CFA Institute Research Challenge

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1 CFA Institute Research Challenge Hosted in Beijing, China Peking University

2 Equity Research / Company Analysis Qingdao Haier Co., Ltd. (SHSE:600690) November Qingdao Haier: The Falling Angel Initiating Coverage SELL Consumer Discretionary Household Appliances Investment Highlights: Market Data (as of 27 Nov, 2015) Washing Machine: Haier s Leading Position Challenged We believe that Midea and Little Swan will surpass Haier to become the top player in the washing machine sector, as they have developed a full spectrum of models that can better meet market demands (by double-branding strategies and focus on product quality since 2013) Air Conditioner: Price War is Stealing Haier s Market Share Due to mistaken strategy, Haier didn t participate in the recent price war in air conditioner sector, leading to a severe market share loss. Market share, as the single most important driver in the sector, is rather hard to take back even if Haier fights a price war in the future Air Conditioner: Haier s Weak Position in Central Air Conditioner Drags the Whole Segment Down We estimate the market size of central air conditioner in China to grow at a 16.3% CAGR to CNY 150bn by 2019, becoming the major source of growth. Despite overall market growth, Haier is losing this pie, owing to the weak technological position Valuations: We initiate a SELL rating on Qingdao Haier with a target price of CNY We use DCF and comparable company approaches to derive our target price, with the belief that Haier s washing machine and air conditioner will miss market expectations Current Price (CNY) 9.92 Target Price (CNY) 9.11 % Decrease -8.2% Rating Sell 52 Week Range (CNY) 8.61~32.20 Market Cap (CNY m) 60,742 Shares Outstanding (m) 6,123 Price Performance (LTM) Qingdao Haier (LHS) SSECI (RHS) Upside Risks: Real Estate: Stronger than expected growth in sales volume of Chinese real estate market, on which white goods are highly dependent Product Upgrade: Demand for product upgrade explodes, bringing forth huge growth for Casarte; Haier s excessive return from its smart appliance portfolio Mergers and Acquisitions: the overseas assets owned by Haier Group (parent company of Qingdao Haier) may be injected into Qingdao Haier in the future and thus increase the its EPS 1

3 Figure 1 Haier s Business Structure 100% 80% 60% 40% 20% 0% Source: Company Website Figure 2 Revenue Breakdown by High-end Mid-end Low-end CNY bn Geographies 10% 11% 11% 11% 12% 12% 90% 89% 89% 89% 88% 88% LTM China Others Source: Company Filings Figure 3 Haier s Brands Source: Company Website Figure 4 Sales from Refrigerator LTM Figure 5 Sales from Washing Machine CNY bn LTM 1. Business Description 1.1. Introduction: the World s Largest White Good Manufacturer Established by reorganizing the Qingdao Refrigerator Factory in 1989, Qingdao Haier is the world s largest home appliance manufacturer by retail volume. According to China IOL, Haier's refrigerators and washing machines ranked #1 in global market shares in 2014 (17%/14.4% by volume). In the domestic market, it has a share of 24%/27% in refrigerator and washing machine by volume, according to CMM. With multi-brand lines, sales reached CNY 89bn in 2014, growing at 2.5% YoY, and net income rose to CNY 6.7bn with a 20.4% YoY. However, besides growth driven by ongoing urbanization, Haier s washing machine and refrigerator sales growth have lagged behind Midea in recent years. Haier has an excellent operational track record, with revenue and net income growing at 23%/20% CAGRs over the past 15 years, but growth has been slowing down (even negative in LTM). Its 3Q15 results have painted a picture of the trends of the business - sales declined by 11.0%, net income declined by 17.0%, both the largest declines ever seen. This sets the tone of our report Business Segments: Multiple Product Lines and Brands Haier s business is divided into 6 segments: Refrigerator, Air-conditioner, Washing Machine, Water Heater, Equipment and Integrated Channel Services. It owns a 51.2% stake in Haier Electronics (1169.HK), which contributed 76%/45% of the sales/ebit in Haier Electronics business includes WM and WH, as well as ICS, which caters to distribution of home appliances for Haier brand and third party brands, logistics for big-item products, and e-commerce. Haier has adopted a multi-brand strategy, with high-end brands of Casarte and Fisher & Paykel (not consolidated), a mid-end brand of Haier and mass-market brand of Leader. Haier brand dominates 95% of the company s home appliance sales in FY2014. As part of its high-end strategy, Haier established a team to run Casarte in 2H2014, hence boosting brand sales up by 40%/40% in 4Q14/1H Refrigerator As the largest business sector through which Haier rose to prominence, refrigerator makes up 28% of revenue in FY2014. Haier led the refrigerator market, which Euromonitor expects to grow at 3% volume CAGR over , with a volume share of 26% (from CMM) in However, refrigerator sales declined by 5.9% YoY in 1H2015, while market was down by 2.1%. Moreover, sales from refrigerator have barely grown since Washing Machine Washing machine makes up 17% of revenue in FY2014. As a leader in the washing machine market, Haier shares 27% ofvolume in Faced with heavy competitions from Midea and Little Swan, Haier has lost 5.3% of washing machine market share since 2012, with growth slowing down in 3Q Air-conditioner Haier is the third-largest air conditioner manufacturer in China, with a market share of 12% by volume in While air conditioner makes up 23% of revenue in FY2014, it has a high penetration in the 3rd and 4th tier markets, with 1,200 air conditioner specialty stores and 18,000 county stores. Despite growth during 2

