SocGen - China Losing It Shine

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11 January 2012 Equity Sector Review www.sgresearch.com Capital Goods China losing its shine Neutral Stock selection Preferred  China entering the danger zone. Siemens Least preferred 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. 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. 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. Atlas Copco  Do not expect another infrastructure stimulus package.  Four new major themes should drive industrial companies’ growth in China.  Changing competitive landscape. Like Japanese industrial companies in the 1980s, the emergence of new entrants from China should significantly change the competitive landscape during this decade. The most at-risk industries include rail transportation, power generation, T&D; and construction equipment as well as segments recently added to the Chinese government’s strategic priorities such as healthcare. We are underweight stocks with high exposure to the Chinese construction theme, namely mining-related stocks (Atlas Copco and Sandvik, both of which we downgrade to Sell). We are overweight Siemens (Buy) as 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. Sébastien Gruter (33) 1 42 13 47 22 sebastien.gruter@sgcib.com  Short infrastructure/mining, long automation/energy efficiency. Gaël de Bray, CFA (33) 1 42 13 84 14 gael.de-bray@sgcib.com Societe Generale (‚SG‛) does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that SG may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE APPENDIX AT THE END OF THIS REPORT FOR THE ANALYST(S) CERTIFICATION(S), IMPORTANT DISCLOSURES AND DISCLAIMERS AND THE STATUS OF NON-US RESEARCH ANALYSTS. Macro Commodities Forex Rates Equity Credit F179665 Derivatives Capital Goods 2 11 January 2012 F179665 Capital Goods Contents 4 8 Investment summary 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 11 January 2012 3 F179665 Capital Goods 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. 4 11 January 2012 F179665 Capital Goods 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 nonperforming loans rather than prosperity. Chinese authorities have started to ease monetary policy (cutting the RRR ratio by 50bps, encouraging lending to SMEs, etc.), although the size of the shadow banking system casts some doubt about the degree of control the 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 Consumption intensity (per capita) Investment driven economy Oil Cem ent Steel 0 2500 5000 BRIC countries Consumption driven economy 10000 15000 GDP per capita $ 20000 25000 30000 35000 Developped countries 40000 Source: SG Cross Asset Research 11 January 2012 5 F179665 Capital Goods 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 Macro trend Rebalancing of the economy Ageing Population Wage Inflation CO2 emissions Sector impacted Construction & Mining Consumer-related industries Healthcare Automation Energy efficiency Top picks Atlas Copco Sandvik Volvo Philips SKF Philips Siemens Smiths Group ABB Invensys Siemens Schneider Schneider Siemens ABB Atlas Copco Source: SG Cross Asset Research Competitive landscape should get 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. 6 11 January 2012 F179665 Capital Goods Assessing the Chinese competition risk for various industries in the Capital Goods sector * Key criteria Rail transport Power generation T&D; Construction equipment Trucks Healthcare Automation Bearings Compressors Tooling Low voltage Strategic Customer consolidation Ticket size OE vs aftermarket/distribution Chinese players Total Risk 5 5 5 4 5 24 5 5 5 2 5 22 5 4 4 3 4 20 High 2 2 4 4 4 16 2 2 4 2 5 15 4 4 3 2 2 15 Medium 3 2 2 3 2 12 Medium 2 2 1 3 2 10 Low 2 2 3 1 2 10 Low 1 2 1 2 2 8 Low 1 1 1 2 2 7 Low Very high Very high Medium to Medium high Source: SG Cross Asset Research / * 5 = highest risk, 1 = lowest risk Portfolio based on ‘Chinese rebalancing’ 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 25 Best positioning Exposure to LT growth trends in China Philips Schneider ABB Siemens 20 SKF High growth but competitive risks Inv ensy s 15 Smiths 10 Atlas Copco Alstom MAN Volv o Nexans Low growth but limited risk Sandv ik Scania 5 High risk profile Vallourec Legrand 0 5 7 Assa Abloy 9 11 13 15 17 19 21 23 25 China competitiv e risks Source: SG Cross Asset Research 11 January 2012 7 F179665 Capital Goods 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 China competition risks efficiency/automation = +; (high =-; low = +) infrastructure/mining = -) Valuation (high = -; low = +) Ranking Schneider SKF Siemens Philips Assa Abloy Legrand ABB Invensys Volvo Scania MAN Vallourec Atlas Copco Sandvik Alstom Nexans Areva Source: SG Cross Asset Research = + + -= + = ++ = = -- ++ + ++ ++ = = ++ + = = = --++ + + ++ ++ = = + + --- + ++ = -= + + = = --+ = --- ++ ++ ++ ++ + = = = = ------------- North America (as % of sales) 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Western Europe (as % of sales) 70% 60% 50% 40% 30% 20% 10% China (as % of sales) 16% 14% 12% 10% 8% 6% 4% 2% Schneider Atlas Copco Schneider Atlas Copco Assa Abloy Assa Abloy Scania Scania Alstom Vallourec Alstom Vallourec Sandvik Siemens Siemens Sandvik Philips Smiths Philips Legrand Invensys Legrand Invensys Nexans Nexans Smiths Assa Abloy Atlas… 0% Areva ABB MAN Volvo MAN ABB SKF SKF Areva Volvo Schneider Legrand Sandvik Scania Philips Alstom Volvo Vallourec Siemens Invensys Smiths Nexans SKF 0% Source: SG Cross Asset Research Atlas Copco (Sell from Hold, TP SEK120) – We have reduced our rating on Atlas Copco from Hold to Sell and cut our target price from SEK125 to SEK120. While the company’s best-inclass profile is more than discounted, with the shares trading at a 25% 2012e EV/EBIT premium to the sector, Chinese risk is fully ignored. Through its mining and construction businesses, China has been a key driver of Atlas Copco’s organic growth since 2004, contributing up to 60% of its growth. The new legs of growth brought by automation 8 11 January 2012 MAN F179665 ABB Capital Goods (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 11 January 2012 9 F179665 Capital Goods 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. 