Asia Pacific Equity Research

07 September 2009

China Strategy
Where to find the next ten-baggers
Chinas past ten-baggers mostly in the manufacturing space: In the past 15 years of development in Chinas stock market, we have seen the price of many Chinese stocks, such as China Mobile (941 HK), Anhui Conch (914 HK), Lenovo (992 HK), and Sichuan Changhong Electric (600839 CH), go up by 10-15x. Most of these companies are in the manufacturing space, against the backdrop of China seizing the opportunity from WTO accession to develop itself into a global manufacturing giant over the past 15 years. Notably, these companies share prices shared one thing in commonthey booked significant gains during the period of low penetration and strong secular growth. Chinas future ten-baggers most likely to be in the consumer space: For long-term investors who can ride through the market volatility, we have identified a number of sectors with a low penetration rate and strong secular growth which may breed the next ten-baggers. Interestingly, all of these are consumer-related sectors, against the backdrop of Chinas mission of shifting its growth engine from fixedasset investment and manufacturing-dominated exports to domestic consumption. Four sectors likely to breed Chinas next ten-baggers: After screening different sectors for their penetration rate and growth potential, we identify four sectors with a low penetration rate and strong secular growth: internet, tissue and diaper, natural gas, and automobiles. We believe the leading companies in these sectors, such as Baidu/Netease/Alibaba, Hengan, Beijing Enterprise/Xinao Gas/Hongkong China Gas, and DongFeng Motor, will offer good long-term opportunities.
China: Top picks
Mkt cap Avg. daily EPS Y/Y growth (%) turnover (US$MM) (US$MM) 09E 10E 11,405 582.8 41.5 51.5 5,348 86.7 26.2 39.2 13,394 28.6 80.1 39.3 6,961 13.4 49.7 9.5 1,680 4.1 17.9 15.6 5,642 10.1 -4.9 16.9 15,485 14.2 12.7 -3.6 9,116 26.1 17.7 15.0 P/E (x) 09E 53.1 19.5 50.1 25.2 16.8 20.2 25.2 13.1 10E 35.0 14.0 36.0 23.0 14.6 17.3 26.1 11.4 P/BV (x) 09E 16.1 4.8 9.6 6.0 2.0 1.1 3.8 2.4 10E 10.5 3.5 7.4 5.6 1.7 1.1 3.5 2.0 ROE (%) 09E 37.2 28.5 21.5 27.3 12.6 5.8 15.2 20.2 10E 36.5 28.9 23.3 25.6 12.7 6.4 13.7 19.5 Div. yield (%) 09E 0.0 0.0 0.0 2.4 2.1 1.6 1.9 1.1 10E 0.0 0.0 0.0 2.7 2.4 1.9 2.1 1.5

China Frank Li
AC

(852) 2800-8511 frank.m.li@jpmorgan.com

Peng Chen
(852) 2800-8507 peng.p.chen@jpmorgan.com

Lan Deng
(852) 2800-8520 lan.x.deng@jpmorgan.com J.P. Morgan Securities (Asia Pacific) Limited

China: The sectors that still have low penetration rates

2006 Internet (users per capita) Tissue (Kg per capita) Natural gas (% of population) Automobile (vehicles per 1,000 persons) 2007 2008 US

10.3% 15.9% 22.4% 75.0% 2.5 6.3% 2.7 7.7% 2.95 23+

N/A 60%+

19.9

24.2

29.2 1200

Source: CEIC, J.P. Morgan.

Baidu.com Netease Alibaba.com Limited Hengan International Group Ltd Xinao Gas Beijing Enterprises Holdings Limited Hong Kong & China Gas DongFeng Motor Co., Ltd

Rec OW N N N OW OW N OW

Ticker BIDU US NTES US 1688.HK 1044.HK 2688.HK 0392.HK 0003.HK 0489.HK

Source: Bloomberg and J.P. Morgan estimates. Prices and valuations are as of 4 September 2009.

