sustainable profitability from superior cost...

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>> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under the FINRA rules. Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take responsibility for this report in particular jurisdictions. BofA Merrill Lynch 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. Refer to important disclosures on page 28 to 30. Analyst Certification on Page 25. Price Objective Basis/Risk on page 25. Link to Definitions on page 25.11273298

China Hongqiao

Sustainable profitability from superior cost advantage

Superior cost advantage on a deliverable basis We believe China Hongqiao (CHQ) has RMB3,800/t cost advantage over marginal producers on a deliverable basis. Such cost advantage comes from 1) RMB2,800/t from lower electricity tariff; 2) RMB200/t from alumina transportation & packaging; 3) RMB300/t from selling molten aluminum instead of ingot; and 4) RMB500/t on high turnover, which lowers inventory, depreciation & financing cost.

Cost advantage drives sustainable profitability CHQ’s profitability comes from its cost advantage over marginal players on a deliverable basis at Shandong as 1) marginal players determine the price as they could not keep producing if prices fall below cash cost over an extended period; 2) profit comes from cost advantage over marginal players; and 3) Shandong is a net importer of aluminum ingot given aluminum products / aluminium ratio of 3.33. Hence, given CHQ’s huge cost advantage over marginal players and its proximity to end-market, we expect its profitability to sustain.

Go-west: Not yet a threat to CHQ in the short term CHQ’s production cost is lower than it western peers in Inner Mongolia, Qinghai and Gansu. Even Xinjiang smelters have their own issues, namely: 1) railway bottleneck caps utilization, leading to higher fixed cost and limited volume increase; 2) higher working capital requirement leads to higher financial cost; and 3) slower tariff savings due to constrains of water and power grid. We believe only limited capacity will run at lower deliverable cost than CHQ.

Prefer CHQ to Chalco According to Wood Mac, CHQ is second lowest cost smelter in China. Hence, we believe for every dollar of sales, CHQ will record higher profit than Chalco, thus deserving higher valuation. We raise our DCF-based PO to HK$5.66, implies 3.96xPE13 and 1.21xEV/sales, 9% premium vs Chalco’s.

Estimates (Dec)

(CNY) 2011A 2012A 2013E 2014E 2015E Net Income (Adjusted - mn) 5,875 5,481 6,720 5,810 9,963 EPS 0.998 0.931 1.14 0.987 1.69 EPS Change (YoY) 24.4% -6.7% 22.6% -13.5% 71.5% Dividend / Share 0.259 0.211 0.285 0.247 0.423 Free Cash Flow / Share (0.431) (0.762) (0.143) (0.182) 1.77

Valuation (Dec) 2011A 2012A 2013E 2014E 2015E P/E 3.94x 4.19x 3.38x 3.91x 2.28x Dividend Yield 6.59% 5.40% 7.40% 6.40% 10.98% EV / EBITDA* 3.66x 3.54x 2.87x 3.07x 1.99x Free Cash Flow Yield* -11.19% -19.78% -3.72% -4.71% 45.88%

* For full definitions of iQmethod SM measures, see page 27.

Price Objective Change BUY

Equity | China | Non-Ferrous-Aluminum & Light Metals 06 May 2013

Roy Zhang >> +852 2161 7154 Research Analyst Merrill Lynch (Hong Kong) [email protected] Yongtao Shi >> +852 2536 3453 Research Analyst Merrill Lynch (Hong Kong) [email protected] Bruce Wang >> 852 2161 7353 Research Analyst Merrill Lynch (Hong Kong) [email protected]

Stock Data Price HK$4.86 Price Objective HK$5.66 Date Established 3-May-2013 Investment Opinion C-1-7 Volatility Risk HIGH 52-Week Range HK$2.96-HK$5.04 Mrkt Val / Shares Out (mn) US$3,686 / 5,885.0 Average Daily Volume 8,748,812 BofAML Ticker / Exchange XCGQF / HKG Bloomberg / Reuters 1378 HK / 1378.HK ROE (2013E) 26.8% Net Dbt to Eqty (Dec-2012A) 32.0% Est. 5-Yr EPS / DPS Growth 17.8% / 20.1% Free Float 15.0%