10 11 January 2012 F179665 Capital Goods 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 25% Chinese official PMI – Inventory index vs backlog index 70 65 15 IP growth yoy PMI 20% 10 5 0 -5 -10 -15 -20 60 55 15% 50 10% 45 40 5% 35 30 0% 25 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-05 May-05 May-06 May-07 May-11 May-08 May-09 May-10 Sep-11 Jan-05 Jan-09 Jan-10 Jan-11 Jan-06 Jan-07 Jan-08 Jan-05 Jan-07 Jan-08 Jan-09 Jan-10 Jan-06 May-06 May-08 May-09 Jan-11 May-11 May-05 May-07 May-10 Sep-05 Sep-07 Sep-08 Sep-09 Sep-10 Sep-06 Source: National Bureau of Statistics Exports show signs of 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. Sep-11 11 January 2012 11 F179665 Capital Goods Chinese exports ($100 million) 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0% 20% 10% 30% 50% Chinese export growth vs PMI yoy chge 60% 65 Export - $100m PMI - New export orders (SADJ) Exports - 3m chge yoy 50% 40% 30% 20% 10% 40% 60 55 50 45 40 35 0% -10% -20% -30% May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Mar-10 Mar-11 Jul-10 Aug-10 Dec-10 Jul-11 Aug-11 Oct-10 Apr-11 Jan-10 Jun-10 Jan-11 May-11 May-10 Feb-10 Sep-10 Feb-11 Jun-11 Sep-11 Oct-11 Apr-10 Source: Datastream Some weakness emerged in FAI growth due to real 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… Total FAI 80% 200% 60% 40% 150% 100% 50% 0% -50% -100% Nov-11 Nov-10 30 …offset by slight uptick in infrastructure spending FAI Real Estate 250% FAI manufacturing Road Railways 20% 0% -20% -40% 01/02/08 01/06/08 01/10/08 01/02/09 01/06/09 01/10/09 01/02/10 01/04/10 01/06/10 01/08/10 01/10/10 01/12/10 01/02/11 01/04/11 01/08/11 01/04/08 01/08/08 01/12/08 01/04/09 01/08/09 01/12/09 01/06/11 01/04/08 01/06/08 01/10/08 01/12/08 01/04/09 01/06/09 01/10/09 01/12/09 01/04/10 01/06/10 01/10/10 01/12/10 01/02/11 01/04/11 01/08/11 Source: National Bureau of Statistics Housing prices start to decline, developers 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. 12 11 January 2012 01/10/11 01/02/08 01/08/08 01/02/09 01/08/09 01/02/10 01/08/10 01/06/11 F179665 01/10/11 Capital Goods % of cities with falling housing prices month-on-month 80% 70% 60% Property sector cooling 120 % yoy, 3mma Housing starts 100 Property sales vol 80 Property investment (RHS) 60 New built Second hand 50 45 40 35 30 50% 40% 30% 20% 10% 40 20 25 20 15 10 5 0 -20 Mar-11 Aug-11 Apr-11 Jul-11 0% Jan-11 May-11 Feb-11 Jun-11 Sep-11 Oct-11 Nov-11 -40 2005 0 2006 2007 2008 2009 2010 2011 Source: National Bureau of Statistics Source: CEIC, SG Cross Asset Research Inventory is building among Chinese property developers, which offered steep discounts to clear out their inventories before the end of 2011. China Securities Journal reported that the number of housing projects on sale at the Beijing Equity Exchange climbed in September and October with developers selling whole development projects. Projects worth up to CNY5bn were on offer. In the week of Dec. 5-12 2011, housing projects worth CNY1.3bn were offered for sale, and housing projects worth CNY1.9bn changed hands. The Journal also reported that some developers opted to pay their debtors, such as building material suppliers or contractors with unsold properties. Among 75 of listed real estate developers listed in the A share market, we calculate that total inventories have reached CNY726bn, an increase of 41% yoy. This situation is expected to get worse in the coming months. Indeed, while demand for new real estate weakens as buyers anticipate lower prices, the number of sqm under construction still far exceeds (by up to 6x) the number of sqm completed, suggesting that a lot of real estate projects have yet to come to market, putting further downward pressure on prices. Residential space under construction by far exceeds space completed Space floor under construction (12M rolling basis) / space floor completed (12M rolling basis) 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 Nov -99 Nov -00 Nov -01 Nov -02 Nov -03 Nov -09 Nov -10 May -98 May -99 May -04 May -05 May -06 May -07 May -08 May -00 May -01 May -02 May -03 May -09 May -10 Source: National Bureau of Statistics May -11 11 January 2012 F179665 Nov -11 Nov -97 Nov -98 Nov -04 Nov -05 Nov -06 Nov -07 Nov -08 13 Capital Goods 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 PBoC + Central GVT RRR cut by 50 bps in Dec 11 Loan to deposit ratio still at 75% Local GVT Financing Vehicles (36% of GDP) BANKS Shadow Banking (32% of GDP) Local GVTs Public companies - Lo w emplo yment rate - Lo w gro wth - Lo w pro fitability Private companies Unde r pre s s ure : - Wage inflatio n - Lo wer expo rt o ppo rtunities - Dependence o n shado w banking Households - High savings rate - Hurt by inflatio n - 65 8,000 7,000 6,000 5,000 4,000 3,000 2,000 Population ages 15-64 50% 40% 30% 20% 10% 1,000 UK Russia Euro area France China World India Brazil Japan 0% 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Source: World Bank Stocks exposed to the ‚ageing population‛ 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, invitro diagnostics laboratory equipment, hearing instruments and healthcare IT. Asia/Australia  OECD members Germany US - 11 January 2012 31 F179665 Capital Goods 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 25% Labour force in China (m) 840 820 800 20% 15% 780 10% 760 740 5% 720 0% 2006 2007 2008 2009 2010 9M2011 Source: National Bureau of Statistics Source: Economist Intelligence Unit 32 11 January 2012 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 F179665 Capital Goods The number of people aged 15-24 entering the Chinese labour market is expected to fall by a third over the next five years. That means wages will rise even more quickly than in the past. Moreover, according to Caixin Online, labour productivity in 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? 400 350 300 250 200 150 100 50 UK How many industrial robots to produce 100,000 vehicles? 3,500 3,000 2,500 2,000 1,500 1,000 500 Spain Italy UK - China North America Spain North America China France Germany France Japan Germany Source: SG Cross Asset Research, International Federation of Robotics Key picks on the ‚productivity/automation‛ theme  ABB derives 38% of group sales from automation businesses (excluding low voltage) and is the second-largest automation player behind Siemens. In particular, the group is the leader in process automation (oil & gas, metals, pulp & paper, power generation) with an estimated 23% market share globally. The group’s flagship automation system is 800xA, which is a 33 11 January 2012 F179665 South Korea South Korea Japan Capital Goods flexible and ‘evolutionary’ system that enables the user to analyse and control the plant, as well as simulate different operating scenarios. ABB has also a strong presence in industrial robots, drives and motors. China accounts for 14% of sales. Siemens derives 27% of sales from its newly-created industry sector, comprising its PLC, DCS, motors, drives and gearboxes activities and its plant solutions in the mining, pulp and paper, cement, water and metals industries. Siemens is the 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 1.27 0.79 0.72 World average 0.36 0.29 0.21 0.51 0.46 Japan Germany US China India Middle East Brazil World Source: IEA 34 11 January 2012 F179665 Capital Goods All these metrics mean that environmental awareness is gaining momentum among Chinese authorities and energy efficiency is increasingly on top of the agenda. According to the National Bureau of Statistics, China has already reduced its energy intensity by 19.1% from 2005 levels, close to the 20% target set under the 11 five-year plan. In the 12 five-year plan adopted in 2011, the target is to reduce the energy consumption per unit of economic output by 16-17% by the end of 2015. The plan foresees substantial investments of over $430bn in renewable energies, smart grids and electric mobility. th th Key picks on the ‚energy efficiency‛ theme  ABB estimates that energy efficiency is a primary buying criteria for around 45% of its sales. The 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.). 