4 Figure 6 Sales from Air-conditioner CNY bn 22.0 CNY bn % 80% 60% 40% 20% 0% Figure 7 Sales from ICS Source: Company Filings Figure 8 Revenue Breakdown by Product Lines Source: Company Filings Figure 9 Residential real estate Sales msm 1,500 1, Source: National Bureau of Statistics (PRC) Figure 10 Number of married couples mn Source: National Bureau of Statistics LTM LTM 11% 16% 16% 21% 20% 20% 13% 5% 11% 9% 5% 6% 7% 5% 3% 5% 7% 8% 18% 17% 17% 17% 17% 19% 18% 17% 19% 21% 23% 21% 36% 34% 32% 30% 28% 29% LTM RF AC WM WH EQ ICS % YTD Residential Gross Floor Area Sold (LHS) YoY Number of marriaged couple (LHS) 0 % FY , its air conditioner sales fell by 18.8% YoY in 1H Integrated Channel Services Under Haier Electronics, the fast-growing ICS business (4-year CAGR of 26.1%) serves as the distribution/logistics network in lower tier cities by offering one-stop supply chain services to Haier brands and third party brands. In 2013, Haier Electronics reached alliance with Alibaba to strengthen logistics cooperation with e-commerce platform Tmall. This can be a potential source of growth, but logistics sales from Tmall are still small, accounting for 1% of total revenue. Further considering the low margin nature of the logistic business (4.8% GPM in 1H2015), we are not optimistic about its effect on Haier s bottom line. 2. Management and Governance Haier has a dedicated management team that has been continuously driving the company s success. Being with Haier for >30 years, Zhang has turned the small factory with a loss of CNY 1.5m into the world s leading white good manufacturer. Zhang is one of the most charismatic leaders in China. He received the "Ideas into Practice" award and was selected into the 2015 Thinkers50 ranking. Known as the "Oscars of Management Thinking", the Thinkers50 rankings are admired globally for its objectivity, and have recognized Zhang of his management methods. Obsessed with the belief in high-value products, Zhang insists Haier always adhere to the "only value of war, not price war" principle. While we respect his belief, we deem such strategy as a potential risk, given the increasingly competitive market. In particular, the sector is one in which customers have homogeneous demands, and are price sensitive. Being excessively tenacious of " high-end market" can pose threat when it shows sign of losing to low-end markets. Haier delivers best practices in corporate governance. The company was awarded the Best Internal Governance Award by National Business Daily, and Annual Information Disclosure Award by Shanghai Stock Exchange. In addition, we evaluated Haier s quality of governance in three main facets: Committees - Established Audit, Risk, Compensation, Nomination and Governance Committees to oversee company operations. Shareholder Rights - Ensures shareholders enjoy equal rights; decisions regarding equity incentive plan, director appointments, and share repurchase are made based on the results of open voting. Fairness - Hired lawyers with securities qualification to attend the shareholders' meeting to witness. 3. Industry Overview and Competitive Positioning 3.1. Key-drivers are trending down, the growth potential is limited The residential real estate sector is a key driver for the white goods industry, as people almost always purchase new appliances when they move into a new apartment. Driven by the relaxation of property control, we see a recent pick-up in the property market, which underperformed in We believe this is a short term factor and the property market is expected to keep slowing down in the future, driven by the descending growth rate of real estate investment amount. 3

5 100 Figure 11 Market Size of refrigerator sector (Sales Value) Source: CMM Figure 12 Market Shares in refrigerator sector (Sales Value, 2015 Sep) Source: CMM Figure 13 Expected growth rate in washing machine sector from Source: CMM, EUROMONITOR Figure 14 Market Shares in washing machine sector (Sales Value, 2015 Sep) Source: CMM Figure 15 Domestic air conditioner market size (Sales Value) Source: CMM Oct RF Amount (CMM, CNY bn) 2.35% 4.33% 1.14% 9.94% 8.00% 27.02% 9.76% 12.01% Haier Siemens Midea Meiling Rongsheng Frestec Hisense Homa 5.00% 4.00% 3.00% 2.00% % 4.20% 3.80% CAGR=3.6% 40% 20% 0% -20% YoY 3.50% 3.10% 2.80% 2015E 2016E 2017E 2018E 2019E 2020E 5.02% 1.47% 6.06% 13.67% Haier Panasonic Siemens Whirlpool % 7.78% % 20.60% 109 Midea & Little Swan SANYO LG Samsung AC Amount (CMM, CNY bn) 40% 20% 0% -20% YoY Besides, new married couples are a huge source of demand, as they have higher tendency to purchase a new set when they start to live together. According to Euromonitor, newly registered married couples peaked at 13.5mm in 2013, and recorded a YoY growth of -3.0% in This signals the demographic change, which will eventually result in a growth friction to white goods Business Segment Overview Refrigerator Sector According to CMM, retail sales of refrigeration appliances in China encountered a further decrease of -9.57% (sales volume) in 2014, reaching only 31.3 million units. Weaker demand is due to the end of government subsidy policy, consumer s sluggish demand and the slowing down of real estate market. We believe the refrigerator sector has become mature, as the sales volume only achieves 5 years CAGR of 1.40%. Looking forward, the industry is driven by replacement demand from existing owners, with their better living standards and rising disposable incomes. As the penetration of refrigeration is high in both urban and rural regions, the Subsidy Policy in has already exhausted the future demands. Given the weak performance of real estate market, we project a 3% CAGR for the market size of refrigerators over next 5 years. Within the competitive landscape, Haier retained its leading position in refrigerator sector with a steady market share of 27-30% (sales value), thanks to well-known brand reputation, as well as innovative new launches, while Siemens, Midea and Meiling remain the second-tier in the refrigerator sector, accounting for 12.01%, 9.76% and 8.00% market shares respectively Washing Machine Sector In 2014, the volume growth rate of washing machine is 0.8%, while sales growth rate is 3.6%. The moderate growth rate in sales is driven by consumer s desire for product upgrade, which leads to increasing ASP in washing machine. Overall, the washing machine penetration rate has reached 76%. Penetration rate is 98% in urban area and 53% in rural area. A huge part of demand in rural area is overdrawn by previous subsidies policy. In future, replacement demand driven by product upgrade in urban area and new purchase demand in rural area driven by urbanization rate will be the key driver for washing machines. Real estate sales will be a weak driver, but not as strong as it used to be. In the future, there are mainly two trends in the industry: firstly, more diversified products/skus are needed to meet the demand of consumer. Secondly, online sale is growing rapidly and has become a key driver. Online sales have substitution effect for offline sales, but contributes positive outcome for the whole industry. While low and middle end products are popular in online sales, the low and middle end products are expected to take up more market share. As for the competitive landscape, market concentration is high in washing machine sector. Competition in top 10 brands is fierce. High-end foreign brands, such as Siemens and Samsung, enjoy a high market presence in tier-1/2 cities and are well-known for their high quality, but they have huge disadvantages in distribution networks. They are taking market shares from domestic brands, leveraging online sales channel. We will see market shares of Siemens and Samsung continue to increase, while Sanyo and Panasonic to decrease. 4