See page 17 for analyst certification and important disclosures, including non-US analyst disclosures.
J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Investment summary
Long-term investors are always looking for ten-baggers, with the aim of riding through market volatility with a portfolio of stocks that can rise multifold. In the past 15 years of development in Chinas stock market, we have seen the price of many Chinese stocks, such as China Mobile (941 HK), Anhui Conch (914 HK), Lenovo (992 HK), and Sichuan Changhong Electric (600839 CH), going up by 1015x. Most of these companies are in the manufacturing space, against the backdrop of China seizing the opportunity from WTO accession to develop itself into a global manufacturing giant over the past 15 years. Notably, these companies share prices shared one thing in commonthey booked significant gains during the period of low penetration and strong secular growth. For long-term investors who can ride through market volatility, we have identified a number of sectors with a low penetration rate and strong secular growth which may breed the next ten-baggers. Interestingly, are all consumer-related sectors, against the backdrop of Chinas mission of shifting its growth engine from fixed-asset investment and manufacturing-dominated exports to domestic consumption. Historical evidence suggests that investors will be rewarded if they manage to accumulate certain industry leaders when these companies expand their business rapidly in a low-penetration market and benefit from the strong secular growth. Whatever the market volatility, these stocks should be able to consistently outperform the market as long as there is a low penetration rate and strong secular growth. After our historical case study, we identify four sectors with a low penetration rate and strong secular growth: internet, tissue and diaper, natural gas, and automobiles. We believe the leading companies in the above sectors, such as Baidu/Netease/Alibaba, Hengan, Beijing Enterprise/Xinao Gas/Hong Kong China Gas, and DongFeng Motor, will offer good long-term opportunities.

Historical case study

Past experience suggests that investors would reap good returns if they could identify at an early stage an industry leader that enjoys very strong growth in a market with a low penetration rate. The investment case appears to be even stronger if the leader itself is an industry consolidator. The past 15 years of development in the Chinese stock market have given us plenty of examples, the three most persuasive of which are China Mobile (941 HK), Lenovo (992 HK), and Sichuan Changhong Electric (600839 CH). Their share prices all booked large gains during the periods in which they expanded their businesses rapidly in a low-penetration market. (1) China Mobile (941 HK) It can be seen that the mobile-phone penetration rate (in terms of the number of mobile-phone subscribers per capita) in China more than doubled from 2002 to 2006, as a result of a combination of rising household disposable income and falling handset costs in China. The penetration rate rose from a low level of 16% in 2002 to 36% by the end of 2006, surpassing the global average of 35.7% for the first time since this statistic became available.
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Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Being the market leader, China Mobile took advantage of the strong growth of mobile-phone users in China during these five years, expanding its customer base from 100 million subscribers in mid-2002 to break the 300 million subscriber milestone by the end of 2006, which translated into a 25% CAGR. On the back of this strong subscriber increase, China Mobiles revenue CAGR accelerated to an average of 25% in 2002-2006 from less than 16% in the previous five years. In addition, China Mobile managed to keep its net margin above 20% despite the expenditure on upgrading its national distribution network. Riding this trend of strong growth in a low-penetration market, China Mobile saw its share price rise over 500% from HK$22 in early 2002 to above HK$120 as of mid2007, outperforming H-shares by more than 60% during the time. This is even more notable if we take into consideration the large market cap of China Mobile. In June 2007, China Mobile surpassed HSBC, becoming the largest listed company by market value at the Hong Kong Stock Exchange.
Figure 1: Mobile-phone penetration rate in China and China mobiles revenue growth since 2002
%

Penetration rate more than doubled from 2002 40% 35% 30% 25% 20% 15% 10% 5% 0% to 2006 28% 16% 21% 23% 36% 31% 26% 21% 27% 25%

2002

2003

2004

2005

2006

Penetration rate of Mobile subscribers (mobile-phone subscriber per capita)

Source: CEIC, J.P. Morgan.

rev enue grow th for China mobile

Figure 2: China Mobiles subscribers from 2001 to 2006

Million persons

350 300 250 200 150 100 50 0

301.2 246.7 136.6 166.1 204.3

104.4

2001

2002

2003

2004

2005

2006

The number of China Mobile's subscribers

Source: J.P. Morgan telecoms team.

Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Table 1: China Mobile kept its net margin above 20% in 2002-2006
China Mobile NP margin
Source: Company data.

2002 25%

2003 22%

2004 22%

2005 22%

2006 22%

Figure 3: China Mobile and H - shares performance in the past 10 years

160 140 120 100 80 60 40 20 0 D ec /01 D ec /02 D ec /03 D ec /04 D ec /05 D ec /06 D ec /07 D ec /08 Apr/02 Apr/03 Apr/04 Apr/05 Apr/06 Apr/07 Apr/08 Aug/02 Aug/03 Aug/04 Aug/05 Aug/06 Aug/07 Aug/08 Apr/09

China mobile surged more than 5 times from early 2002 to 2007, outperformming H-shares by over 60% during the period.