11 January 2012 35 F179665 Capital Goods 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 Customer consolidation Ticket size OE vs aftermarket/distribution Chinese players Total Risk 5 5 5 4 5 24 5 5 5 2 5 22 5 4 4 3 4 20 High 2 2 4 4 4 16 2 2 4 2 5 15 4 4 3 2 2 15 Medium 3 2 2 3 2 12 Medium 2 2 1 3 2 10 Low 2 2 3 1 2 10 Low 1 2 1 2 2 8 Low 1 1 1 2 2 7 Low Very high Very high Medium to Medium high Source: SG Cross Asset Research / * 5 = highest risk, 1 = lowest risk Where Chinese firms have caught up with global 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) 30 25 20 15 10 5 0 27x 22x 18x 13x 10x 9x 7x 4x 4x 3x 1x 1x Bearings Wind turbine * Healthcare Cutting tools Trucks T&D; Air compressors Source: SG Cross Asset Research, Company Data * Based on GW 36 11 January 2012 F179665 Rail Transportation Mining equipment Low voltage Construction Equipment Powergen Capital Goods 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 Industries most at risk Attractive Pricing risks but volatile Consolidation of the customer base Nuclear High Transportation Auto Equipment Wind Power T&D; Mining equipment Fossil Power Generation Medical Equipment Automation Cable Low Compressors Bearings Tooling Locks Ultra - low Voltage Pricing power High Size of each contract Low Source: SG Cross Asset Research China’s 12 five-year plan highlighted seven new strategic industries. Most of these industries are still in a nascent phase of development in the country. The government will provide financial support to these industries and preferred access to capital. th 11 January 2012 37 F179665 Capital Goods  Alternative fuel cars – Investment is likely to focus on the development of hybrid cars and electric cars as well as better fuel-cell batteries. The country aims to produce 5 million newenergy vehicles by 2020. Biotechnology – This includes biomedicines, new vaccines for disease prevention, advanced medical equipment and even extends to marine biology.   Environmental and energy-saving technologies – Energy efficiency (lighting, building automation, energy efficient motors, etc.), pollution control, clean coal, waste-matter recycling and seawater usage are among the many targets. Alternative energy – China wants to further develop nuclear power plants, solar power, wind power, smart grids and bioenergy. The plan also targets promoting the internationalisation of these strategic industries.   Advanced materials – Rare earth, special-usage glass, high-performance steel, high- performance fibres and composites, engineering plastic, nano and superconducting material. New-generation information technology – The plan includes the development of cloud computing, high-end software, virtual technology and new display systems.   High-end equipment manufacturing – This mostly includes aircraft, high-speed rail, satellites and offshore equipment. Local companies are gradually moving up the learning 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. 38 11 January 2012 F179665 Capital Goods 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 entrylevel market segment, whose entire value chain is located in Shanghai. Some 600 Somatom Spirits have already been installed in China, primarily in rural areas. But such cost-optimization expertise is also used worldwide, with another 1,200 such scanners installed outside of China. As demonstrated by ABB (with the company facing a steady intrusion of low-cost, midsegment competitors in its traditional T&D; market with increasing price pressure as a result), western capital goods companies must be quick at moving towards the medium-end market segment before local players move up the value chain. At ABB, already more than 80% of products for the Chinese market are now engineered and made locally. 11 January 2012 39 F179665 Capital Goods China competition risks – Industry profiles 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 40 11 January 2012 F179665 Capital Goods 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 Customer consolidation Ticket size Aftermarket/Distribution Chinese players Total Source: SG Cross Asset Research 5 5 5 2 5 22 Highly strategic industry, often controlled by governments High customer consolidation – a couple of utilities by country Very large ticket items (EPC contracts, etc.) Very profitable aftermarket business 3 large players, already controlling 80% of the domestic market Very high risk – Chinese players already very active overseas in the coal-fired and hydro markets China remains the largest power market 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 300 CHINA 250 Asia ex-China LATAM 200 AFRICA / M-E EUROPE N AMERICA 100 150 50 0 Source: Platts Global Power Plants database But activity is now declining from its 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 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 11 January 2012 41 F179665 Capital Goods 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 1200 1040 1000 792 800 625 600 392 400 200 0 5% 440 962 876 20% 100 83 80 15% 60 10% 40 24 20 0 20 16 28 68 25% Capacity additions are past the peak (GW) 120 100 101 88 90 713 517 68 40 0% 2003 2004 2005 2006 2007 2008 2009 2010 2011e 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Installed base (GW) Source: Platts Global Power Plant Database Growth rate (%, RHS)) Source: IEA IEA 20102020 Nuclear and wind are taking share from 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 Nuclear Other Wind 1% 2% Gas 2% 4% Hy dro 17% Wind 20% New capacity additions by fuel, 2011-2020e Nuclear 8% Other 4% Coal 40% Coal 74% Gas 8% Hy dro 20% Source: Platts Global Power Plants Database Source: IEA 42 11 January 2012 F179665 Capital Goods 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) 25 Other 24% Shanghai Electric 30% 23.7 €bn 20 15.8 15 9.9 10 9.5 7.7 6.6 5.6 4.9 4.7 1.9 5 Harbin Power 20% Dongfang 26% Source: Company data, SG estimates 0 MHI Doosan BHEL Harbin GE Shanghai Source: Company data Shanghai Electric – Strong cooperation with 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 90 80 70 Revenue breakdown by product, 2010 10% 9% 8% CNY Rmb bn bn Other 4% Industrial Equipment 28% 60 50 40 7% 6% 5% Dongfang Siemens T hermal Power 40% 4% 3% 2% 30 20 10 0 2006 2007 2008 2009 2010 2011e 2012e 1% 0% Services 19% Revenues EBIT margin (%, RHS) Wind & Nuclear 9% Source: Company data, IBES Source: Company data Shanghai 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 43 11 January 2012 F179665 Andritz Alstom Capital Goods partnerships/JVs with Siemens and Toshiba-Westinghouse in China, which allow it to quickly adopt new technologies. Finally, the group aims to further accelerate its development in export markets, which already represented 19% of its 2010 sales. This notably reflects large contract wins for coal-fired plants in Iraq, India, Africa and Vietnam. Shanghai Electric – Main export contracts booked over 2009-2011 Contract details Country Value Date 2x610MW coal-fired power plants 125x2MW onshore wind turbines 66x660MW steam turbine and generator sets 2x600MW