Zhong Ke San Huan:Leading magnet producer with fair valuation;Hold

Beneficiary of robust EV growth but pressure from raw materials; maintainingHold on valuation

    We believe that Zhong Ke San Huan (ZKSH), as a leading magnet producer, shouldbe a direct beneficiary of robust EV growth momentum globally, particularly givenits recent contract with Tesla. However, we expect some cost pressures frompraseodymium and neodymium oxide price hikes. Intense competition amonghigh-end magnet producers makes cost pass through a bit harder. The company iscurrently trading at 42x/32x 2017/18E DB EPS and 3.9x/3.6x 2017/18E DB BVPS,respectively. We maintain Hold on valuation.

    Improving sales mix; meaningful contributions from Tesla starting from 2018

    Within ZKSH's magnet sales, we expect magnets for electric vehicles (EV) to reach14% and 28% of the total by 2017and 2018, up from 5-10% in 2016, thanksto strong EV momentum globally and ZKSH's contract with Tesla in particular.Auto magnets, as a whole, could then reach 60%+ and c.70% of its total salesby 2017and 2018, respectively. We thus envision a continuous improvement ingross margin, given auto motors' margin of c.30% vs. mature sectors' 15%-20%in general. The Tesla contract further underpins ZKSH's leading position butmeaningful contribution starts from 2018.

    Cost pressures due to rare earth price hike

    We expect some cost pressures due to recent rare earth price hikes. For instance,the price of Pr-Nd (praseodymium and neodymium) metal, which accounts for80%+ of total raw material costs, has increased by 10%yoy in 1H17. Accordingto company IR, market share and client relationships are still its major focus,meaning that it will not pass on all the incremental cost to its customers.

    Maintaining Hold on valuation; risks

    We derive our target price for ZKSH via a DCF methodology with a WACC of8.8%. Our target price translates into 43x/32x 2017/18E DB EPS and 3.9x/3.6x2017/18E DB BVPS, generally in line with A-share magnetic material companies'valuations at 40x/32x Bloomberg consensus 2017/18EPS and 3.5x/3.2x 2017/18BVPS, respectively. Risks include policy changes in the rare earth industry andstronger/weaker momentum in EV sales globally.