Key Changes (CNY) Previous Current Price Obj. HK$5.40 HK$5.66

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China Hongqiao 06 May 2013

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iQprofile SM China Hongqiao Key Income Statement Data (Dec) 2011A 2012A 2013E 2014E 2015E (CNY Millions) Sales 23,626 24,805 31,136 35,256 43,576 Gross Profit 8,176 8,003 9,938 8,714 14,288 Sell General & Admin Expense (211) (365) (458) (518) (641) Operating Profit 8,244 8,043 9,988 8,770 14,358 Net Interest & Other Income (290) (614) (967) (972) (985) Associates NA NA NA NA NA Pretax Income 7,954 7,429 9,021 7,799 13,374 Tax (expense) / Benefit (2,078) (1,948) (2,300) (1,989) (3,410) Net Income (Adjusted) 5,875 5,481 6,720 5,810 9,963 Average Fully Diluted Shares Outstanding 5,885 5,885 5,885 5,885 5,885 Key Cash Flow Statement Data Net Income 5,875 5,481 6,720 5,810 9,963 Depreciation & Amortization 841 1,340 1,592 2,042 2,334 Change in Working Capital (1,180) (1,443) (694) (965) (1,149) Deferred Taxation Charge NA NA NA NA NA Other Adjustments, Net 94 842 1,538 2,044 2,261 Cash Flow from Operations 5,630 6,221 9,156 8,930 13,409 Capital Expenditure (8,169) (10,708) (10,000) (10,000) (3,000) (Acquisition) / Disposal of Investments 0 0 0 0 0 Other Cash Inflow / (Outflow) (729) (936) 34 30 17 Cash Flow from Investing (8,898) (11,644) (9,966) (9,970) (2,983) Shares Issue / (Repurchase) 5,219 0 0 0 0 Cost of Dividends Paid 0 (1,536) (1,241) (1,680) (1,453) Cash Flow from Financing 8,084 7,114 (547) (2,682) (2,454) Free Cash Flow (2,539) (4,487) (844) (1,070) 10,409 Net Debt (293) 7,144 10,501 14,222 6,250 Change in Net Debt (1,657) 7,666 3,357 3,722 (7,972) Key Balance Sheet Data Property, Plant & Equipment 16,424 26,711 35,120 43,078 43,744 Other Non-Current Assets 2,381 2,807 2,807 2,807 2,807 Trade Receivables 1,314 1,363 1,575 1,869 2,219 Cash & Equivalents 7,485 9,175 7,818 4,097 12,069 Other Current Assets 2,065 4,320 4,802 5,473 6,272 Total Assets 29,669 44,377 52,122 57,324 67,111 Long-Term Debt 3,982 9,660 11,660 11,660 11,660 Other Non-Current Liabilities 81 305 0 0 0 Short-Term Debt 3,211 6,659 6,659 6,659 6,659 Other Current Liabilities 3,999 5,415 5,986 7,058 8,334 Total Liabilities 11,272 22,039 24,304 25,377 26,653 Total Equity 18,397 22,338 27,818 31,948 40,458 Total Equity & Liabilities 29,669 44,377 52,122 57,324 67,111 iQmethod SM - Bus Performance* Return On Capital Employed 33.0% 18.4% 17.5% 13.6% 19.6% Return On Equity 45.7% 26.9% 26.8% 19.5% 27.5% Operating Margin 34.9% 32.4% 32.1% 24.9% 32.9% EBITDA Margin 38.5% 37.8% 37.2% 30.7% 38.3% iQmethod SM - Quality of Earnings* Cash Realization Ratio 1.0x 1.1x 1.4x 1.5x 1.3x Asset Replacement Ratio 9.7x 8.0x 6.3x 4.9x 1.3x Tax Rate (Reported) 26.1% 26.2% 25.5% 25.5% 25.5% Net Debt-to-Equity Ratio -1.6% 32.0% 37.7% 44.5% 15.4% Interest Cover 27.4x 12.5x 10.0x 8.8x 14.3x Key Metrics

* For full definitions of iQmethod SM measures, see page 27.

Company Description China Hongqiao is a low cost integrated aluminum

producer in China, ranked No.4 by capacity as of end of 2012. China Hongqiao focuses on its aluminum smelting business with its cheap supply of electricity and alumina from its captive plants. 70% of its revenues derive from selling molten aluminum to local customers. The company plans to grow through capacity expansion and vertical integration.