coal-fired power plants 2x600MW coal-fired power plants Source: SEG Iraq India India Vietnam Botswana $1,000m $8,291m $1,380m $1,956m Apr-11 Apr-11 Oct-10 Oct-09 Mar-09 Dongfang Electric – the first mover into nuclear and wind 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 60 50 40 30 6% Revenue breakdown by product, 2010 14% 12% CNY RMB bn bn CNY bnbn CNY Construction & Services 13% Hydro Power 8% 10% 8% 20 10 - 4% 2% 0% T hermal Power 54% Wind & Nuclear 25% 2006 2007 2008 Revenues 2009 2010 2011e 2012e EBIT margin (%, RHS) Source: Company data, IBES Source: Company data Among the three Chinese leaders, Dongfang Electric was the first group to move into the nuclear and wind power equipment markets. Its total order backlog at the end of 2010 in power generation was CNY140bn (€15.6bn), or 3.7x 2010 revenues, of which 63% attributable to thermal power generation, 16% to wind and nuclear, and 10% to hydro. In conventional thermal power generation, the group is well positioned in large-scale hydro and coal-fired power generation equipment. In 2011, momentum remained positive and the group expects to deliver a total of 38GW production capacity of power generation equipment, up 10% yoy. Beyond 2011, the construction of new thermal power generation units in China is however expected to decrease, which would severely affect the number of thermal orders for the group in the future. Dongfang 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 44 11 January 2012 F179665 Capital Goods Electric now intends to enhance its marketing efforts and explore new markets such as the Middle East, eastern Europe, South America and Africa, and gradually expand into the middleto high-end markets. Dongfang Electric - main export contracts in 2009-2011 Products Country Value Date Low pressure heater for nuclear power plants 10x660MW steam turbine and generators sets 166 units of 1.5MW wind turbines 300MW coal-fired power plant 1800MW hydro power plant 2x622MW coal-fired power plants 2x660MW coal-fired power plants (consortium with Kepco) 3,300MW hydro power plant equipment Source: SG Cross Asset Research, company data France India India Bosnia Ethiopia Vietnam Saudi Arabia Brazil $2,500m $203m $700m $450m $1,400m $1,700m $400m Jun-11 Dec-10 Nov-10 May-10 May-10 Mar-10 Mar-09 Nov-08 Dongfang Electric also has the greatest exposure to nuclear. Dongfang Electric was an early entrant in the Chinese nuclear power market (1996) and offers the longest track record of the Chinese groups, with more than 10 years of R&D; experience. The company already has a track record with the CPR-1000 model (a Chinese version of 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 35 Revenue breakdown by division, 2010 9% Rmb bn CNY bn 30 25 20 15 10 5 8% 7% 6% 5% 4% AC/DC motors and Ancillary others 9% equipment 3% Engineering services 18% 3% 2% 1% 2004 2005 2006 2007 2008 2009 2010 2011e 2012e Revenues EBIT margin (%, RHS) 0% Hydro power 8% T hermal power 62% Source: Company data, IBES Source: Company data Harbin has significant exposure to an increasingly saturated thermal power equipment market and was the leader in market for 300MW and 600MW steam turbines and generators in China in 2010. Harbin also leads the hydro power equipment market, with close to 50% of the domestic installed base. Finally, it has a small presence in the gas turbine market. Recent export successes have compensated for the declining domestic market in thermal power generation. 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 11 January 2012 45 F179665 Capital Goods 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 16x660MW supercritical steam turbine and generators Thermal power equipment 750MW combined cycle power plant Source: Company data India India Vietnam Pakistan $1,060m $1,470m $162m $400m Jan-11 Sep-10 Feb-10 Sep-09 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 Others 16% Shanghai 20% Hydro turbines market share, 2008 Other 16% Harbin 20% Toshiba 4% MHI 4% GE 4% Alstom 4% Siemens 4% Andritz 10% Dongf ang 16% VoithSiemens 12% Dongfang 19% BHEL 6% Harbin 19% Alstom 26% Source: Platts Global Power Plants database Source: Andritz, Alstom 46 11 January 2012 F179665 Capital Goods Gas turbines market share, 2009-2010 Hitachi BHEL 1% 1% Ansaldo 3% Tuga 6% MHI 10% Wind turbines market share, 2010 Other 17% Other 8% Sinovel 11% Goldwind 9% GE 38% Siemens 6% Gamesa 7% Dongfang 7% Guodian United Power 4% Suzlon 7% Vestas 15% Alstom 12% Enercon 7% GE 10% Source: BTM Siemens 21% Source: Platts Global Power Plants database The only way to compete is via partnerships with Chinese 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. 11 January 2012 47 F179665 Capital Goods 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 Customer consolidation Ticket size Aftermarket/Distribution Chinese players Total Source: SG Cross Asset Research 5 5 5 4 5 24 Strategic industry, often controlled by governments Very high– Municipalities, governments Very large ticket items Limited aftermarket business 2 large players, controlling 100% of their domestic market Very high risk – Chinese players already larger in size than traditional players Rail infrastructure investments in China peaked in 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 Latin America India 4% 5% Asia-Pacif ic 5% Global rail transportation market share by player, 2010 Invensys 2% Ansaldo STS 3% KHI 3% Others 9% CSR 16% CIS 7% Europe 36% CAF 3% TMH 4% CNR 15% North America 10% GE 6% Siemens 11% Bombardier 15% China 33% Source: UNIFE Alstom 13% Source: Company data, Bombardier, UNIFE Under the Chinese mid- and long-term railway network plan, investments in railway infrastructure have grown rapidly, with a peak in 2010 at around CNY700bn. However, 2011 was a turning point for spending on infrastructure following the dismissal of the Ministry of Railway (MOR) due to corruption charges and the collision between two high speed trains in July, killing some 43 passengers. This was the world’s first fatal train accident on a dedicated 48 11 January 2012 F179665 Capital Goods high-speed line. Facing financing constraints and increased losses, the MOR then decided to cut spending on infrastructure to an expected CNY470bn in 2011 and CNY400bn in 2012, 43% lower than the peak. It is clear that the MOR faces a declining rate of return on new projects and many new lines appear to be under-utilised. High speed rail (km) 12,000 Chinese railway infrastructure spending (CNY bn) In operation In construction 800 707 700 623 -43% 10,000 600 Bn Y uans 8,000 500 400 300 337 469 400 6,000 4,000 200 89 100 155 179 2,000 0 2011e China Spain Japan France Others Germany Italy Belgium Source: MOR Source: International Union of Railways Rolling stock investments usually lag rail infrastructure investments by 2-3 years. Therefore, the decline in infrastructure spending from 2011 on should be followed by a similar trend for rolling stock investments. As shown in the graph below, based on recent data from UNIFE, mentioned by Alstom, the Chinese rolling stock market should decline by at least 20% in 2014-2015 vs the 2008-2010 peak. Chinese rolling