved in the transition.
Page 12 Deutsche Bank AG/Hong Kong
Deutsche Bank AG/Hong Kong Page 13
Figure 21: China air conditioner exports breakdown in 2005
9%
Source: https://www.doczj.com/doc/402809372.html,
Industry cost structure
We think the increase in the raw material prices over the last year is one of the key factors
accelerating the industry consolidation, as the price of some raw materials such as copper has jumped to a level that is forcing many small players to terminate their operations since the beginning of this year. Our simulation indicates that a 63% increase in the copper price (average price on the LME in the first 6 months of 2006 compared with the ASP in 2005) will add 9% to cost of goods sold, and in turn, depress the gross margin to only 10%.
Figure 22: LME’s copper price (US$/Ton)
02000
400060008000100001/2/03
7/2/031/2/047/2/041/2/057/2/051/2/067/2/06
Source: London Metal Exchange
High raw material cost pressure can be eased for the bigger player
Page 14 Deutsche Bank AG/Hong Kong
Figure 23: Cost structure of an air conditioner
Copper
Steel Compressor Elec controler
Plastic
Others Source: Deutsche Bank estimates
We believe the major players have been less affected by the higher raw material costs because: 1) the price hike in the 2nd quarter of this year will ease the cost pressures, and 2) major players are fully leveraging their economies of scale to squeeze upstream suppliers for lower costs. In the first half of 2006, the gross margin of some major component manufacturers has declined sharply to around 11% from over 18% in 2005 due to the pricing pressure partly attributed to air conditioner manufacturers, 3) some major players also have a high internal manufacturing rate for certain key components, such as compressors, which provides flexibility to absorb part of the increasing raw material costs.
As per forecasts of the DB metal research team, the copper price will likely peak this year and start to decline from 2007.
Figure 24: Copper price forecasts as per DB’s metal research team
200420052006E 2007E 2008E Cooper price(Usc/1b) 129.9
167289.3 265218.8YoY % chg
61%
28.6%
73.2%
-8.4%
-17.4%
Figure 25: Galvanized steel price chart
4,000
5,0006,0007,0008,0001/7/05
4/7/05
7/7/05
10/7/05
1/7/06
4/7/06
7/7/06
Source: China Iron and Steel Association
Pricing
Price hike impacted players who adopted low-price strategy
The major vendors raised the prices of air conditioners from 5% to 15% in the second
quarter of 2006. It is not easy for both the Chinese consumers and the retailers to accept the
price hike as most of them are more familiar with endless price wars in retail stores. This is
evidenced by the sales decline in the biggest sales season of 2006 after the price hike.
However, we think more significant issues behind the price hike are: 1) players who adopted
a low-price strategy have been negatively impacted as they have been forced to raise the
price due to cost pressures, 2) demand will likely return in the late 2006 or early 2007 once
consumers understand that the price movement is a two-way traffic instead of a one-way
traffic to the downside only, 3) some manufacturers have changed their strategies to
maintain profitability rather than chasing market shares as far as raw material costs stagnate
at the current high levels, and 4) the pricing power has moved slightly in favor of the vendors.
Figure 26: Price hikes announced by major domestic vendors in 2006
Price increase
Haier 7-10%
Media 5-10%
Gree 10%
Other brands 5-15%
Source: Company information, Deutsche Bank estimates
Air conditioner manufacturers have been crying out for a price hike for the last several years
as a result of the continuously increasing raw material costs and downside pricing pressure
from big retailers. However, they have been frustrated every year by strong resistance from
major retailers who have bigger bargaining power. The situation has changed in 2006.
Vendors announced their price-hike plans in the first quarter as a consequence of sharply
increasing copper price. Big retailers responded by purchasing roughly 10m units of low-
priced old models to drag the price down before the sales season. After a severe argument
on the justification of the price hike between the two groups, vendors finally raised the price
in the second quarter.
Major retail chain stores have become the margin killer for home appliance manufacturers as
a consequence of constant requests for lower prices and sharing of marketing expenses,
supported by the stores’ fast-increasing bargaining power especially in the first-tier cities. The
recent merger between Gome, the top home appliances retailer in China, and Yongle, from
our point of view, will further strengthen retailers’ position in their pursuit of higher pricing
power.
Some of the major players, in order to compete with the low-price strategy adopted by major
retailers, have implemented differentiated strategies, such as the service-oriented strategy
followed by Gree, as evidenced by its 6-year guarantee plan, and the energy efficient
products promoted by Hisense. All of these have not only gained strong support from both
consumers and retailers but also raised the standard to be followed by smaller players.
Moreover, big players’ self-owned retail channels such as Gree’s 2,500 branded stores have
also eased price pressure from big retailers.