8000 7000 6000 5000 4000 3000 2000 1000 0

CHINA MOBILE LTD (LHS)

Source: Bloomberg.

HSCEI INDEX (RHS)

(2) Lenovo (992 HK) The computer penetration rate in China (in terms of possession of computer per household) experienced a dramatic increase from 1998 to 2002, from 3.8% in 1998 to 20.6% in 2002, boosted by the first computer boom in China, which arose from increasing household wealth and city dwellers realization of the importance of computers. The low computer penetration and the subsequent boom in computer demand in China provided a golden opportunity for Lenovo, the biggest domestic PC producer and service provider, to make a foray into the personal computer business and boost its revenue. From 1998 to 2002, Lenovo had achieved a CAGR of 50% in its revenue, and strengthened its dominant profile in China, with its market share increasing from low teens to over 20% by the end of 2002. This significant business expansion helped Lenovos share price rise to HK$12 in early 2000 from less than HK$1 in 1998. While the burst of the tech bubble snapped this remarkable two-year rally and sent the price down by the end of 2002, Lenovo still outperformed H shares by a sizeable margin of more than 500% in the period from 1998 to 2002, giving a significant return to investors who had identified this opportunity in Chinas computer sector at its low-penetration-and-strong-seculargrowth stage.

Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Figure 4: Computer penetration rate in China and Lenovos revenue growth from 1998 to 2005
60.0 50.0 40.0 30.0 20.0 10.0 1998 1999 2000 2001 2002 2003 2004 2005 Possession of computer per 100 Urban Household (LHS)
Source: CEIC, J.P. Morgan.

107%

Penetration rate rose from 3.8% to 20.6% from 98% 50% 1998 to 2002 56% 27.8 20.6 9.4 13.0 -23% -3% 41.5 33.1 15% -3%

125% 100% 75% 50% 25% 0% -25% -50%

3.8

5.9

rev enue grow th for Lenov o (RHS)

Figure 5: Lenovos and H shares performance in 1998-2002

16 14 12 10 8 6 4 2 0 Aug/93 Aug/94

Lenov o

H share

10000 8000 6000 4000 2000 0

Aug/95

Aug/96

Aug/97

Aug/98

Aug/99

Aug/00

Aug/01

Source: Bloomberg.

(3) Sichuan Changhong Electric (600839 CH) Similar to the above two examples, the share price of Sichuan Changhong, the Ashare listed TV producer, rose more then 10x from Rmb2 in early 1995 to over Rmb25 by mid-1997. The low penetration in Chinas color TV sector and resultant strong secular growth for color TV producers was the decisive factor in Sichuan Changhongs stellar performance during that period, in our view. From the chart below, it can be seen that color TVs penetration rate among Chinas urban households rose from a low level of 14.3% per urban household in 1993 to 35.9% in 1999, reflecting the strong demand for color TV along with urban households rising wealth and appetite for a higher quality of life. Benefiting from this strong secular growth, Sichuan Changhong Electric was able to raise its revenue notably from 1994 to 1997.

Aug/02
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Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Figure 6: Color TV sectors penetration rate in urban China and Sichuan Changhongs revenue growth from 1998 to 2000
40.0% 63% 57% 49% 39% 20% 14.3% 19% 19.5% 14.6% 17.3% 7% 10.0% -13% 0.0% 1992 1993 1994 1995 1996 1997 Color TV (unit per urban household*) (LHS) -26% 1998 1999 2000 19.8% 23.4% 29.4% 35.9% 32.1% 70% 60% 50% 40% 30% 20% 10% 0% -10% -20% -30%

30.0%

20.0%

Rev enue grow th for changhong electric(RHS)

Source: CEIC, J.P. Morgan. * Assuming Chinese urban family average of 3.5 people.

Figure 7: Sichuan Changhong Electric A-share performance in the 1990s

Source: Bloomberg.

Identifying potentials winners in sectors with strong secular growth and a low penetration rate
After reviewing the above three case studies, we observe that share price appreciation occurred in leading companies operating in a low-penetration market. We have identified four sectors that currently have a low penetration rate and strong secular growth: internet, tissue and diaper, natural gas, and automobiles. In our view, the leading companies in the above sectors, such as Baidu/Netease/Alibaba, Hengan, Beijing Enterprise/Xinao Gas/Hong Kong China Gas, and DongFeng Motor, will offer good long-term opportunities.

Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Internet sector: Baidu/Netease/Alibaba While the number of internet users in China at 298 million as of the end of 2008 and ranked No.1 in the world, Chinas internet penetration rate (at 22.4%, in terms of internet users per capita, as of the end of 2008) is still low compared to that of developed countries, such as the US (which has a penetration rate of 75%), Japan (71%), and Korea (65%). Hence, we believe the strong expansion of internet usage will be sustained at least for the next 5-10 years until the internet penetration rate in China catches up with or gets close to that in developed countries. Indeed, lower computer prices, decreasing connection fees, and government support should continue to drive internet growth in China.
Figure 8: China internet penetration rate (internet users per capita)

Source: CNNIC, J.P. Morgan estimates.

Among all internet companies in China, Baidu in the search engine sector, Netease in the online gaming area, and Alibaba in the online business-to-business (B2B) market are our favorites as they are perceived to be positioned well to capture the strong revenue growth in the China internet sector. (a) Baidu: The king in the domestic search market Given that the search market is still at a nascent stage of growththe coverage ratio was only 24% and search advertising as a percentage of total advertising market was 3.3%this market is expected to deliver strong growth of over 40% in the next two years, driven by major positives summarized in the table below, according to our internet analyst, Dick Wei.

Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Figure 9: China search market forecasts

Avg. Internet users (Mn) Number of search (Bn) Coverage Click through rate Price per click (Rmb) PPC Market (Rmb M) PPC Market (US$ M) Growth rate (Rmb, %) Total Search Market (Rmb M) Total Search Market (US$ M) Growth rate (Rmb, %) Search ad as % of total ad market 2004 87 47 12% 20.0% 0.25 280 34 94% 584 71 304% 0.7% 2005 103 62 14% 21.0% 0.29 506 62 80% 846 103 45% 0.9% 2006 124 82 17% 22.5% 0.34 1,062 134 110% 1,442 182 70% 1.4% 2007 174 123 21% 24.3% 0.40 2,472 328 133% 2,851 378 98% 2.4% 2008 239 161 24% 25.5% 0.44 4,299 623 74% 4,663 676 64% 3.3% 2009E 295 209 26% 25.5% 0.45 6,234 909 45% 6,614 964 42% 4.4% 2010E 348 254 29% 26.2% 0.47 9,039 1318 45% 9,438 1,376 43% 5.3%

Source: CNNIC, J.P. Morgan estimates. Note: Excluding distributor discount.

Table 2: Major drivers for search market growth

(1) Strong growth of Internet usage in China (2) Rise in number of web pages and websites in China (3) More popularity of search engines for information as the number of Chinese websites is growing (4) More popularity of search engines as an advertising channel for small medium enterprises (SME) with limited budget (5) Increasing monetization rate from search traffic
Source: J.P. Morgan.

At the company level, Baidu, which has been consistently gaining significant market share from its major competitors over the past few years, with its current market share at 62%, has become the No.1 search engine in China. Hence, the dominant position in the market could enable the company to tap the strong sector upturn, which would bolster the companys underlying revenue growth.
Figure 10: Baidus market share in China's search market (2007 and 2008)
China Search (Revenue) Market Share 2008
Zhongsou, 0.9% Sogou, 0.9% Yahoo! China, 5.8% Others, 2.4%

China Search Market Share 2007

Sogou, 2.2% Zhongsou, 2.0% Others, 2.1%

Yahoo! China, 11.0%

Google, 27.8%

Baidu, 62.2%

Google, 23.4%

Baidu, 59.3%

Source: Analysys.com.cn

Source: Analysys.com.cn

Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Figure 11: BaiduNet revenue (i.e. revenue ex-TAC) growth

Source: Company reports, J.P. Morgan internet team.

(b) Netease: A proxy to strong gaming revenue growth While online gaming has experienced a rapid growth in China in the last few years, forming a multi-billion US$ market, online gamings penetration rate in China is still far below that of its peer Asian countries, whose citizens have a similar culture and entertainment habits. As online games are still a low-cost and easily available entertainment option for internet users, we expect continued robust growth of online gaming for the coming years against the backdrop of a low-penetration market in China. Netease, one of the leading online game developers and operators in China, is benefiting from this sectoral upturn and is likely to book very strong revenue growth going forward. Meanwhile, with its more diversified game portfolios (flagship games: Westward Journey 2 and Fantasy Westward Journey 2; small titles: TF, Ghost, and FJ; and newly acquired but yet launched World of Warcraft), strong execution and distribution strength, Netease should continue to gain market share from the smaller companies. These positive drivers should earn the company a higher price in the long term, in our view.

Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Figure 12: Online game penetration and paying online game penetration in different Asian countries
Online game penetration in different Asian countries
60% 50% 40% 30% 20% 10% 0% 2004 Korea
Source: IDC.

Paying online game penetration in different Asian countries

25% 20% 15% 10% 5% 0%

2005

2006 China

2007

2008

2009 Taiwan
Source: IDC.

2004 Korea

2005

2006 China

2007

2008

2009 Taiwan

Hong Kong

Hong Kong

Table 3: Leading online gaming companies by revenue market share (%)

Company Shanda NetEase Giant Interactive The9 Sohu Perfect World NetDragon Kingsoft Others

2008 23% 19% 12% 13% 10% 5% 11% 3% 3%

Source: Company reports, IDC, J.P. Morgan estimates for companies covered by J.P. Morgan.

(c) Alibaba: A leader in the online business-to-business (B2B) marketplace in China Positioning itself well in the fast-growing online commercial business, Alibaba is perceived to seize the solid long-term business fundamentals and is able to ride the cyclical market upturn. Meanwhile, the increase in value-added service (VAS), upside from closer cooperation with Taobao and rising international revenue should provide an additional earnings boost.

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Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Table 4: Internet sector valuation comparable table

Rec N OW N N N N OW OW OW NR NR Ticker 1688.HK BIDU US JRJC US NTES US NINE US SINA US SOHU US VIT US NCTY US 700.HK PWRD US Mkt cap (US$MM) 13,394 11,405 204 5,348 50 1,710 2,346 582 204 29,734 1,959 P/E (x) 09E 10E 50.1 36.0 53.1 35.0 NM 64.5 19.5 14.0 NM 34.4 15.8 20.1 6.2 42.0 14.0 NM 25.0 13.6 15.7 5.8 30.4 11.7 P/BV (x) 09E 10E 9.6 7.4 16.1 10.5 2.0 1.8 4.8 3.5 0.3 3.1 4.1 3.0 0.5 18.0 6.0 0.3 2.6 3.0 2.5 0.4 11.9 3.9 ROE (%) 09E 10E 21.5 23.3 37.2 36.5 -4.9 3.0 28.5 28.9 -2.1 8.8 31.4 15.9 7.5 53.4 53.4 -1.0 11.5 25.8 17.4 7.5 46.5 47.2 Div. yield (%) 09E 10E 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 14.4 0.4 0.0 0.0 0.0 0.0 0.0 0.0 0.5 0.0

Alibaba.com Limited Baidu.com China Finance Online Netease Ninetowns Internet Technology Group Co. Ltd. Sina Corp Sohu.Com VanceInfo Technologies Inc. The9 Limited Tencent Perfect World

Source: Bloomberg and J.P. Morgan estimates. Please note that valuation numbers for Tencent and Perfect World are based on Bloomberg consensus estimates. Price and valuations are as of 4 September 2009.

(2) Tissue and diaper sector: Hengan As the leading Chinese tissue and diaper manufacture, Hengan is benefiting from the rising demand for high-end quality tissue papers, sanitary napkins, and disposable diapers, due to the continued improvement of living standard of domestic consumers. Of the three major products (tissue papers, sanitary napkins and disposable diapers), which comprise 97% of Hengans revenue in 2008, two productstissue and disposable diapersstill have relatively low penetration rates in China (please see Figure 13 and Table 6). While people in China use more sanitary napkins than the global average, the penetration level (around 72%) is still shy of that in developed countries, such as the US (91%).
Figure 13: A low penetration rate in the tissue market
Kg per capita
Tissue consumption per capita (Kg) 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 3.4 Ov er 23kg

1.9

2.1

2.2

2.4

2.6

2.8

2.5

2.7

2.95

2000

2001

2002

2003

2004

2005

2006

2007

2008

World (2008)

North Ammerica (2008)

Source: China National Household Paper Industry Association. J.P. Morgan.

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Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Table 5: Low penetration rate and high secular growth for the baby diaper sector in China
Estimated penetration rate (current consumption/estimated potential consumption) China (2008) world (2004) US (2004) Estimated market compound growth rate by volume consumed up to 2010
Source: China National Household Paper Industry Association, company reports.