6 Figure 16 Competitive landscape in air conditioner (Sales Value, 2015 Sep) Source: CMM Figure 17 Ownership in urban regions % 3.1% 4.1% 16.7% 31.0% 12.2% 25.0% Gree Midea Haier Aux Group Chigo Hisense Kelong Others (per 100 households) Source: National Bureau of Statistics Figure 18 Ownership in rural regions 0 Air Conditioner Refrigerator (per 100 households) Washing Machine Source: National Bureau of Statistics Figure 19 Ownership in different dimension (per 100 households, 2013) Washing Machine Air Conditioner Refrigerator Air Conditioner Refrigerator Washing Machine Source: National Bureau of Statistics Midea and Littleswan has become No.1 in sales volume and have shortened the difference in sales value Air Conditioner Sector The residential air conditioner market in China has grown at a CAGR of 13% from 2009 to The sector growth is expected to slow but should remain at no less than mid-single-digit in the coming 3-5 years as urbanization in China continues. In 2014, urbanization rate in China was 55%, compared with over 80% in most developed countries. However, the industry is suffering from excess inventory due to the cold summer in 2015 and weaker channel management, resulting in higher channel inventory. Inventory is expected to be cleared by mid In terms of penetration, China currently averages >120 air conditioner per 100 urban households, compared with >200 in most developed countries. In rural areas in China, there are only 25 air conditioners per 100 households. Rural households are likely to purchase air conditioners given the fast-improving living standards. Moreover, Chinese households are used to installing air conditioners in every room, further increasing the penetration rate for air conditioners. Replacement demand, which accounts for 41% of total demand, will also be resilient. According to Euromonitor, the replacement cycle for air conditioners is 6 years, comparing to 10 years and 11 years in refrigerators and washing machines. So, the replacement demand is stronger in the air conditioner sector. In terms of competitive landscape, the air conditioner sector is rather concentrated, with top 3 players (Gree, Midea and Haier) taking ~70% of the market. Gree is the dominant brand, with the lion's share of value at 31%. Haier is ranked no.3, with a share of 12%. The competitions in the air conditioner sector, as we believe, will become fiercer, because smaller players are aggressively employing a strategy to catch customers needs. Also, in order to meet consumers needs for energy conservation and environment protection, energy-saving products become the focus of new product development Air conditioner sector becomes the next driving force Limited space for further penetration in refrigerator and washing machine sectors, yet air conditioner sector becomes the next driving force. In the past 14 years, market penetration rates have been primarily driven by the growth of rural regions, as well as the air conditioner sector in urban regions. We believe that the Rural Subsidy Policy in has already exhausted the future incremental demands for refrigerators and washing machines in China s rural regions. In 2013, ownership per household for refrigerator and washing machine in urban areas reached 80% and 91% of Japan s level, which represents the level for mature markets. Meanwhile, the air conditioner sector lags behind and there remains plenty of space for future penetration. Specifically, the ownerships of refrigerator, washing machine and air conditioner in first-tier provinces have been on the verge of Japan s level, so we expect the majority of future demands will be mainly from low-to-mid-end market. With the downtrend in real estate cycle and transformation of demand structure (from penetration to replacement), the white goods industry is shifting from golden period to mature period. Going forward, the industry will experience more intense competitive landscape and diminishing sale effect. 5