Deutsche Bank AG/Hong Kong Page 15
RMB appreciation and new environmental standards
A higher RM
B exchange rate against the U.S. dollar has become another factor depressing
the air conditioner vendors’ already thin margins since the country raised the exchange rate
from last July. We estimate that if the speed of RMB appreciation accelerated to 4%-5%
annually from the 3% forecast by Jun Ma, DB’s chief economist for Greater China, an
exporter’s gross margin may decline by nearly 9%-16%. For many small OEMs in the export
market, the RMB risk is one of the highest barriers to overcome.
However, we believe big players could transfer RMB appreciation risk to retailers by
increasing the export price due to higher pricing power than small players. At the same time,
big players are improving their internal management abilities to compete with RMB
appreciation as evidenced by lesser currency loss recorded in the first half of 2006 than 2H05
when RMB appreciated 2%.
Figure 27: Key assumptions on RMB appreciation
Average Price 20052006E2007E 2008E
RMB/US$ 8.2 7.9 7.6 7.3
Source: Deutsche Bank estimates
At the same time, we believe big players, as compared with the smaller ones, have been less
affected by the recent introduction of environmental standards in the EU market, as
evidenced by the strong export shipments growth this year for some big players. Industry
experts estimate that retailers may compensate over 80% of the increasing costs that result
from the new standards for big manufacturers but only 20% or even lower for the smaller
ones.
New environmental standards
WEEE Directive in Europe from August 13 2005
RoHS in Europe from July 1 2006
Potential environment protection standards in the U.S. next year
New Energy Efficiency Standard in China from March 1 2005
Page 16 Deutsche Bank AG/Hong Kong
Deutsche Bank AG/Hong Kong
Page 17
Competition
Gree to benefit as competition squeezes smaller players
Gree has accelerated its growth momentum by fully leveraging the growth opportunity as its main competitors’ growth rates have slowed down. Moreover, many small players are exiting the market due to the skyrocketing costs. Based on our channel check, foreign brands have not only contracted their product mix to focus on high-end products but also reduced sales organizations, due to lack of economic scale in the Chinese market and increasing cost pressures. We believe competition has become more favorable for Gree, which has adopted a differentiated strategy in the marketplace due to its: 1) profit-first strategy supported by its high quality and better service, 2) business strategy focusing on the air conditioners alone, 3) self-distribution channel which enables the company to reach growth markets.
Figure 28: 2005 China air conditioner market share by shipments
19%
Source: Company data, https://www.doczj.com/doc/402809372.html,, Deutsche Bank estimates
Figure 29: Market share comparison of the top foreign brands in 65 major domestic cities
0%
1%2%3%4%5%Mitsubishi Electric
Matshita Sharp Mitsubishi Heavy
LG
Hitachi Samsung
Source: GFK
Profit-first strategy supported by high quality/better service vs. low-price strategy
Gree has implemented a profit-first strategy supported by its high quality/better service policy, as compared to the low-price strategy adopted by some air conditioner manufacturers, including Midea, to expand their market shares in the first-tier city market with support from big retailers. As several of Gree’s main competitors have changed the low-price strategy due to increasing cost pressures, we think Gree will not only maintain its profit but also achieve higher sales growth in comparison to its competitors in the next several years.
Focusing on main business vs. diversification strategy
As many of China’s home appliances manufacturers which have chased business diversification for years by entering different business areas to become Comprehensive Home Appliance Providers are confronting various challenges, as evidenced by their huge losses in 2005, Gree has maintained its growth and profitability by focusing on its main business to become the No. 1 player in the international air conditioner industry since last year.
We highly value Gree’s focused business strategy not only because of the value it has created for the company’s shareholders, but also because we strongly believe that the strategy is the best way for a Chinese home appliances company to maintain long-term sustainable growth under the current market environment.
Figure 30: Revenues from main business on total revenue for top three players
In RMBb Gree Midea Group Haier Group
Air Conditioner sales 17.6 14.4 15.0
Group sales 19.6 21.3 103.9
% of main business on total sales 90% 68% 14%
Business Areas Air con Air con Air con
Small appliance Compressor Refrigerator
Small appliance TV
Refrigerator Handset
Washing machine
PC
Washing machine
Source: Company data, Haier’s sales on Air conditioner including all air conditioner business of the group companies
Figure 31: Business focus of top home appliances players
2005 TCL ChangHong Hisense Konka
Sales from Main Business 33.69.99.2 9.3
Total Sales 51.71533.4 11.5
% of main business on total sales65%66%28% 81%
Self distribution channel vs. big retailers-oriented distribution
Unlike many peers dependent largely on big retailers for distribution, Gree has cooperated
with regional retailers to operate over 2500 of its branded stores selling only its air
conditioners. This is the only successful retail chain store operated by vendors and retailers.