21.1% 44.0% 96.0% 20.0%

Hence, we believe there is still enough room for Hengan, the market leader, to gain new business and grow its top line without triggering severe margin erosion. Indeed, Hengan has seen its revenue increasing rapidly, and has retained an about 40% gross margin since 2005. Despite the rising competition given the entry of international giants, Hengan maintains its leading market share in China (around 20% for tissue and sanitary napkins and 12% for baby diapers, according to an industry report), due to its strong nationwide distribution network and recognized brand names. Positioning itself well in such a booming market, Hengan should be able to generate attractive returns for investors in the long run.
Figure 14: Hengans gross margin and revenue growth
44% 42% 40% 38% 36% 34% 2006 2007 Gross margin
Source: company reports and J.P. Morgan.

2008 Rev enue grow th

2009E

Table 6: Tissue Paper sector valuation comparable table

Rec N NR Ticker 1044.HK 3331 HK Mkt cap (US$MM) 6,961 622 P/E (x) 09E 10E 25.2 23.0 16.6 14.3 P/BV (x) 09E 10E 6.0 5.6 2.5 2.2 ROE (%) 09E 10E 27.3 25.6 16.3 16.5 Div. yield (%) 09E 10E 2.4 2.7 1.5 1.7

Hengan International Group Ltd Vinda International Holdings *

Source: Bloomberg and J.P. Morgan estimates. Please note that valuation data for Vinda international is based on Bloomberg consensus estimates. Prices and valuations are as of 4 September 2009.

(3) The natural gas sector: Beijing Enterprise/Xinao gas/Hong Kong China Gas Another area with strong secular growth and low penetration lies in the natural gas sector, which has a very low penetration rate in China, leaving room for gas demand upside potential. The latest available statistics (as of the end of 2007) shows that only 101.9 million people, out of Chinas total population of 1.32 billion, had access to natural gas in 2007. This translates into a penetration rate of only 7.7% in China as of the end of 2007.

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Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Meanwhile, cross-country comparison tells us that the per-capita natural gas consumption level in China is by far below that in developed economies such as the US and Korea (Figure 16), and natural gas does not account for a meaningful share of total primary energy consumption in China (3% ), versus the US (25%) and Korea (14%) (Figure 17). Hence, we believe the natural gas sector in China is still at an early stage of development, with plenty of secular growth opportunities emerging both from increasing penetration with more people becoming gas consumers and the pick-up in per-capita consumption levels.
Figure 15: A low penetration rate in natural gas sector in China
% of population having access o natural gas

10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 1996

Source: CEIC.

7.7% 5.4% 4.3% 1.3% 1.5% 1.8% 2.0% 2.5% 2.9% 3.3% 6.3%

1.2%

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Figure 16: Cross-country/city comparison of natural gas consumption levels (2007)

1,000 800 600 400 200 USA S. Korea China Beijing NG cons (indus+pow er) (in m3 per US$1000 GDP RHS) Per cap NG consump (resi+comm) (in m3 / capita LHS) 83% 0% 100% 0% 35 30 25 20 15 10 5 -

Source: CEIC, BP, BJ Government Statistics. % figures represent % of natural gas sourced domestically.

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Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Figure 17: Natural gas as a percentage of total energy consumption

60% 50% 40% 30% 20% 10% 0%

Ge US rm an Au y str ali a Ja pa n Fr an S. ce Ko re a
P/E (x) 09E 10E 16.8 14.6 30.1 26.2 20.2 17.3 25.2 26.1 P/BV (x) 09E 10E 2.0 1.7 4.7 4.1 1.1 1.1 3.8 3.5

Ru ss ia

Source: BP.

Within this sector, we like three leading companiesBeijing Enterprise, Xinao Gas, and Hong Kong China Gas: (a) Beijing Enterprises: Being the largest natural gas supplier with annual gas sales more than 4 billion cubic meters, Beijing Enterprises has strong long-term growth prospects, especially given its leverage to the projected strong gas demand upside in Beijing, in our view. Also, the company is in a strong cash position, which should make it well equipped for further industry consolidation. (b) Xinao Gas: With only a 20-25% penetration rate, Xinao Gas has significant room for further growth. In addition, experienced management with a quality execution track record has helped the company establish itself in the China city gas sector among its listed peers, in our view. (c) Hong Kong & China Gas: Hong Kong & China Gas should benefit from its China operations which will increasingly become a key driver of its future earnings growth. We believe it is likely to spin off its China operations, and this might well serve as a catalyst for its share price.
Table 7: Gas sector valuation comparable table
Rec OW NR OW N Ticker 2688.HK 1193.HK 0392.HK 0003.HK Mkt cap (US$MM) 1,680 1,298 5,642 15,485 ROE (%) 09E 10E 12.6 12.7 16.3 16.8 5.8 6.4 15.2 13.7 Div. yield (%) 09E 10E 2.1 2.4 0.9 1.1 1.6 1.9 1.9 2.1