7 Figure 20 Market shares according to 40% 30% 20% 10% 0% sales amount Source: CMM, THOMSON ONE Figure 21 Market shares according to 40% 30% 20% 10% 0% sales volume Source: CMM, THOMSON ONE Figure 22 Forbes Mass affluent class population Source: Forbes China Figure 23 Number average selling price 0% -4% -8% -12% (Sep) Haier Panasonic Siemens for air-conditioner players (2015) Source: CMM Midea & Little Swan SANYO (Sep) Haier Midea & Little Swan Panasonic SANYO 11.2% % 16.6% 15.9% % 16% 10.1% 12% 8% 4% 0% Mass affluent class Growth rate Mar Apr May Jun Jul Aug Sep % -5.20% Total Midea -1.90% -5.10% -0.50% -0.20% -1.60% Gree Haier 4. Investment Summary 4.1. Washing Machines: Haier s Leading Position is threaten Low end markets: challenged by Media & Littleswan In washing machine sector, Haier is losing market share significantly (value:-3.4%; volume: -5.3%) since 2012, while Midea & Littleswan have gained total market shares of 3.37% from 17.23% in 2012 to 20.60% in 2015 (YTD, in sales value, 19.73% to 24.65% for sales volume). Haier has two star models in low-end market: M1268/M1269 series ranging from 899 to 1198 and Z2WH/M2WH series ranging from 999 to 1599, but it seems that these two models are not enough to meet the demand of picky clients. Littleswan covers , , , with 4 models. Midea covers ,798, with 3 models. These are all very popular models in low-end market and provide customers with more options. Haier s market position is challenged by model sea strategy and double branding strategy of M&L. We believe the passive situation for Haier in low-end market will continue unless Haier puts more models into the market. Table 1 Low end models for Haier, Midea & Littleswam Brand Haier Haier Midea Midea Midea Littleswan Littleswan Littleswan Littleswan Model M1268/9 Z/M2WH V1010H V3006G Eco11W V H V1059/(H) easy60w Capacity (L) Price Range Source: CMM, EUROMONITOR, THOMSON ONE, company filings Limited high end market for Casarte Total white goods consumption is CNY billion, which is 0.93% of total national consumption CNY 32,831 billion. Based on these numbers, we assume 1% of income will be used on buying white goods. The lowest selling price for Casarte seires is CNY 5,000, indicating only household with annual income 500,000+ will consider buying Casarte. According to CHFS (Chinese Household Financial Survey), for the richest 1% households (4.3 million households), their average annual income is CNY 494,322, very close to CNY 500,000. Assuming that 100% of them are buying Casarte, implied annual average sales for Casarte is CNY 21.5 billion. According to Forbes China, the growth rate of mass affluent class (invesfigure funds more than CNY 600,000) has already dropped to 10%, which is still much higher than GDP growth rate + CPI. Based on the estimation above, we believe that growth rate for Casarte will drop to 10% or even lower in 3 years Air Conditioner: Price War is Stealing Haier s Market Share Major players in white goods sector have started fierce price war Since 2015H1, major players including Gree and Media started a price war, lowering their ASP so as to quickly clear their inventories. In the meantime, the discounts and promotions also helped them boost market shares and expand distribution channels, which are the key success factors for a manufacturer in a saturated market like white goods Market share remains the key to win In such a matured market with volume steadily growing at 3.1% CAGR since 2011, manufacturers revenue and net income growths are mainly driven by their 6

8 Figure 24 Market share has dropped 2.53% since 2015 Feb 13% 12.93% losing 2.53% market 12.26% 12.05% 11.81% 12% 11.49% 11% 10% 9% Source: CMM, EUROMONITOR Figure 25 Haier s lower than expected air conditioner revenue in 2015H1 0.00% -5.00% % % % Haier % Source: Company Filings Figure 26 China air conditioner market size (CNY bn) Source: CMM, THOMSON ONE Figure 27 Central air conditioner market share 10.97% 10.74% 10.58% Industry -4.68% Central AC Others 26% Trane 3% Haier 4% Carrier 4% McQuay 5% York 6% Hisense Hitachi 8% Residential AC Gree 18% Dakin 13% Midea 13% Source: Euromonitor, THOMSON ONE market shares, due to the following three reasons: Branding effect and consumer behavior - With its market share losing in the price war and the lack of effective marketing, Haier s air conditioner business is severely suffering from brand crises stirred by losing market share. Control over distributors - With a larger market share, a manufacturer can effectively lift inventory turnover rate, which can either attract more distributors or have the power to lower rebates, both help with the company s overall profitability. Take Gree as an example, thanks to the largest market share, they are capable of returning 5~6 bps without upfront discounts to distributors. Economies of scale - Large-share manufacturer benefit from lower raw material prices, efficient management model and usage of fixed costs, and broader labor educations, hence enjoying a lower per unit cost of goods sold Haier s strategy will push it to the dead end Haier s management follows a long standing strategy of not participating in price wars of any kind. As its CEO, Zhang Ruimin, once publicly stated, Haier has always insisted on not participating in price wars, but only value wars. In the air conditioner sector, Haier lost 1.67% share during the first 8 months of 2015, whilst that of Gree surged by 8.96%. This has led to its underperformance in 2015, and greatly damaged its shareholder value, no matter how Zhang applauds their strategy of protecting the margin. In the air conditioner market, the lost market share is hard to grasp back for Haier, due to the following two reasons: - Value and services mindset - Haier insists on not participating in price war, as they are committed to providing value and services to customers. - Zero-inventory business model - Without any inventory in advance, it is hard for Haier to quickly boost outputs to take part in price wars. Evidence has shown that in the latest quarter, after major price reduction in March and April, Haier has been gradually recovering its price since June. The little discount in the peak season in July is resulted from a lack of capability to produce more air conditioners within such short-term. Based upon our analysis, we believe Haier s mistaken strategy made itself losing market share in air-conditioner, which is quite hard to gain back Air Conditioner: Weak position in central air conditioner drags the segment down Central air conditioner market is the future focus of growth The central air conditioner market is a higher growing and more fragmented sector comparing to residential air conditioner, with multiple foreign players such as Dakin and York taking large shares due to the higher entry barrier, having grown at a CAGR of 15.7% from 2009 to Due to higher complexity and stability requirements, central air conditioner sector also has a higher gross margin (30-40%), compared with residential air conditioner s 15%-30%. In 2014, the central air conditioner market size in China was CNY71bn, compared with the residential air conditioner market of CNY145bn. Central air conditioner will continue to grow quickly in coming years as China is on its way to roll out more infrastructure projects and commercial facilities to maintain its GDP growth and these will be the main drivers for central air conditioner demand. 7

