AVIC Avionics:Margins for modernization;initiating with Buy
Superior returns and restructuring potential justify premium valuation; Buy
AVIC Avionics is one of China's largest suppliers of avionics, the "brain"system of an aircraft. High entry barrier enables the company to enjoy superiorreturns vs. its peers. We expect its earnings to return to growth trajectory in2015 and further accelerate during 2016-2017 (20% CAGR in 2015-2017). Wesee value-accretive asset injections as a key catalyst for the stock. We initiatecoverage with a Buy rating and a P/E based target price of Rmb32.
Riding on China’s military aircraft upgrade cycle
We believe rising budget allocation to military aircraft procurement is set tobenefit the domestic avionics market, which is currently dominated by AVICAvionics. Unlike domestic military airframers, component suppliers are lessexposed to product concentration risk, with better pricing power, hence higherprofitability. The imminent avionics upgrade cycle for PLA’s existing air fleet, ifmaterialized, could yield upside potential to our forecasts in the coming years.
Value-accretive asset injections on the horizon
Positioned as the ultimate listing platform for AVIC’s avionics segment, webelieve further asset injections into AVIC Avionics are conceivable givensubstantial assets still remain at AVIC with sizable profits. Currently, the listcois managing these assets via entrustment agreement, making further assetinjection a sensible next move, in our view. Our scenario analysis suggeststhese asset injections, if they take place, could enhance AVIC Avionics’ 2016Eearnings by as much as 164%.
Valuation and risks
Our target price of Rmb32 is derived based on 67x FY16E EPS, a 20% premiumto its historical mid-cycle P/E in the past five years. We believe such premiumis justified given accelerated growth and upside potential from avionicsreplacement cycle. Moreover, potential asset injections, if materialized, couldbring down our target P/E to 25x. Key risks include an unexpected decrease inChina’s military spending and delay in asset restructuring.