Investment Thesis We have a Buy recommendation on China

Hongqiao. We believe the shares are mispriced given the poor dynamics of the aluminum industry. As a large-scale integrated producer with strong local government support, we expect Hongqiao to sustain its healthy profitability. Improving trading liquidity and recovering aluminum price would serve as catalysts to the share price. Downside is limited by its defensive valuation and decent dividend yield. Table 1: Better quality; cheaper valuation 2013E CHQ Chalco Ticker 1378 HK 2600 HK Turnover (RMB mn) 28,936 152,360 EV/sales 1.07 1.11 Gross margin 31.9 2.82 Net margin 22.3 -2.5 ROE 25.2 -9 ROA 14.4 -1.5 Net debt-to-equity ratio (2012) 32.9 181.6 Source: BofA Merrill Lynch Global Research estimates

Chart 1: CHQ is lowest cost producer in China

China Hongqiao

Source: BofA Merrill Lynch Global Research estimates

Stock Data Price to Book Value 0.8x


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We prefer China Hongqiao – Buy rating with PO of HK$5.66 (20% upside) – to Chalco We have a Buy rating on China Hongqiao for the following reasons:

1. CHQ has superior cost advantage on a deliverable basis, leading to its healthy profitability. We believe China Hongqiao (CHQ) has RMB3,800/t cost advantage over marginal producers on a deliverable basis. Such cost advantage comes from 1) RMB2,800/t from lower electricity tariff; 2) RMB200/t from alumina transportation & packaging; 3) RMB300/t from selling molten aluminum instead of ingot; and 4) RMB500/t on high turnover, which lowers inventory, depreciation & financing cost.

2. We believe its cost advantage is sustainable. 1) Closer to the end market leads to superior cost advantage on a deliverable cost; 2) Vertical integrated model leads to better cost control. Compared to smelters that purchase electricity from the national power grid, we estimate CHQ could benefit from lower coal cost by saving Rmb300/t of Aluminium produced.

3. Go-west (Capacity addition in the west) is not yet a threat to CHQ CHQ’s production cost is lower than it western peers in Inner Mongolia, Qinghai and Gansu. Even Xinjiang smelters have their own issues, namely: 1) railway bottleneck caps utilization, leading to higher fixed cost and limited volume increase; 2) higher working capital requirement leads to higher financial cost; and 3) slower tariff savings due to constrains of water and power grid.

Stock-price catalysts 1. Improving trading liquidity China Hongqiao’s trading liquidity has improved significantly recently. YTD, it’s average daily trading volume has stabilized above 4mn shares (vs a sub-million level prior to Aug-2012). We believe the improving liquidity will attract more investors to this stock, thus reducing its original liquidity discount.

2. Recovering aluminum price BofAML’s commodity team forecast aluminum price at US$1,981, US$1,917 and US$2,000 for 2Q, 3Q and 4Q13, respectively, which is higher than the current price of US$1,865. We believe a recovery in aluminum price will remove headwinds on CHQ’s share price in the near term.

Chart 6: Aluminum price trend

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Source: Bloomberg; BofA Merrill Lynch Global Research estimates

Initiation Report CHQ, 22 April 2013: A Rare, Mispriced Opportunity Chart 2: Cost advantage: key source of sustainable profitability

Price

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Cost curve / Supply curveDemand curve

Price determined byMarginal player and demand

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CHQProfit determined bycost advantage

Chart 3: CHQ’s cost lower than most players in the west provinces

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Chart 4: Improving trading liquidity

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Chart 5: Al price most resilient among all metal

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Table 2: BofA Merrill Lynch aluminium price forecast 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E BofAML aluminum Price forecast USD/t 2,180 2,086 1,755 1,981 2,216 2,116 2,113 1,975 2,250 2,357 2,459 2,562 2,562 2,562

SHFE spot (inc. VAT) RMB/t 19,407 16,959 14,027 15,690 16,820 15,620 15,572 14,558 16,586 17,376 18,128 18,881 18,881 18,881 YoY change -2.8 -4.3 -15.9 12.9 11.8 -4.5 -0.1 -6.5 13.9 4.8 4.3 4.2 - - Discount to LME USD/t 18.1 18.9 -6.4 12.8 8.6 -3.1 - - - - - - - - Source: BofA Merrill Lynch Global Research estimates

Chart 7: Cost advantage over peers determines CHQ’s sustainable profitability

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CHQProfit determined bycost advantage



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Superior cost advantage on a deliverable basis We estimate CHQ has RMB3,800/t cost advantage over marginal producers on a deliverable basis. Such cost advantage comes from 1) RMB2,800/t from lower electricity tariff; 2) RMB200/t from alumina transportation and packaging; 3) RMB300/t from selling molten aluminum instead of ingot; and 4) RMB500/t due to high turnover, which lowers inventory, depreciation and financing cost.