9 Figure 28 Domestic central air conditioner market share 65% 62% 61% 57% 55% 53% 50% 47% 44% 7% 9% 9% 9% 11% 10% 11% 12% 13% 16% 15% 16% 17% 17% 14% 14% 14% 13% 5% 5% 3% 3% 2% 4% 3% 4% 4% 5% 6% 7% 10% 11% 14% 16% 17% 18% Gree Midea Dakin Hisense Hitachi Haier Others Source: Euromonitor, THOMSON ONE Figure 29 Selected technological advance of competitors Selected technological advance 2015 Gree s million-kilowatt centrifugal chiller broke foreign monopoly 2012 Midea and Carrier agreed to form JV in India 2011 Midea introduced full DC inverter air conditioner, with energy efficiency up to Gree launched the world s first super high efficiency centrifugal chiller 2010 Midea rolled out the first three-control air conditioner 2009 Midea introduced Carrier s DC inverter to best-selling model MDV Gree developed DC inverter air conditioner, breaking JPN s tech monopoly 2005 Gree developed world's first ultra-low temperature digital air conditioner 2002 Gree developed GMV digital multi-connected air conditioner Source: Company Filings Table 2 FCFF Prediction (CNY million) FY 2015E FY 2016E FY 2017E EBIT 4,980 4,458 4,203 -Tax D&A 1,164 1,119 1,128 - WC Capex -2,527-2,665-2,802 FCFF 2,014 2,047 1,759 (CNY million) FY 2018E FY 2019E FY 2020E EBIT 4,370 4,952 6,025 -Tax ,048 + D&A 1,274 1,428 1,589 - WC Capex -2,970-3,150-3,319 FCFF 1,967 2,502 3,480 Table 3 WACC WACC Rf 3.0% Rm 6.5% Beta 1.03 Rd 4.9% D/(E+D) 10% Tax Rate 17.0% WACC 9.2% Table 4 Target Price (CNY million) PV of FCF 10, PV of TV 31, Enterprise Value 42, TV as a % of EV 75% - Minority Interest -9, Totel Debt -2, Excess Cash 24, Equity Value 55, Outstanding Shares 6, Target Price: 9.11 Applying the average area of commercial construction completed / central market size multiple, which historically ranges from x, we estimate the market size of central air conditioner in China will grow to CNY150.1bn by 2019, implying a CAGR of 16.3% vs.7.1% for residential air conditioner by Euromonitor Despite market growth, Haier is losing this pie, now and forever There is a clear trend of domestic manufacturers taking shares from foreign players, as the quality of domestic products have been improving to reach the international standard. Gree, by surpassing Daikin in central air conditioner market in China in 2012, takes the largest share, driven by its strong brand and quality products. Midea, on the other hand, surpassed Daikin as well in the 1H2015, becoming the second player. By contrast, as the first to enter the market, Haier (1996) has been thrown far off by Gree (2003) and Midea (2002). The main engines of central air conditioner systems is the technical barrier for most domestic players, thus the Big 4, McQuay, Trane, Carrier and York control 70% of the world s central air conditioner market. In recent years, investing heavily in technology have made Gree and Midea s counterattacks against the foreign players very successful. Yet, we do not see Haier making a move. The lost market share will further weaken Haier s future market position in air-conditioner sector, and as with the negative impact on the potential revenue growth in the air-conditioner market, which is the largest white-good market. 5. Valuation Target Price: CNY 9.11/Share Recommendation: Sell We value Haier based on discounted cash flow analysis and multiples of comparable firms. DCF incorporates our key assumptions, including slow growing industry, declining market share, improving gross margin and increasing selling expense. Public company multiples reflect the current market s opinions of future growth of similar companies DCF Analysis In DCF analysis, we make detailed income statement and cash flow projections until 2020, and then we apply the perpetual growth to compute its terminal value. We calculate the implied EV/EBITDA multiple and benchmark with comparable companies to justify our assumptions. FCFF predictions are shown in Table 2. Key assumptions and key considerations include (For detailed assumption, please refer to Appendix 2 DCF Valuation Assumptions): Revenue: Estimated by breaking down Haier s business into different business lines. The change of market share is in line with our prior analysis on Haier s competitive positioning in air conditioner and washing machine sectors. Casarte s sales is estimated separately to evaluate its impact. Gross Margin: A slight increase due to Casarte s growth and KKR s participation Operating Margin: Selling expense as a percentage of revenue increases to open market for Carsarte. General and administration expense is assumed to be 7% of revenue, in line with historical proportion. CAPEX and Operating Working Capital: The percentages of revenue are the same as historical average level. Terminal Value: We incorporate a 2% terminal growth rate, implying an exit 8