stock market likely to decline after 2013e 9 8 7 6 5 4 3 2 1 0 2008-10 High Speed Source: UNIFE 2010, Alstom, SG Cross Asset Research €bn 8.4 8.3 6.6 2011-13e Regional Locos Metro 2014-16e LRV Chinese players have a monopoly on their local 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 11 January 2012 49 F179665 2012e 2007 2008 2009 2010 2005 2006 Capital Goods the prices and cost structure of similar products and profit margins. The MOR is also responsible for testing, formulating technical standards and safety specifications and delivering production licences. CNR and CSR were formed from the break-up of China Locomotive & Rolling Stock Corporation in 2000 and today provide a full range of rail transportation equipment, including locomotives, freight wagons, passenger carriages, multiple units and urban railways. CSR is the leading Chinese rail transportation equipment 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 90 80 64 70 60 50 46 35 23 27 2% 1% 0% 2006 2007 2008 2009 2010 2011e 5% 4% 3% 86 7% 6% CSR - Revenue breakdown by segment, 2010 Others 20% Locomotiv e 28% 40 30 20 10 - Passenger carriage 7% Metro 11% High Speed trains 23% Revenues (Rmb bn) EBIT margin (%, RHS) Freight wagon 11% Source: Company data, Bloomberg Source: Company data CNR is the second major player, leading the locomotive 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 90 80 5.0% 70 60 50 40 30 20 1.0% 35 41 62 4.0% 3.0% 2.0% 84 6.0% CNR - Revenue breakdown by segment, 2010 Others 30% Locomotiv e 24% 26 21 10 2006 2007 2008 2009 2010 2011e Passenger carriage 6% Metro 8% High Speed trains 19% Freight wagon 13% 0.0% Revenues (Rmb bn) EBIT margin (%, RHS) Source: Company data, Bloomberg Source: Company data 50 11 January 2012 F179665 Capital Goods 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 highpowered electric locomotive manufacturing was achieved on the back of the technological transfers shown in the two tables below. In December 2011, CSR unveiled an ultra-high-speed test train, intended to give Chinese engineers the opportunity to research train and track behaviour at speeds up to 500km/h! This train was developed with the support of the Ministry of Railways and the Ministry of Science & Technology. Electrical Multiple Units (EMU) – technology transfers to China Seller Model Buyer Date Commercial speed (km/h) Chinese name Units Contract size (€m) Alstom Kawasaki Siemens Bombardier Siemens Bombardier Source: Company data Pendolino Shinkansen E2-1000 Velaro ICE-3 Zefiro Velaro Zefiro CNR CSR CNR CSR CNR CSR 2004 2004 2005 2007 2009 2009 200 200 300 250 350 380 CRH-5 CRH-2 CRH-3 CRH-1 CRH-3 CRH-1 60 60 60 40 100 80 660 na 669 413 750 700 Locomotives – technology transfers to China Company Partner Model Characteristics CSR CSR CSR CNR CNR CNR CNR Source: Company data Siemens Siemens Siemens Alstom Alstom Toshiba Bombardier EuroSprinter EuroSprinter EuroSprinter Prima Prima SSJ3&EH500; IORE Kiruna 8-axle and 9600kw 6-axle and 9600kw 6-axle and 7200kw 6-axle and 9600kw 8-axle and 9600kw 6-axle and 9600kw 6-axle and 7200kw Critical size and 30% cost 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. 11 January 2012 51 F179665 Capital Goods Price comparison between main high-speed train models 40.0 35.0 30.8 30.0 30.0 €m 35.0 28.6 25.0 20.0 15.0 10.0 5.0 22.1 20.0 0.0 Alstom AGV Bombardier Zef iro Siemens Velaro Alstom TGV Duplex CNR CRH3 CSR CRH1 Source: Company data, Railway Gazettte, Brazil TAV project – Capital Cost report (2009) Rail transport market share - 2002 Others 18% Bombardier 21% Rail transport market share - 2010 Others 9% KHI 3% CAF 4% Ansaldo 4% CSR 16% Japanese 8% CNR 3% CSR 3% GM 4% Ansaldo 4% TMH 4% CNR 15% GE 6% Alstom 17% Siemens 11% Bombardier 15% GE 7% Siemens 15% Alstom 13% Source: UNIFE 2010, Bombardier Transport, Companies data, SG Cross Asset Research Chinese manufacturers have already expanded their presence overseas, as illustrated by some recent contracts awarded to CSR and CNR in emerging markets, primarily for metro carriages and locomotives. CNR and CSR – Main recent contracts abroad (2010-2011e) Country Product Supplier Value Date Georgia Middle East Iran Georgia Mongolia New Zealand Australia Saudi Arabia Malaysia India Belarus Argentina Pakistan 5 additional EMUs Metro vehicles ZK1-E wagon bogies 5 EMUs Locomotives 300 wagons Locomotives 10 mainline locomotives Urban rail vehicles Metro/subway Locomotives Metro/subway Coaches CSR CSR CSR CNR CSR CNR CNR CSR CSR CSR CSR CNR CNR CNR na €64m €280m €23m €24m €22m €22m €12m na €454m na €76m €343m €78m Sep-11 Sep-11 Aug-11 Apr-11 Mar-11 Jan-11 Dec-10 Sep-10 Jul-10 Jul-10 Jun-10 Mar-10 Jan-10 Jan-10 Turkmenistan 60 freight locomotives Source: Company data 52 11 January 2012 F179665 Capital Goods 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 Customer consolidation Ticket size Aftermarket/Distribution Chinese players Total Source: SG Cross Asset Research 5 4 4 3 4 20 Strategic industry High – Grid operators, utilities, energy-intensive industries Products and Systems (large HVDC contracts, bulk tenders) Limited service business New players emerging and gradually taking share in their domestic market High risk – Chinese players already gaining share in China and India 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 E. Europe / Russia 6% Other Asia 6% W. Europe 14% India 10% MEA 5% LatAm 4% North America 17% Chinese investments in power grid construction 800 CAGR 14% 700 600 500 400 289 300 214 200 150 245 579 675 CAGR 18% 427 390 345 497 367 Developed Asia 8% 100 0 2008 2009 2010 2005 2006 2007 2011e 2012e 2013e 2014e China 30% 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 ($51bn) invested in 2010. Based on more detailed data from the China Electricity Council, we note that the key investment areas will be in UHVDC with expected investment of CNY100bn per year (20% of total) and in the Smart Grid segment with another CNY100bn spending targeted per year. 2015e 11 January 2012 53 F179665 Capital Goods The UHVDC (Ultra High Voltage Direct Current) technology allows transport of very high amount of power over long distances with minimum losses compared to AC systems (Alternating Current). Siemens, ABB and Alstom remain the only companies to truly master this technology at this stage. However, Chinese players are gradually moving up the learning curve. Large HVDC projects awarded in China since 2007 Date Winner Project name Amount ($m) kV km MW Client Product Apr-11 ABB Apr-11 ABB Apr-11 Siemens Apr-09 ABB Jun-08 ABB Apr-08 Siemens Dec-07 ABB Jun-07 Siemens Jinping-Sunan Jinping-Sunan Xiluodu-Guangdong Ningxia-Shandong Shenyang-Liaoning Xiangjiaba-Shanghai Xiangjiaba-Shanghai Yunnan-Guangdong 120 165 175 175 140 70 208 130 440 390 800 800 500 800 660 500 800 500 800 800 2,090 2,090 1,286 1,451 1,350 920 2,000 1,225 2,000 1,400 7,200 State Grid 7,200 State Grid Valves, control system Transformers 6,400 Southern Grid Valves, control system 5,000 Southern Grid Valves, transformers 4,000 State Grid 3,000 State Grid 6,400 State Grid 6,400 State Grid Transformers Transformers Transformers Substations, systems Apr-11 Siemens Nuozhadu-Guangdong