Savings from lower electricity tariff In 2012, CHQ achieved average tariff of RMB0.245/kwh (excluding VAT), out of which self-generated electricity cost was RMB0.227/kwh and contract electricity cost was RMB0.290/kwh (excluding VAT).

We think CHQ’s average electricity tariff is RMB0.20/X lower than that of marginal players, which could translate into RMB2,800/t cost advantage of aluminum produced.

CHQ aims to increase its power self-sufficient ratio to 70% from the current 55%. Given the easing coal price pressure, we believe CHQ will sustain its power tariff advantage.

Chart 8: CHQ’s electricity cost is lower than most of the aluminum producing areas

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Chart 9: Self-owned power capacity

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CHQ has RMB3,800/t cost advantage over marginal producers on a deliverable basis

CHQ enjoys lowest electricity tariff among peers – contributes RMB2,800/t cost advantage over marginal players

CHQ continues to expand its installed power capacity and improves its power self-sufficiency level


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Savings from lower alumina cost CHQ gets most of its alumina supply from Weiqiao Gaoxin Aluminum, which has 4mt alumina capacity. The supplier is adjacent to CHQ’s aluminum manufacturing facility in Weiqiao base. As per CHQ’s management, such proximity generate about RMB200/t savings from reduced transportation and packaging expenses.

CHQ and Gaoxin have signed a long-term sales agreement which enables CHQ to purchase alumina at RMB500/t below market prices. In return, CHQ will acquire 60% of Gaoxin’s annual production every year.

Further, CHQ has built up 3mt alumina capacity at Zouping production base, which will replicate low-cost alumina model and lift its alumina self-sufficient ratio.

Chart 10: CHQ’s alumina supply is really close to its aluminum lines

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Alumina supply is located close to CHQ’s facility – contributes to RMB200/t savings


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Savings from selling molten aluminum instead of ingot CHQ sells 70-80% of its aluminum in molten form instead of ingot. We believe this will save about RMB200/t from eliminating ingot casting and packaging for aluminum smelters and RMB500/t from re-melting aluminum ingot for aluminum fabricators. Due to the nature of the product, molten aluminum has a very short selling distance. Therefore, we expect CHQ to achieve about RMB300/t cost advantage than out-of-province suppliers on a deliverable basis to Shandong.

In addition to savings from re-melting processing cost, downstream fabricators may also reduce investment in re-melting equipment, lower inventory and achieve higher product quality control. As a result, we believe it is an industry trend for aluminum processors to move near smelters and form a close eco-system.

Chart 11: CHQ sold most of its aluminum in molten form

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Chart 12: Short distance from CHQ’s facility to major clients

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Source: Google map; BofA Merrill Lynch Global Research estimates

Selling molten aluminum eliminates ingot making for CHQ and re-melting for clients – contributes RMB300/t savings

CHQ’s customer is very close to its smelter facility


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Savings from higher efficiency CHQ’s integrated and low-cost model enables it to achieve a very efficient operational level. The company’s self-owned power plant has an average utilization hour of above 7,000 hours vs industry average of 4,800 hours in 2012. In addition, the utilization rate of company’s aluminum line is constantly above 100%, higher by 20-30% than industry average.

Given the higher utilization rate, its fixed cost such as depreciation and financial costs are lowered on a per ton basis. In addition, we believe the company will achieve lower inventory by selling molten aluminum, thus requiring less working capital to operate the business and lowering financial cost.

We estimate such high efficiency brings about RMB500/t cost savings to CHQ.

