Hongdu Aviation:Hopes for restructuring fully priced in;initiating with Sell

Organic growth not sufficient to support demanding valuation; Sell

    We initiate coverage on Hongdu Aviation, China’s largest military trainingaircraft (trainer) supplier, with Sell and a target price of Rmb15. While we arepositive on China’s trainer upgrade cycle, we believe Hongdu's near-termearnings outlook remains lukewarm due to a slower-than-expected productionramp-up. Substantially higher-than-peer valuation multiples are thereforeunjustifiable based on its organic growth.

    Long-term beneficiary of trainer upgrade cycle, but near-term risks persists

    In light of the accelerated progress in modernizing the PLA’s combat aircraft,we see significant upgrade potential for China’s trainer fleet. With theintroduction of the L-15 advanced trainer model, we believe Hongdu is poisedto benefit from the PLA’s trainer upgrade cycle in the long term. That said, inthe near term, we do not expect the kick-start of a new model cycle to restoreHongdu’s earnings to their peak level due to a disruption in production causedby its factory relocation. We forecast an EPS CAGR of 17% during 2015-2017,from a low base. Our earnings estimates are 14-22% below BloombergFinance LP consensus.

    Scope for asset restructuring exists, but great level of uncertainty involved

    We believe Hongdu’s rich valuation may have been built largely upon thehopes of asset injections in relation to AVIC’s aero-equipment segment. Wenote that the previously-proposed injection of AVIC’s aero-equipment assetsinto Chengfei Integration (002190.SZ) was not completed which suggests thatHongdu may not be the vehicle for consolidation in this segment.

    Valuation and risks

    We use an EV/Sales-based valuation methodology across all A-share listeddefense airframers, as their earnings are largely constricted by the current“cost-plus-5%” pricing mechanism for military products. Our target price ofRmb15 is based on an EV/Sales of 2.7x on FY16E, one s.d below its mid-cyclelevel to reflect near-term downside risk to earnings. There is very significantasset injection potential, but even a hypothetical >400% EPS accretion wouldstill result in an elevated P/E of 30-40x. Key upside risks include significantasset restructuring and a better-than-expected production ramp-up of the L-15.