Feb-08 Siemens Guizhou-Guangdong 3,000 Southern Grid Valves, control system 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) $bn 18 16 14 12 10 8 5.9 6 4 2 5.4 3.9 2.6 1.9 1.5 1.4 1.1 0.8 0.7 0.7 16.6 11.9 0 Hy osung SPX Schneider XD Electric Alstom TBEA 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 54 11 January 2012 CG Power Siemens Toshiba TWBB F179665 BHEL ABB GE Capital Goods 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 T BEA 20% T BEA 31% Others 39% XD Electric 10% Baoding 6% Siemens Areva 5% 3% ABB 17% XD Electric 13% Others 39% Market share transformers China - 2009 Market share transformers China – 2011 TBEA 27% Others 39% Siemens 1% Areva 4% ABB 9% XD Electric 12% Baoding 4% Siemens 3% Areva 2% ABB 6% Baoding 11% 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) Transformation capacity (MVA) Electricity sales (TWh) Revenue (CNY bn) Cumulative patents Source: State Grid 381,764 983,380 1,500 750 866 618,837 2,131,930 2,689 1,543 6,528 Over 1,000,000 Over 4,000,000 3,800 Over 2,000 - 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. 11 January 2012 55 F179665 Capital Goods State Grid Corporation of China Sales: 3.9bn Rmb GIS/Circuit breaker 30% XJ Electric Sales:13.1bn Rmb XJ SGCC 100% Sales:5.1bn Rmb CET Pinggao 25% Pinggao Elec Sales: 2bn Rmb GIS/Circuit breaker; HV sw itch Speco Sales:1.1bn Rmb Transformer CZ-Toshiba Sales:2.5bn Rmb Transformer Source: SG Cross Asset Research JV 50% Pinggao Toshiba Sales: 1bn Rmb (Equity-accounted) HV sw itch 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 25,000 14% 12% Breakdown of revenues by segment, 2010 Electrical Contractors 5% Solar Silicon Wafers 15% Other 3% 20,000 10% 15,000 8% 6% 4% 5,000 2% 0 0% 10,000 Transformer 57% Wire and Cable 20% 2004 2005 2006 Revenue 2007 2008 2009 2010 2011e 2012e Operating margin (%, LHS) Source: Company data, Bloomberg Source: Company data, Bloomberg 56 11 January 2012 F179665 Capital Goods 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 16,000 14,000 14% 12% 10% 8% 8,000 6% 6,000 4,000 4% 2% 0% Breakdown of revenues by product, 2010 Insulator & Capacitor Lightning 4% Arrester 5% Rectifying Device 9% Other 6% 12,000 10,000 Transformers 41% 2,000 0 2006 2007 2008 2009 2010 2011e 2012e Revenue Operating margin (%, LHS) Switchgear 35% 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 8,000 7,000 15% 13% Breakdown of revenues by product, 2010 Photovoltaics 7% Wind Energy 10% Others 4% 6,000 5,000 4,000 3,000 2,000 11% 9% 7% 5% 3% 1,000 0 1% -1% 2006 2007 2008 2009 2010 2011e 2012e Revenue Operating margin (%, LHS) Transformer 79% Source: Company data, Bloomberg Source: Company data, Bloomberg 11 January 2012 57 F179665 Capital Goods 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 Customer consolidation Ticket size Aftermarket/Distribution Chinese players Total Source: SG Cross Asset Research 4 4 3 2 2 15 New addition in the Chinese government’s priority list Increased share of government tenders Medium Services and upgrades offering a recurring and profitable stream of revenue Domestic competitors still small in size Medium risk – Increasingly challenged 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) 2000 1800 RMB bn 1754 1800 Government spending on healthcare (2000-2011e) 600 RMB bn 480 1600 1400 1200 1000 800 14% CAGR (2000-10) 1129 500 1454 400 25% CAGR (2000-10) 399 1097 866 759 658 568 300 276 199 600 400 200 0 476 515 200 132 100 78 85 104 49 57 64 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Mindray, MOH Source: Mindray, MOH 58 11 January 2012 F179665 Capital Goods Density of MR Imaging systems per m people 45 40 Population (m) 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 0 in million 35 30 25 20 15 OECD Av erage ~15 10 5 UK Italy USA 0 Austria China USA UK China Korea Austria Switzerland Germany 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 countylevel 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. 11 January 2012 59 Switzerland Germany Korea Japan Japan Brazil F179665 Brazil India India Italy Capital Goods 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 GE 23% Others 37% Siemens 11% Aloka 2% Omron 2% Hitachi 4% Source: Sinotes Consulting Philips 10% Toshiba 5% Shimadzu 6% 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 60 11 January 2012 F179665 Capital Goods 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 Other domestic brands 9% Mindray 14% In-vitro diagnostics Patient monitoring & anaesthesia Other domestic brands 19% Foreign brands 50% Foreign brands 50% Other domestic brands 34% Foreign brands 77% Mindray 16% Mindray 31% 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 lowcost 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. 11 January 2012 61 F179665 Capital Goods 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 900 800 25% 700 600 20% 15% 400 300 200 5% 100 0 2005 2006 2007 2008 2009 2010 Operating Margin 2011e 0% 10% 30% 500 Sales (million $) Source: Mindray, Bloomberg 62 11 January 2012 F179665 Capital Goods Mindray: breakdown of sales – 2003 Developed markets 8% Emerging markets (ex China) 12% Mindray: breakdown of sales – 2010 Others 1% Developed markets 25% Others 5% China 42% China 75% Emerging markets (ex China) 32% 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 800 700 600 500 Wandong: breakdown of sales by geography 12% 10% 8% 6% 4% 2% 0% Overseas 6% 400 300 200 100 0 2003 2004 2005 2006 2007 2008 2009 2010 2011e Sales (in million Yuan) Operating Margin Domestic 94% 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. 11 January 2012 63 F179665 Capital Goods 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 Customer consolidation Ticket size OE vs Aftermarket/Distribution Chinese players Total Source: SG Cross Asset Research 2 2 4 4 4 16 Not strategic but construction industry is or has been Thousands of customers globally Significant investment for contractors Independent dealers can provide entry points into new markets Large domestic market and 3-4 large players 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) Caterpillar 9% RoW; 10% Others 9% Volvo 7% Komatsu 5% Asia ex China; 14% Latin America; 6% North America; 16% China; 42% Other Chinese 18% XGMA 3% Hitachi 4% Kobelco 1% Zoomlion 11% XCMG 8% Shantui 4% Liugong 5% Lonking 4% Hunan Sunward 1% Europe; 12% Sany Heavy 11% 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 64 11 January 2012 F179665 Capital Goods 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 60,000 50,000 Revenue breakdown by product, 2010 25% 20% 15% Excavator 19% T ruck crane Rotary drilling 8% 6% Crawler crane 5% Road machinery 4% Spare parts 3% Others 1% Concrete machinery 54% 40,000 30,000 10% 20,000 10,000 2004 2005 2006 2007 2008 2009 2010 2011e 5% 0% Revenues EBIT % 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 50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 2006 2007 2008 Revenue 2009 2010 EBIT % 2011e 10% 20% 18% Revenue breakdown by product, 2010 22% Material Handling 1% Financial leases 3% 16% 14% 12% Excavators 2% Road construction 4% Others 11% Concrete machinery 44% Crane machinery 35% 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. 