Xinao Gas China Resources Gas Beijing Enterprises Holdings Limited Hong Kong & China Gas

Source: Bloomberg and J.P. Morgan estimates. Please note that valuation numbers for CRG are based on Bloomberg consensus estimates. Prices and valuations are as of 4 September 2009.

(4) Automobile sector: DongFeng Motor While the total number of Chinas passenger vehicles is the largest in the world, the penetration rate in China is very low, at 29.2 per 1,000 persons as of 2008. The mature markets such as the US, Europe and Japan already have high penetration rates, and therefore offer less growth potential. Chinas passenger vehicles market is increasingly being driven by first-time buyers in tier-two and tier-three cities. Despite its already massive size, the passenger vehicle market still offers a lot of growth potential in the next five to ten years, due to its low penetration rate and large pool of potential buyers.

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U Ca K na da

HK Ch ina

Frank Li (852) 2800-8511 frank.m.li@jpmorgan.com

Asia Pacific Equity Research 07 September 2009

Figure 18: ChinaPenetration rate of cars (number of passenger vehicles per 1,000 persons)

Source: CEIC, J.P. Morgan.

Table 8: Car penetration rate in European countries and US (units/per 1000 persons)

Source: Data for Europe is based on ACEA and J.P. Morgan estimates, while US data is based on Wardsauto and J.P. Morgan estimates. *Europe car penetration rate is based on car possession per one thousand population while car penetration rate in US is based on car possession rate per one thousand driving age population which represent around 75% of the population.

That said, the passenger vehicle sector has been rather cyclical, with growth in the car market witnessing rather high volatility in the previous two cycles. Chinas first auto boom occurred in 2003 when the sale of domestically made sedans rose a significant 79% due to the breakout of demand in tier-one cities. Chinas auto sector experienced stellar performance in 2003. Then, when a large part of the pent-up demand in tier-one cities was unleashed, the car market experienced a two-year consolidation period (2004 and 2005), and the sales growth of domestically made sedans slowed down from 79% in 2003 to 17% and 20% in 2004 and 2005, respectively. During the downturn of 2004 and 2005, Chinas auto stocks on average lost 70% of their value. It was not until 2006 that the second boom kicked off on the breakout of car demand in tier-two cities. During the second auto boom, many auto stocks went up 2-3x again. Yet in April 2008, the auto sector started to lose steam again, wiping 70% off the share prices of most auto names during its cyclical downturn from April 2008 to January 2009. In early 2009, Chinas third auto boom kicked off on the breakout of car demand in tier three cities, and on the back of a series of supportive policies from Chinese government.
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Asia Pacific Equity Research 07 September 2009

While we are positive about the auto sectors medium-term growth, we do not recommend that investors buy Chinas auto names now, given that: (1) their valuations have become a bit stretched after staging a 300-400% rally this year from the trough; and (2) it is uncertain whether the government will renew the preferential vehicle purchase tax cut for small cars at the end of the year, which has been a key driver of car sales this year. We would accumulate China auto stocks when their valuations come down to a more attractive level, and when we become more comfortable with the continued robust sales growth for FY10 if the government can renew in the next two to three months its policy of vehicle purchase tax cut for small cars, which is due to expire at the end of the year. Among all the domestic auto producers, we believe DongFeng Motor (DFM) stands out as being well positioned to ride the coming cyclical upturn, given its leading position in most of its wide range of auto business lines, multi-strategic-partner business model, and competitive product line-ups. DFM has consistently outperformed its peers in both market upturns and downturns. Investors may want to accumulate this name if the share price goes down due to the market volatility or due to the next cyclical downturn.
Table 8: Auto sector valuation comparison
Mkt cap (US$MM) 3492.3 9115.4 430.9 400.5 1784.2 P/E (x) 09E 10E 10.6 9.8 13.1 11.4 93.0 34.9 12.0 10.6 9.7 9.6 P/BV (x) 09E 1.7 2.4 0.5 0.9 1.7 ROE 09E 17% 20% 1% 8% 21% Div. yield (%) 09E 0.0 0.0 0.0 0.0 0.0