Chart 13: CHQ has higher utilization rate of its aluminum line than industry average

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Chart 14: CHQ’s power equipment has highest utilization rate than its peers

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Source: CEC; BofA Merrill Lynch Global Research estimates

CHQ’s integrated model leads to significantly higher efficiency and utilization than its peers – contributes RMB500/t cost savings


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Table 3: Total cost savings from efficiency gain Total cost savings from efficiency gain 653 Depreciation (Aluminum Line) Unit capex / ton of aluminum Rmb/t 10,000 Depreciation policy Years 10 Unit depreciation / ton of aluminum Rmb/t Assuming 105% utilization 952 Assuming 80% utilization 1,250 Cost savings 298 Depreciation (Power Plant) Unit capex / MW Rmb/t 4,000 Depreciation policy Years 20 Unit depreciation / ton of aluminum Rmb/t Assuming 7500 hours 373 Assuming 4800 hours 583 Cost savings 210 Financial cost (Working capital) Unit aluminum cost Rmb/t 15,000 Funding cost % 6% Unit working capital cost / ton of aluminum Rmb/t Assuming cash conversion cycle 30-day 74 Assuming cash conversion cycle 60-day 148 Cost savings 74 Financial cost (Fixed assets investment) Unit fixed assets 8,000 Borrowing % 50% Funding cost % 6% Unit financial cost / ton of aluminum Rmb/t Assuming 105% utilization 229 Assuming 80% utilization 300 Cost savings 71 Source: BofA Merrill Lynch Global Research estimates


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Cost advantage drives sustainable profitability CHQ’s profitability comes from its cost advantage over marginal players on a deliverable basis at Shandong.

1) Marginal players determine the price

Marginal players determine the market price as they could not keep producing if prices fall below their cash cost over an extended period.

2) Profitability comes from cost advantage over marginal players

We think CHQ’s profitability comes from its huge cost advantage (RMB3,800/t by our estimate) over marginal players. Even if marginal players are willing to bear small losses (eg, RMB500/t), CHQ would still be able to break even due to the scale of cost difference. Therefore, in our view, CHQ’s profitability is sustainable.

Chart 16: Source of sustainable profitability

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3) Shandong is a net importer of aluminum ingot

As Shandong has the highest aluminum-to-downstream aluminum products’ output ratio, Shandong is a net importer of aluminum ingot. Hence, CHQ (holding 50% market share locally) does not face any difficulty in selling its products.

In addition to production cost advantage, CHQ may see additional savings on a deliverable basis compared to producers outside the provinces. Such savings come from lower transportation cost, selling molten aluminum instead of ingot and higher turnover.

Chart 15: Marginal players determines price Price

Volume


Price determined byMarginal player and demand

Demand Source: BofA Merrill Lynch Global Research estimates

Shandong has a large downstream market. Marginal players have to compete with CHQ on a deliverable to Shandong basis instead of cash production cost basis.


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Chart 17: Shandong has highest aluminum-to-aluminum products output ratio

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Chart 18: China alumina-aluminum products – Major production areas

Source: BofA Merrill Lynch Global Research


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Go-west: Not yet a threat to CHQ in short term CHQ’s production cost is lower than it western peers in Inner Mongolia, Qinghai and Gansu. Even Xinjiang smelters have their own issues, namely: 1) railway bottleneck caps utilization, leading to higher fixed cost and limited volume increase; 2) higher working capital requirement leads to higher financial cost; and 3) slower tariff savings due to constrains of water and power grid. We estimate only limited capacity will run at lower deliverable cost than CHQ. Therefore, we believe go-west will have a limited impact on CHQ in the near term.

Chart 19: Aluminium production cost by provinces

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We compare CHQ’s cost with that of the smelters in North West China:

According to Wood Mac data, CHQ’s alumina cost is only higher than that of Ningxia province and Shaanxi province, but lower than the rest. Its electricity cost is only higher than that of Xinjiang province.

Overall, CHQ’s cost is lower than most of the smelters in the west. Only smelter in Xinjiang, with captive power unit, could see low cost than CHQ on a production basis. However, CHQ may still have advantage in terms of transportation, operations continuity and closer integration with clients given the proximity.

We think CHQ is more cost competitive than most smelters in western provinces We estimate CHQ is as competitive as smelters in Xinjiang on a deliverable basis to Shandong

Chart 20: Unit alumina cost per ton of aluminum produced

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Chart 21: Unit electricity cost per ton of aluminum produced

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Table 4: CHQ is competitive against Xinjiang smelters on a deliverable basis Xinjiang smelters vs CHQ

Alumina Xinjiang: Imported from Henan / Shanxi / Guangxi provinces; estimate higher transportation cost of RMB500 per ton of aluminum produced; primarily domestic bauxite CHQ: Domestic supply; high availability in the region; bauxite imported from Indonesia and Australia

