2018A-Share Defense Sector Outlook:Sector likely to experience upcycle over next three years

Equipment procurement likely to enter 3-year upcycle with focus on equipmentupgrade The procurement of military equipment follows five-year procurement plans andgovernment spending plans. Based on historical experience, new orders and revenuerecognition tend to be lower in the first two years of the five-year period and increase yearby year during the following three years. In addition, the implementation and confirmationof equipment procurement plans were subject to the impact from China’s military reformin 2016-2017, which has in turn affected military equipment companies’ order executionand product deliveries. The defense sector achieved overall growth of 2% in 9M17,roughly comparable to the slowest pace seen during the 12th FYP period. We believemilitary equipment procurement is likely to proceed in accordance with a new system in2018, and that it is likely to experience an upcycle during the last three years of the 13thFYP period.

    Military equipment procurement is affected by economic conditions and the fiscalspending budget. With China’s rapid economic growth, the PLA’s equipment procurementis demonstrating characteristics such as strengthening procurement power, expandingprocurement scale and increasing tech value-added in equipment purchased.

    Reform being carried out, asset securitization accelerating Ownership reform at thefirst batch of 41 military research institutes is likely to achieve substantial results in 2018,and steady progress should be made in mixed ownership reform. Military product pricingand negotiation rules and an equipment procurement reform program are likely to beintroduced, which should improve the industry competitive landscape and profit allocation.

    In addition, speedy progress should also be seen in major defense company groupconsolidation and central SOE reform.

    Asset securitization will remain a key investment theme for the defense sector. We thinkthat the progress in asset securitization is also subject to the five-year-period pattern:minimal progress was seen in the securitization of defense sector company groups’assets during 2016-2017; as we move into the third year of the 13th FYP period, assetsecuritization is likely to accelerate as defense companies seek to accomplish their 13thFYP objectives. This should drive a rebound in sector valuation.

    Three investment ideas First, we prefer potential leaders during the integration ofdefense sector development with economic development such as Xiangtan ElectricManufacturing (600416 CH), Hangxin Aviation Technology (300424 CH), PengqiTechnology (600614 CH) and Highlander Digital (300065 CH). Second, we likecompanies with continued earnings growth such as AVIC Jonhon Optronic Technology(002179 CH), China Shipbuilding Industry Group Power (600482 CH), AVIC Helicopter(600038 CH) and Zhonghang Heibao (600760). Third, we like listed companies underdefense groups with reform potential such as AVIC Electromechanical Systems (002013CH) and Inner Mongolia First Machinery (600967 CH).

    Risks: Lower-than-expected military spending, uncertainties about asset injectionprogress and schemes, slower-than-expected reform progress, uncertainties surroundingthe progress of reform at research institutes, slower-than-expected equipment R&D;uncertainties about companies’ M&A activities, uncertainties about companies’ militaryproduct orders, the risk of gross profit margin declining.