11 January 2012 65 F179665 Capital Goods Revenue (CNYm) and margin history 35,000 16% 14% Revenue breakdown by product, 2010 Scraper 15% Compaction machinery 7% 30,000 25,000 20,000 12% 10% 8% 15,000 10,000 6% 4% 2% 0% 5,000 - Crane 62% 2008 2009 Revenues 2010 2011e EBIT % Spare parts 6% Concrete machinery 4% Pavement construction machinery 3% Fire-fighting machinery Others 1% 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 righthand 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 mediumsize 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) Xiagong Hunan 2% JCM Sunward 2% 3% Futian Lovol 3% Liugong Machinery Yuchai 3% 5% Volvo 5% Excavators – Evolution of market shares Foreign 100% Chinese Sumitomo Other 2% 3% Komatsu 14% 90% 80% Doosan 13% 22.6% 21.9% 26.3% 28.2% 30.5% 70% 60% 50% Caterpillar 6% Kobelco 9% Hitachi 11% Hyundai 11% 40% 30% 20% 10% 0% 2006 Source: CCMA Source: CCMA 77.4% 78.1% 73.7% 71.8% 69.5% Sany Heavy Industry 9% 2007 2008 2009 2010 66 11 January 2012 F179665 Capital Goods 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) 2000 1800 1600 Zoomlion Sany XCMG 641 1400 1200 1000 577 800 600 400 200 202 458 273 218 239 610 383 2007 Source: Company Data 323 326 272 2010 0 2008 2009 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 $9.3bn (up 35% from 2009, albeit still 25% down vs 2008), with the majority being components and low to mediumend products. However, a portion of these exports was accounted for by non-Chinese companies which are manufacturing parts or complete equipment in China and then shipping them abroad. Export of construction & mining equipment ($m) Breakdown of exported construction & mining equipment by value Other Excavator 4% 5% Bulldozer 3% 14,000 12,000 10,000 8,000 6,000 4,000 2,000 2001 Source: CCMA Loader 9% Component 35% Crane 11% Fork-lift truck 5% Grader / leveller 3% Earth Lifting / moving / handling grading machine machine 3% 5% Road roller / tamping machine 3% 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: CCMA Elevator / Concrete escalator machine 10% 4% 11 January 2012 67 F179665 Capital Goods 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. 68 11 January 2012 F179665 Capital Goods 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 Customer consolidation Ticket size OE vs aftermarket/distribution Chinese players Total Source: SG Cross Asset Research 2 2 4 2 5 15 Not strategic Highly fragmented customer base High for customers Great importance – capital turnover key for customer’s profit generation Among the largest players 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 South America 5% Western Europe 22% Geographical breakdown of deliveries in 2010 South America 7% Western Europe Af rica 1% 8% North America 11% Eastern Europe 5% North America 39% Asia-Pacif ic 31% Af rica 1% Asia-Pacif ic 68% Eastern Europe 2% 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. 11 January 2012 69 F179665 Capital Goods Market share 1998 (medium and heavy duty trucks) Scania 3% Toyota 2% Tata 5% Paccar 7% Other 5% MAN 4% Navistar 9% Isuzu 3% Hyundai 1% Ford 7% GM 3% DMC 8% Market share 2010 (medium and heavy duty trucks) Volvo Toyota 5% 1% Scania 2% DMC 7% CNHDTC 1% SHAANXI AUTO 4% CNHDTC 8% Volvo 12% FAW 7% Ashok Leyland 1% Paccar 3% Tata 8% Daimler 19% FAW 11% Other 22% Daimler 8% MAN 4% IVECO 2% BEIQI FUTIAN 4% Ashok Leyland 3% GM 0% Ford 3% IVECO 4% Isuzu Navistar Hyundai 1% 3% 1% 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) Other 19% FAW 15% CNHTC 7% Dongfeng 20% Other 7% FAW 23% JAC 11% Dongfeng 32% Sichuan Nanjun 10% Qingling 6% North Benz 4% JAC 2% CHONGQING HEAVY 3% Foton 11% CNHTC 19% SHAANXI AUTO 11% 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. 70 11 January 2012 F179665 Capital Goods Market share distribution by truck prices in China Chinese players 40% 35% 30% 25% 20% 15% 10% 5% 0% Japanese players European players 95-150,000 30-37,000 45-52,000 52-60,000 67-75,000 150,0000 11 January 2012 71 F179665 Capital Goods 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 20,000 18,000 16,000 1.2% Export of light, medium and heavy duty trucks (volume) 40,000 Volume Market share 1.6% 35,000 1.4% 30,000 25,000 1.0% 0.8% 0.6% 0.4% 20,000 15,000 10,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0.2% 5,000 Mar-10 Dec-09 Mar-11 Aug-11 Aug-10 Dec-10 Apr-10 Apr-11 Jul-11 Jul-10 Jan-10 May-11 May-10 Feb-10 Feb-11 Jun-11 Jun-10 Jan-11 2004 Source: Company Data 0.0% 2005 2006 2007 2008 2009 2010 2011e Source: China Association of Automobile Manufacturers (CAAM) 72 11 January 2012 F179665 Sep-11 Sep-10 Nov-10 Oct-11 Oct-10 - Capital Goods 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 Customer consolidation Ticket size Aftermarket/Distribution Chinese players Total Source: SG Cross Asset Research 3 2 2 3 2 12 Growing government focus on energy efficiency and high-tech manufacturing Scattered end-customer base Low- to medium-ticket items (PLC, DCS, actuators, instruments, robots) Various channels (OEMs, systems integrators, distributors) Emerging market competitors still very small Medium risk – High barriers to entry but likely to become strategic 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) Other Asia 18% EMEA 36% China 12% Automation market in China (1999-2013e) 35 30 25 $bn CAGR 12% 20 15 10 CAGR 16% Other Americas 6% USA 19% Source: Siemens 5 1999 2002 2003 2006 2007 2008 2010 2000 2001 2004 2005 2009 2011e 2012e Source: Gonkong China Industrial Control 2013e Germany 9% 0 11 January 2012 73 F179665 Capital Goods 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 Other 16% UK 1% Taiwan 2% Spain 3% France 3% China 4% Fanuc 15% Japan 29% Panasonic 15% Market share of robotics in China, 2009 Other 8% ABB 20% Italy 6% Korea 8% Germany 13% Source: IFR Source: ABB OTC 18% North America 15% Kuka 9% Yaskawa 15% 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 Other 6% PLC 7% DCS 6% IPC 4% HMI 3% Other controls 2% Other 31% Chinese automation market by sector Chemical 18% Motion control 8% Instrument & Sensor 15% Power Generation 17% LV drives 18% Oil & Gas 4% Other actuators 5% Control valve 18% Source: Gonkong China Industrial Control MV drives 5% Other drives 3% Building Material 5% Metallurgy 11% Source: Gonkong China Industrial Control Petrochemical 14% 74 11 January 2012 F179665 Capital Goods 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 100 Million Yuan 1800 1600 1400 1200 Nb. of companies with sales < 100 Million Yuan Revenues and market shares of top 10 bearing companies in China T OP 10's sales (CNY bn) as % 35 30 25 20 15 10 5 0 40% 35% 30% 25% 20% 1000 800 600 400 200 0 2001 2002 2003 2004 2005 2006 2007 2008 15% 10% 5% 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 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 Harbin Bearing Group Wafangdian Source: SG Cross Asset Research, Company Data 6,000 4,000 2,500 Leading Chinese bearing manufacturer, less than 5% of revenues derived from export Acquired by AVIC in 2008, very focused on bearings for railway and aerospace sectors State-owned enterprise but SKF has 19.7% of shares 78 11 January 2012 