Power supply

Xinjiang: Most smelters still use grid-tariff; estimated at Rmb0.30/kwh. Smelters with captive power station have lower electricity cost, but still have to pay fees to the regional grid; estimated at Rmb0.18/kwh CHQ: Captive power station and power grid; self-generated power: RMB0.23/kwh; long-term supply contract: RMB0.29/kwh 1 cent savings on unit electricity cost => RMB140 cost saving on unit aluminum production

Sales Xinjiang: Most smelters have to transport aluminum ingot to end-market for sale, which incurs higher sales cost and longer AR turnover days CHQ: Sell 70% of its aluminum in molten form within the region; long-term relationship with buyers; low sales cost and minimum AR; preferred by downstream due to supply stability and consistency

Inventory

Xinjiang: Due to transportation constrains, we estimate Xinjiang smelter would keep more inventory of alumina and aluminum; estimated inventory turnover days are 30-60 days longer CHQ: Benefit from local integration of alumina-aluminum-downstream aluminum products; minimum aluminum inventory given its sales of molten aluminum Every 30-day equivalent of working capital costs RMB70 per ton of aluminum produced

Utilization Xinjiang: Unstable utilization rate given the tough weather, relatively undeveloped infrastructure and long transportation distance; estimated at 85% CHQ: Very high utilization of over 100% given its integrated model; No supply interruption due to alumina or power shortage; no difficulty in sales given the abundant local demand

Financing cost Xinjiang: Higher financing cost on a unit production basis due to higher initial capex, higher funding need on working capital and lower utilization

Transportation Xinjiang: Estimate RMB400/t to transport aluminum ingot from smelter to end-market CHQ: Minimum transportation cost due to short sales distance

Depreciation Xinjiang: Higher depreciation on a unit production basis due to higher initial capex and lower utilization Resources Xinjiang: High availability of low-cost coal; but lack of water, well-developed power grid and transportation system Manufacturing process CHQ: Sales of molten aluminum could save ingot-making cost of RMB200/t for smelters and re-melting cost of RMB500/t for downstream processors Work force We estimate Xinjiang's cost of salary to be 30-50% higher than CHQ's given the lower population and fewer skilled workers. Source: BofA Merrill Lynch Global Research estimates

Chart 22: Unit cash cost per ton of aluminum produced

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Chart 23: Unit operating cost per ton of aluminum produced

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Investment risks Ineffective controls on new capacity addition Although the Chinese government recently announced a new policy to restrain aluminum-smelting capacity growth, ineffective execution by local governments could result in continuously strong capacity additions over the next couple of years, depressing the already weak domestic aluminum prices. The historical failure in effectively controlling new capacity additions in China makes us skeptical about the execution effect of this new round of capacity control.

Policy may prevent CHQ from expanding The government’s new policy to control new capacity additions may make CHQ’s capacity growth target undeliverable, especially for the company’s two projects with annual smelting capacity of 760,000 tons under plan currently and result in a sharp deceleration in its capacity growth.

Failure to replicate in other regions CHQ’s current production base’s very strong profitability is mainly due to the self-owned electricity transmission line, attractive alumina and electricity supply contract with Gaoxin and its captive power plant. However, CHQ may not be able to replicate the currently successful business model in other areas and if it cannot expand capacity at its current production bases, the company may have to face the risk of reduced profitability.

Lower domestic aluminum price Although CHQ’s earnings have much less sensitivity to changes in domestic aluminum prices than that of Chalco, domestic aluminum prices are still the most important factor for the company’s earnings. The larger-than-expected increase in new capacity and weaker-than-expected domestic aluminum demand may result in a lower aluminum price and trigger earnings growth decline for CHQ.

Sharply increased coal price Coal costs account for nearly 90% of CHQ’s total costs for self-generated electricity. Also, the electricity purchase price from Gaoxin will be revised up if the coal price increase exceeds 20%. Our calculation shows that a 10% coal-price increase may result in around a 7% net-profit decline.

Rising raw material cost Bauxite and alumina are key raw materials for CHQ’s aluminum business. In the past, the company has shown great control over its raw material cost, which is crucial to its superior cost advantage over peers. But, if there is an unexpected raw-material price hike, it could have a significant impact on its profitability.

Regulation cost from environment-related matters The increasing focus on environmental protection in China could also potentially lead to higher investment and operational cost for CHQ’s power, alumina refinery and aluminum smelting businesses.