10 Upside/Downside -8% Upside/Downside After adjustment -14% Table 5 Sensitivity Analysis EV/EBITDA of 8.4x. WACC: shown as Table 3. Risk free rate comes from YTM of 10 year government bond. Beta comes from the historical performance of Qingdao Haier s stock relative to SHSZ market index Comparable Valuation Using Multiples Although there are many players in the white goods industry, there are a few with similar size and comparable market position as Haier s. Therefore, we exclude small players with revenues less than CNY 10bn. The multiples for comparable companies are as below: Table 6 Selected Comparable Multiples Company Mkt cap EV P/E(X) P/SALES (X) Name (CNY mn) (CNY mn) 15E 16E 15E 16E A-Share Listed Media Group 120, , x 8.3x 0.8x 0.8x Gree 111,832 49, x 7.2x 0.9x 0.9x Hisense 22,506 21, x 13.9x 0.7x 0.7x Hisense Kelon 9,678 12, x 17.8x 0.4x 0.4x Little Swan 12,686 11, x 11.3x 1.0x 0.8x Meiling 5,432 6, x 15.0x 0.5x 0.5x Mean 15.1x 13.3x 0.7x 0.8x Haier (Adj.) 64,994 64, x 12.0x 0.8x 0.7x Haier 60,742 59, x 11.3x 0.7x 0.6x When applying our estimates of Net Income and Sales for FY2015 and FY 2016 to trading multiples, we conclude with a valuation range of CNY /Share Target Price Our target price is 9.11 CNY/Share, which combines comprehensive valuation methods we have discussed above. Valuation ranges given by different assumptions as shown in the sensitivity analysis in Figure 33. Figure 30 Residential real estate sales and white good sales YTD Residential real estate Sales (YoY%) YTD China White Goods Sales (YoY%) Source: National Bureau of Statistics 6. Investment Risks 6.1. Economics Risks As we can see from Figure 30, residential real estate sales act as a strong leading driver of white goods sales (approximately leading by 3 months). If there is a stronger-than-expected growth in sales volume of Chinese real estate market, it might induce an increasing incremental demand of white goods and thus provides augmented spaces for Haier to achieve revenue growth Market Risks Figure 31 Scenario Analysis Management of Haier may react to the competition rapidly, by focusing more on the low-to-middle-end market, thus the market share of Haier may fall less significantly. The revenue growth of Caserte may be faster than expectation Merger and acquisition The parent company of Qingdao Haier, Haier Group, has acquired overseas white goods assets, boosting the valuation Scenario Analysis In order to check the robustness of DCF model, we conduct a scenario analysis by setting up three upside scenario and two down side scenarios as Figure 31. By incorporating all these factors, we can achieve the adjusted price range. The estimated price in the bull-case scenario is still lower than the current 9

11 market (CNY 9.92) and adjusted current market price (CNY 10.61). Therefore, we reaffirm our sell recommendation on Qingdao Haier. Table 7 Financials History Forecast Financial Analysis 2013A 2014A 2015E 2016E Profitability Gross Margin 23.6% 25.2% 25.3% 27.5% EBITDA Margin 7.6% 7.8% 4.5% 3.8% EBIT Margin 6.6% 7.6% 8.6% 5.9% Net Margin 6.4% 7.5% 5.4% 4.6% Return on Assets 11.8% 11.2% 6.7% 5.9% Return on Equity 57.8% 44.8% 27.8% 24.5% Liquidity Current Ratio Quick Ratio Cash Ratio Operation Days Reiceivable Outstdg Days Sales of Inventory Total Assets Turnover Financial Leverage Liability to Equity Asset to Equity Interest Coverage Table 8 Financials (Cont d) Forecast 2017E 2018E 2019E 2020E Profitability Gross Margin 27.4% 27.5% 27.5% 27.4% EBITDA Margin 3.3% 3.1% 3.4% 4.0% EBIT Margin 5.0% 4.5% 4.4% 4.7% Net Margin 4.2% 4.1% 4.4% 5.0% Return on Assets 5.3% 5.2% 5.6% 6.4% Return on Equity 22.8% 23.1% 24.7% 27.7% Liquidity Current Ratio Quick Ratio Cash Ratio Operation Days Reiceivable Outstdg Days Sales of Inventory Total Assets Turnover Financial Leverage Liability to Equity Asset to Equity Interest Coverage Shareholder Dividend Payout Ratio 30.6% 30.6% 30.6% 30.6% 7. Financial Analysis Consumption Upgrade Consumption upgrade in China is key driver for increasing gross margin, as a result of higher per capita disposable income in both urban and rural areas. This trend has experienced rapid development during 14-15, which also contributed to the raise in unit prices. With the accelerated pace of life, home appliances with stronger capacity and more functionalities are gaining increasing popularity Increasing Market Competition We will see major players continue to gain markets share from minor players. Home appliance is a traditional manufacturing industry where there is a strong effect of scale of economy. Larger market shares represent lower cost of goods and higher supply chain bargaining power. Based on our analysis, Haier is losing market shares in both air conditioner and washing machine markets, thus we will see a decrease in its EBITDA margin and net profits. This is mainly due to higher R&D expense and commission fee to promote high end products. We expected EBITDA margin drop to 3.1% in 2018E from 4.5% in 2015E and then rebound to 4% in 2020E driven by larger contribution from high profits Casarte products Stable Operation Haier is experiencing organizational transformation towards a flatter management structure. However, KKR is helping on cost saving projects. In general, the operations will maintain stable, and historical data is also supporting this statement. We expect days of receivable outstanding, of sales of inventories, and total assets turnover to keep at 21.8 days, 42.9 days and Cash cow Haier s business is generating strong cash flow, despite deteriorating profitability. The CFO is enough to cover capital expenditure, increase in net working capital, as well as investment activities. And it is also contributing to the cash balance after about 30% of dividend payout ratio. As a result, we will see the cash balance increase to CNY 38 billion in 2020E from 29 billion in 2014A under the circumstances where no long-term debt is issued and all short-term is paid back DuPont Analysis Based on our analysis on 2015Q3 financial report, we expected ROE drop to 27.8% in 2015E from 44.8% in 2014A and 57.8%, as a result of deleveraging and worse profitability combined. We expect the decline trend in ROE to continue, but in a lower rate, from 27.8% in 2015E to 22.8% in 2017E and then back to 27.7% driven by rebound in profitability. The equity multiplier is 2.05, 1.58 and 1.24 in 13A/14A/15E respectively, which explains about 40% decrease in ROE. The net margin is 6.4%, 7.5% and 5.4% in 13A/14A/15E, which explains 15% decrease. 10