We believe Gree’s self-distribution channel has become the company’s core competitive
advantage over major retail chain stores by providing support on sales and maintaining
pricing power.
Figure 32: 2005 1Q China’s air con sales volume
breakdown by channel
Figure 33: 2005 Gree’s sales breakdown by channel by
shipment
63%
arket
7%
regional
retailers
Gree
Store
34%
Normal
Store
33%
33%
Source: GFK: based on 65 Chinese city data Source: Company data
Page 18 Deutsche Bank AG/Hong Kong
Gree vs. Midea
We believe Gree will continue to gain market share in both domestic and international
markets while maintaining its profit target in the next 2 years by fully leveraging the growth
opportunity as other low-price competitors are seeing a slowdown in growth momentum due
to higher cost pressure, and not to mention, many small players are exiting the market. On
the other hand, due to higher cost pressure from the marketplace, Midea may lose the
expansion opportunity as a result of changing its low-price-oriented growth strategy to focus
more on profitability.
Figure 34: Major competitors’ comparison
Gree Midea Haier
Strategy Quality and service Low Price Design/marketing
Product lines
Window type: 20% Window type: 20% Window type: 21%
Split Type: 60% Split/Stand Type: 70% Split Type: 45%
Stand Type: 15% Central con: 10% Stand Type: 20%
Central con: 5% Central con: 14%
11M 7M
Capacity(Units/yearly) 13m
16m(2007)
ZhouHai: 10m ShuanDe: 4.5M QingDao:1.5M
ChongQing: 3m WuHu: 3M JiaoNan: 1M
Brazil: 0.2m WuHan: 3.5M Dalian: 1M
Pakistan: 0.1m HeFei: 1M
WoHan: 1M
QingDao: 1M(Central Con)
ChongQing: 1M
Shipment(2005) 10M 10M 7M
Distribution Channel Gree-branded store: 34% Regional retailers: 30% Regional retailers: 30%
Regional retailers: 33% Big chain stores: 70% Big chain stores: 70%
Big chain stores: 33%
International market exposure 25% 49% 30%
Growth – Gree should grow faster than Midea
We estimate Gree will achieve an over 25% CAGR on sales to reach RMB35b in 2008 from
RMB18b in 2005 driven by strong growth in the international market and the central air
conditioner segment. Its growth momentum has accelerated in the first half of 2006, as the
company has announced a 33% sales growth on YoY base, while many of its competitors
have experienced a slower or even a negative growth. Even though the industry will enter a
phase of moderate growth ahead, according to our estimate, we believe Gree has the strong
capability to reach a growth rate higher than the industry average - as evidenced by its 88%
CAGR unit sales growth, nearly 87% higher than the industry average of 47% recorded in the
past 3 years.
In comparison, we think Midea’s sales growth momentum will slow down to an estimated
12% CAGR from RMB16bn in 2005 to RMB23bn in 2008 as a consequence of its changing
strategy to focus on profitability instead of chasing the market share. This will result in the
loss of an expansion opportunity as smaller players are exiting the market.
Deutsche Bank AG/Hong Kong Page 19
Page 20 Deutsche Bank AG/Hong Kong
Figure 35: Gree’s sales forecast(RMB B)
Figure 36: Midea’s sales forecast(RMB B)
10
20
30
402002
2003
2004
2005
2006E
2007E
2008E
0%
10%20%
30%
40%50%
10
2030
402002
2003
2004
2005
2006E
2007E
2008E
-20%
0%20%
40%60%Source: Company data, Deutsche Bank estimates
Source: Company data, Deutsche Bank estimates
Figure 37: Gree’s air conditioner sales key assumptions
Unit Breakdown(M units) 2003200420052006E 2007E 2008E Domestic 7.5 8.4 9.7 11.2International 2.5
4.3
5.77.3 Total
5 710 12.7 15.4 18.5 International/Total 25%
34%
37%
40%
Unit growth rate Domestic 12% 17%14%International 74%
30%30%Total 36%43%27%
21%
20%
Sales Breakdown(RMB b)
Domestic Home Air con 7.910.8 13.215.0 17.1 19.2Domestic Central Con 0.5 0.7 1.0 1.6 2.7 4.8 Domestic Total 8.4 11.5 14.216.6 19.8 24.0 International 1.6 2.3 3.4 5.8 7.5 10.3Total
10.0 13.8 17.6 22.4 27.3 34.3 International/Total 16%
16%
20%
26%
28%
30%
Sales growth rate
Domestic Home Air con 38%22%14% 14%12%Domestic Central Con 34%33%60% 70%80%Domestic Total 37%22%17% 19%21%International 39%54%69% 30%35%Total
38%
27%
27%
21%
26%