Denway Motors DongFeng Motor Co., Ltd. Brilliance China Automotive Great Wall Motor Company Limited Geely Automobile Holdings Ltd

Rec UW OW N N NR

Ticker 203 HK 489 HK 1114 HK 2333 HK 175 HK

Source: Bloomberg, J.P. Morgan estimates. J.P. Morgan estimates for rated stocks, Bloomberg consensus estimates for non-rated stocks. Prices and valuations are as of 4 September 2009.

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Asia Pacific Equity Research 07 September 2009

Companies Recommended in This Report (all prices in this report as of market close on 07 September 2009, unless otherwise indicated) Alibaba.com Limited (1688.HK/HK$21.90/Neutral), Baidu.com (BIDU/$329.48 [03-September-2009]/Overweight), Beijing Enterprises Holdings Limited (0392.HK/HK$38.70/Overweight), DongFeng Motor Co., Ltd. (0489.HK/HK$8.36/Overweight), Hengan International Group Ltd (1044.HK/HK$44.30/Neutral), Hong Kong & China Gas (0003.HK/HK$18.32 [04-September-2009]/Neutral), Netease (NTES/$41.32 [03-September-2009]/Neutral), Xinao Gas (2688.HK/HK$12.40 [04-September-2009]/Overweight)
Analyst Certification: The research analyst(s) denoted by an AC on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an AC on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analysts compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.

Important Disclosures
Market Maker: JPMSI makes a market in the stock of Baidu.com, Netease. Market Maker/ Liquidity Provider: JPMSL and/or an affiliate is a market maker and/or liquidity provider in Alibaba.com Limited, Hengan International Group Ltd. Client of the Firm: Hengan International Group Ltd is or was in the past 12 months a client of JPMSI. Hong Kong & China Gas is or was in the past 12 months a client of JPMSI. Netease is or was in the past 12 months a client of JPMSI. Non-Investment Banking Compensation: An affiliate of JPMSI has received compensation in the past 12 months for products or services other than investment banking from Hong Kong & China Gas.

Important Disclosures for Equity Research Compendium Reports: Important disclosures, including price charts for all companies under coverage for at least one year, are available through the search function on J.P. Morgans website https://mm.jpmorgan.com/disclosures/company or by calling this U.S. toll-free number (1-800-477-0406) Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analysts (or the analysts teams) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analysts (or the analysts teams) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analysts (or the analysts teams) coverage universe.] The analyst or analysts teams coverage universe is the sector and/or country shown on the cover of each publication. See below for the specific stocks in the certifying analyst(s) coverage universe.

Coverage Universe: Frank Li: Aluminum Corporation of China Limited (2600.HK), Angang Steel Company Limited - A (000898.SZ), Angang Steel Company Limited - H (0347.HK), Baoshan Iron & Steel - A (600019.SS), Brilliance China Automotive (1114.HK), China Coal Energy (1898.HK), China Shenhua Energy (1088.HK), Denway Motors (0203.HK), DongFeng Motor Co., Ltd. (0489.HK), Great Wall Motor Company Limited (2333.HK), Maanshan Iron and Steel - A (600808.SS), Maanshan Iron and Steel - H (0323.HK), Minth Group (0425.HK), Qingling Motors Co (1122.HK), Shandong Weigao Group Medical Polymer Co. Ltd. (8199.HK), Shougang Concord International (0697.HK), Sinotruk (3808.HK), WSP Holdings (WH), Weichai Power (2338.HK), Yanzhou Coal Mining - A (600188.SS), Yanzhou Coal Mining - H (1171.HK), Zijin Mining Group Co Ltd (2899.HK)

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Asia Pacific Equity Research 07 September 2009

J.P. Morgan Equity Research Ratings Distribution, as of June 30, 2009 Overweight (buy) 36% 55% 36% 77% Neutral (hold) 46% 56% 52% 72% Underweight (sell) 18% 42% 12% 60%

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*Percentage of investment banking clients in each rating category. For purposes only of NASD/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold rating category; and our Underweight rating falls into a sell rating category.

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Asia Pacific Equity Research 07 September 2009

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