12 Appendix 1. Detailed Investment Highlights 1.1. Washing Machines: Haier s Leading Position is threaten Midea & Littleswan is surpassing Haier, especially in low end market In washing machine sector, Haier is losing market share significantly (value:-3.4%; volume: -5.3%) since 2012, while Midea & Littleswan have gained total market shares of 3.37% from 17.23% in 2012 to 20.60% in 2015 (YTD, in sales value, 19.73% to 24.65% for sales volume). It is claimed that the difference between the growth rates of value and volume is due to Haier s product upgrades, but more importantly, there s no doubt that that Haier fails to maintain its market share in low end markets. We believe that Midea and Little Swan (M&L) will surpass Haier to become the top leader in the washing machine sector, as they have developed a full spectrum of models that better meet market demands (by their double-branding strategies and by focusing on product quality since 2013) Figure 32: Market shares according to sales amount (LHS) and sales volumes (RHS) 35% 30% 25% 20% 15% 10% 5% \ 35% 30% 25% 20% 15% 10% 5% 0% (Sep) 0% (Sep) Haier Panasonic Siemens Midea & Little Swan SANYO Haier Panasonic Siemens Midea & Little Swan SANYO Source: CMM, EUROMONITOR, THOMSON ONE, company filings Low end markets: challenged by Media & Littleswan In the low end market, Haier is being challenged by model sea and double brands of Media & Littleswan. Haier has two star models in low end market: M1268/M1269 series ranging from 899 to 1198 and Z2WH/M2WH series ranging from 999 to But it seems that these two models are not enough to meet the demand of picky clients. We list as below other popular models of Midea & Littleswan from micro data on retail channels. Littleswan covers , , , with 4 models. Midea covers ,798, with 3 models. These are all very popular models in low end market and provides customers with more options. Haier s market position is challenged by model sea strategy and double branding strategy of M&L. We believe that the passive situation for Haier in low end market will continue unless Haier puts more models into the market. Table 9: Low end models for Haier, Midea & Littleswan Brand Haier Haier Midea Midea Midea Littleswan Littleswan Littleswan Littleswan Model M1268/9 Z/M2WH V1010H V3006G Eco11W V H V1059/(H) easy60w Capacity (L) Price Range Source: official website 11

13 Haier is losing in low end market Seeing from micro data from retail channels and online channels, we deduct Haier is losing in low end market. We manually collected data of the weekly top 10 bestseller for washing machine starting from 2014 by AVC, which monitors 5,250 home appliance stores across 1,018 cities and counties. The data show the brands, prices, rankings, market shares and model types of each bestseller. With the data of 82 weeks, representing a total market share of 15.1%, we can get an idea of the competition between the leading players, especially Haier, Midea & Little Swan. In the low end market (below 1500), the difference between Haier and Midea & Littleswan narrowed down significantly in 2014, and the difference basically disappears in Midea & Littleswan has already dominated the market below 1000 in our top 10 bestseller list. So, faced with cut-throat competitions from Midea and Little Swan, Haier s shares in the low end washing machine market are shrinking severely. Figure 33: Market Share in Top 10 Bestsellers Figure 34: Market Share in Top 10 Bestsellers below % 5.0% 8.0% 4.0% 6.0% 3.0% 4.0% 2.0% 2.0% 1.0% 0.0% Haier Midea & Little Swan 0.0% Haier Midea & Little Swan Source: CMM, EUROMONITOR We also collected data of recent monthly sales volume of washing machines from tmall official store of Haier, Media, Littleswan and Siemens. We filters out models of sales volume <500/m. The data includes monthly sales, branding, and other detailed information on models. The data indicates that Midea & Littleswan do surpass Haier in low end market, even though Haier ranks 1 st in tmall home appliance category at tmall. Considering customers of online channels are more sensitive to the price. We believe that Midea and Littleswan have established an image of low price and high quality. Given the fact that online sales are growing rapidly, we are quite conservative about Haier s performance on low end market. Figure 35: Monthly Sales Volume for selected brands Figure 36: Monthly Sales Volume Share for selected brands 100% 80% 60% 40% 20% 0% Haier Midea & Littleswan Galanz Siemens Haier Midea & Littleswan Galanz Siemens Source: Manually collected from tmall.com 12

14 Mid-high end markets are dominated by foreign brands We also collected data from suning.com. For the sales volume is not available on suning.com, we use number of comments as a proxy for sales volume, which follows the formula: number of comments = sales volume * comment rate. Big number of comments indicates either stronger sales volume or higher participation rate. For the analysis is focused on mid-high end market, we filter out models of price <3500. Brands include Beko, Bosch, Casarte, Daewoo, Electrolux, Haier, LG, Littleswan, Midea, Panasonic, Samsung, Sanyo, Siemens, Whirlpool and other brands available on suning. As the data indicates, in mid-high end market, Haier and Casarte are not performing as well as it claims to be. Overall, Haier is weaker than LG and Siemens & Bosch in mid-high end market. If we exclude , Haier is even weaker than Samsung. This is consistent with our on-site visits to several home appliance stores in Beijing. Our survey shows that mid-high end customers prefer foreign brands for their high quality and brand premium. We believe that it is difficult for Haier to acquire more market shares in mid-high end market, faced with fierce competitions from LG, Samsung, Siemens & Bosch and other foreign brands. We are conservative about how much Haier could benefit from the so-called product upgrade, especially in the mid-high end market. Figure 37: Cumulative Volume for products above 3500 Figure 38: Cumulative Percentage for products above % 80% 60% 40% 20% 0% Haier Casarte Midea & Littleswan Others Panasonic Whirlpool Sanyo Samsung Siemens & Bosch LG Source: Manually collected from suning.com Haier Casarte Midea & Littleswan Others Panasonic Whirlpool Sanyo Samsung Siemens & Bosch LG Limited high end market for Casarte Total sales for air conditioner, Refrigerator and washing machine are CNY billion, 89.4 billion and 57.6 billion respectively in Per capita white goods consumption capita is CNY 223, which is 1.11% of Per capita disposable income CNY 20,167 in Total white goods consumption is CNY billion, which is 0.93% of total national consumption CNY 32,831 billion. Based on these numbers, we assume 1% of income will be used on buying white goods. The lowest selling price for Casarte seires is CNY 5,000, indicating only household with annual income 500,000+ will consider buying Casarte. According to CHFS (Chinese Household Financial Survey), for the richest 1% households (4.3 million households), their average annual income is CNY 494,322, very close to CNY 500,000. Assuming that 100% of them are buying Casarte, implied annual average sales for Casarte is CNY 21.5 billion. 13