F179665 Capital Goods Key Chinese players in the Cutting Tool market Tooling Estimated revenues (CNYbn) Comments Zhuzhou Cemented Carbide Shanghai Tool Works Source: SG Cross Asset Research, Company Data 1,200 600 The most advanced cutting tool manufacturer in China. Sales offices in Europe and in the US Regional player only, mostly in the low-end segment Key Chinese players in the stationary air compressor market Stationary air compressors Estimated revenues (CNYbn) Comments Fusheng Industrial Kaishan Source: SG Cross Asset Research, Company Data 3,000 1,600 Owned by private equity, 70% of sales made in China Regional player only, mainly reciprocating compressors …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 CHINA TODAY CHINA TOMORROW Foreign brands Premium Chinese and foreign brands Premium Medium Chinese brands Medium Low-end Source: SG Cross Asset Research 11 January 2012 79 F179665 Capital Goods 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 Customer consolidation Ticket size Aftermarket/Distribution Chinese players Total Source: SG Cross Asset Research 1 1 1 2 2 7 Below the radar screen Very fragmented and scattered end-customer base Very low ticket items (switches, sockets, etc) Distribution network, a prerequisite for success Local market structure preventing Chinese to expand overseas successfully Low risk – High barriers to entry (norms, standards, access to distribution) 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 Market positioning High-end market: 12bn Yuan Schneider ABB Siemens Noark (CHINT) Mid-end market: 15bn Yuan Chang Renming Nader Low -end market: 33bn Yuan CHINT Delixi Tengen... Price 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 5050 JV with Delixi to offer a different value proposition from its existing premium offering,  80 11 January 2012 F179665 Capital Goods 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 12 10 20% 18% Chint – Revenue breakdown by division (2010) Power Other Supply 3% 7% 16% 8 6 4 14% 12% 10% Power Control 25% Power Distribution 34% 8% 2 2006 2007 2008 2009 2010 2011e 2012e Revenues (in RMB m) 6% 4% EBIT margin (%, RHS) Terminal devices 31% 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). 11 January 2012 81 F179665 Capital Goods 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 300 50% 250 38% 200 150 49% 43% 12% 100 50 36% 0 Buy Companies Covered Hold Cos. w/ Banking Relationship Sell Source: SG Cross Asset Research 82 11 January 2012 F179665 Capital Goods MSCI DISCLAIMER: The MSCI sourced information is the exclusive property of Morgan Stanley Capital International Inc. (MSCI). Without prior written permission of MSCI, this information and any other MSCI intellectual property may not be reproduced, redisseminated or used to create any financial products, including any indices. This information is provided on an ‚as is‛ basis. The user assumes the entire risk of any use made of this information. MSCI, its affiliates and any third party involved in, or related to, computing or compiling the information hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of this information. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in, or related to, computing or compiling the information have any liability for any damages of any kind. MSCI, Morgan Stanley Capital International and the MSCI indexes are service marks of MSCI and its affiliates or such similar language as may be provided by or approved in advance by MSCI. IMPORTANT DISCLOSURES Areva Areva Areva Daimler Daimler Dong Honeywell Legrand Legrand National Grid National Grid Schneider Vallourec SG acted as joint bookrunner in Areva's bond issue. SG acted as offer's sponsorof the conversion of Areva's investment certificates into shares. SG is acting as financial advisor to Areva SG acted as joint lead manager in Daimler Finance North America LLC' senior high grade bond issue. SG acted as co manager in Daimler Finance North America LLC' senior high grade bond issue. SG acted as joint deal manager and joint bookrunner in Dong Energy's tender offer (7.75% 01/06/3010 EUR). SG acted as co-manager in Honeywell's bond issue. SG acted as sole bookrunner in the disposal of Wendel & KKR's stakes into Legrand. SG acted as joint bookrunner in legrand's bond issue (4.375% 21/03/18 EUR). SG acted as joint bookrunner of KEYSPAN 's bond issue. (Subsidiary of National Grid) SG acted as joint deal manager in National Grid's Tender offer. SG acted as joint bookrunner in Schneider's bond issue (Eur500mm long 7yr). 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. SG or its affiliates act as market maker or liquidity provider in the equities securities of ABB, Alstom, Atlas Copco, BASF SE, CRH PLC, Daimler, MAN, Philips, Schneider, Siemens, Vallourec, Volvo. SG or its affiliates expect to receive or intend to seek compensation for investment banking services in the next 3 months from Alstom, Areva, Bombardier, Daimler, MAN, Rio Tinto, Siemens, Vallourec, Volvo. SG or its affiliates had an investment banking client relationship during the past 12 months with Alstom, Areva, Bombardier, DONG, Honeywell, Legrand, MAN, National Grid, Rio Tinto, Schneider. SG or its affiliates have received compensation for investment banking services in the past 12 months from Areva, DONG, Daimler, Honeywell, Legrand, National Grid, Schneider, Vallourec. SG or its affiliates managed or co-managed in the past 12 months a public offering of securities of Areva, DONG, Daimler, Honeywell, Legrand, National Grid, Schneider, Vallourec. SGAS had a non-investment banking non-securities services client relationship during the past 12 months with ABB, Atlas Copco, BASF SE, Bombardier, CRH PLC, Daimler, Honeywell, MAN, National Grid, Rio Tinto, SKF, Schneider, Siemens, Vallourec, Volvo. SGAS had a non-investment banking securities-related services client relationship during the past 12 months with Alstom, Apple, Bombardier, Emerson, Honeywell, National Grid, Rio Tinto, Rockwell, Siemens. SGAS received compensation for products and services other than investment banking services in the past 12 months from ABB, Alstom, Apple, Atlas Copco, BASF SE, Bombardier, CRH PLC, Daimler, Emerson, Honeywell, MAN, National Grid, Rio Tinto, Rockwell, SKF, Schneider, Siemens, Vallourec, Volvo. SGCIB received compensation for products and services other than investment banking services in the past 12 months from 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. FOR DISCLOSURES PERTAINING TO COMPENDIUM REPORTS OR RECOMMENDATIONS OR ESTIMATES MADE ON SECURITIES OTHER THAN THE PRIMARY SUBJECT OF THIS RESEARCH REPORT, PLEASE VISIT OUR GLOBAL RESEARCH DISCLOSURE WEBSITE AT http://www.sgresearch.com/compliance.rha or call +1 (212).278.6000 in the U.S. The analyst(s) responsible for preparing this report receive compensation that is based on various factors including SG’s total revenues, a portion of which are generated by investment banking activities. Non-U.S. Analyst Disclosure: The name(s) of any non-U.S. analysts who contributed to this report and their SG legal entity are listed below. 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