15 Figure 39: Forbes Mass affluent class population % % % 16.6% % % 16.0% 12.0% 8.0% Mass affluent class % Growth rate % Source: Forbes China Given the fact that Haier s 2015 sales estimate for Casarte is 10 billion, Haier s target to double sales of Casarte in 5 years, which implies 15% CAGR, seems almost impossible. According to Forbes China, the growth rate of mass affluent class (invesfigure funds more than CNY 600,000) has already dropped to 10%, which is still much higher than GDP growth rate + CPI. It is almost impossible that the growth rate of number of households with annual income more than CNY 500,000 will maintain at 10%, for there are only 4.3 million of them compared to 15 million mass affluent class. Based on the estimation above, we believe that growth rate for Casarte will drop to 10% or even lower in 3 years Air Conditioner: Price War is Stealing Haier s Market Share Since 2015H1, major players in white goods sector have started a fierce price war Since 2015H1, major players including Gree and Media started a price war, lowering their ASP so as to quickly clear their inventories. In the meantime, the discounts and promotions also helped them boost market shares and expand distribution channels, which are the key success factors for a manufacturer in a saturated market like white goods. In 2015, except for March, Midea has been lowering their ASP to the largest extent, especially in the last 3 months. At the same time, Haier s ASP even remained unchanged during high sales season (typically from June to August) Figure 40: Number Average selling price for air-conditioner players (2015) 0.00% Mar Apr May Jun Jul Aug Sep -0.50% -0.20% -4.00% -1.90% -1.60% Total Gree -5.20% -5.10% Midea -8.00% Haier % % Source: Forbes China 14

16 Market share remains the key for winning in the air conditioner market In such a matured market with volume steadily growing at 3.1% CAGR since 2011, manufacturers revenue and net income growths are mainly driven by their market shares, due to the following three reasons: Branding effect and consumer behavior - consumers are very scrupulous in choosing the brands for white goods, which are normally low-frequency consumption decisions, and very important without doubt. Market share hence serves as a positive signal to consumers, whose decisions are easily affected by the others. That being said, with its market share losing in the price war and the lack of effective marketing, Haier s air conditioner business is severely suffering from brand crises stirred by losing market share recently. Market share is what Haier, the globally largest white good producer, can t afford to lose. Control over distributors - distributors revenues comprise of two parts: inventory turnover rate and rebate. With a larger market share, a manufacturer can effectively lift inventory turnover rate, which can either attract more distributors or have the power to lower rebates to them, both of which help with the company s overall profitability. Take Gree as an example. In their offline channel, thanks to the largest market share, they are capable of returning 5~6 bps without upfront discounts to distributors. On the other hand, Haier, being the 3rd largest player in air conditioner, needs to provide 2~3bps upfront discounts and 4~5 bps return points to their distributors. Economies of scale - this is rather plain and easy to understand. Large-share manufacturer benefit from lower raw material prices, efficient management model and usage of fixed costs, and broader labor educations, hence enjoying a lower per unit cost of goods sold Haier s strategy to give its market share up will push it to the dead end Haier s management follows a long standing strategy of not participating in price wars of any kind. As its CEO, Zhang Ruimin, once publicly stated, Haier has always insisted on not participating in price wars, but only value wars. In fact, Haier s current switch to high-end and so-called high value products has made it hard to take part in price wars, because the two concepts are simply contradictory. The firm s DNA may have mutated to the point where it works against all of those worthy principles, particularly client-centricity. In the air conditioner sector, Haier lost 1.67% share during the first 8 months of 2015, whilst that of Gree surged by 8.96%. This has led to its underperformance in 2015, and greatly damaged its shareholder value, no matter how Zhang applauds their strategy of protecting the margin. The management believes Haier s products are worth the price, yet the fact that they are beginning to lose ground has mercilessly slapped them on the face. Figure 41: Market share has dropped 2.53% since 2015 Feb Figure 42: Haier s lower than expected air conditioner revenue in 2015H1 13% 12% 11% 12.93% losing 2.53% market share 12.26% 12.05% 11.81% 11.49% 10.97% 10.74% 10.58% 0.00% -5.00% % Haier Industry -4.68% 10% % 9% % % Source: CMM, EUROMONITOR, THOMSON ONE, company filings There is limited upside potential for Haier s participation in price war In the air conditioner market, the lost market share is hard to grasp back for Haier, due to the following two reasons: Value and services mindset - Haier insists on not participating in the air conditioner price war, as they are so committed 15