Accounting credibility Given the deep valuation discount and significant margin premium over peers, investors are concerned over its accounting credibility. The controlling shareholder has another listed company: Weiqiao Textile (2698 HK), which has been listed on HKEx since 2003 without accounting scandals. In addition, its auditor Deloitte has been provided service to CHQ since IPO.


15

Bauxite shortage The company imports bauxite primarily from Indonesia for its Alumina operation. Recent tightening of bauxite supply from Indonesia could potentially affect its raw material supply. However, the company has announced to invest US$1bil and establish a joint venture to produce alumina in Indonesia. Meanwhile, it has been one of the few that received Indonesia government’s approval to continue export bauxite from Indonesia


16

Prefer CHQ to Chalco Wood Mac estimates that CHQ’s cost is US$306/t lower than that of Chalco. Hence, we believe for every dollar of sales, CHQ will record higher profit and deserves a higher unit enterprise value. Our DCF based PO of HK$5.66, implies 3.96xPE13 and 1.21xEV/Sales, 9% premium to that of Chalco’s.

Table 5: Peers Comps Mkt cap P/E EV/Sales P/B EV/EBITDA Net Margin (%) ROE (%) Company Ticker Share price US$M 2012 2013E 2012 2013E 2012 2013E 2012 2013E 2013E 2013E Aluminium China CHINA HONGQIAO 1378 HK 4.86 3,686 4.2x 3.4x 1.3x 1.1x 1.0x 0.8x 3.5x 2.9x 22% 27% CHALCO 2600 HK 2.86 4,985 NM NM 1.2x 1.1x 0.7x 0.8x 46.9x 34.1x -3% -16% JIAOZUO WANFANG ALUMINUM 000612 CH 9.79 1,033 53.5x 23.3x 1.6x 1.6x 1.8x 1.7x 59.4x 29.2x 4% 7% YUNNAN ALUMINIUM 000807 CH 4.78 1,195 36.8x 56.2x N/A N/A N/A 1.9x N/A N/A -1% 3% SHANDONG NANSHAN ALUMINUM 600219 CH 6.15 1,932 10.6x 10.1x 0.9x 0.7x 0.7x 0.7x 5.3x 3.3x 6% 7% Aluminium Global ALOCA AA US 8.46 9,889 33.8x 16.9x 0.9x 0.9x 0.8x 0.7x 10.8x 7.8x 3% 4% NORSK HYDRO AHY NO 26.98 9,485 103.8x 49.1x 1.1x 1.1x 0.8x 0.8x 10.3x 10.4x 2% 2% UC Rusal 486 HK 3.76 7,361 26.9x 111.7x 1.7x 1.6x 0.7x 0.7x 19.9x 15.9x 1% 1% ALUMINA LIMIMITED AWC US 0.92 2,632 NM NM NM NM 0.9x 0.9x NM NM NM 0% Source: Bloomberg, BofA Merrill Lynch Global Research estimates

According to Wood Mac, CHQ sits at 35 percentile of the cost curve globally and it is the second-lowest cost smelter in China as per 2012 operating cost.

Given the cost advantage, we believe CHQ is able to maintain over 100% utilization rate and a healthy profit margin despite of industry-wide margin deterioration.

Chart 24: CHQ is the second lowest cost aluminum producer in China

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Wood Mac estimates that CHQ’s cost is US$306/t lower than that of Chalco

Better profitability => higher valuation Therefore, CHQ deserves a valuation premium to Chalco.

Third-party Wood Mac data show that CHQ is among the lowest cost aluminum producer both domestically and globally


17

Chart 25: CHQ sits at 35 percentile of the global aluminum smelter cost curve

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18

Sensitivity analysis CHQ’s profit is highly sensitive to fluctuations in aluminum price. Every 1% change in aluminum price could cause a 3.4% change in CHQ’s 2013E net profit. In addition to aluminum price, CHQ’s profit is also highly dependent on its production volume, utilization rate, alumina price and electricity tariff.

Chart 26: Impact on 2013E net profit for every 1% increase in factors shown below

3.4%

-0.9%-0.8%

1.1%

1.0%

-2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0%

Aluminum Price

Alumina Price

Electricity TariffProduction Volume

Utilization Rate


Aluminum price Table 6: Sensitivity analysis on aluminum price

Chg. aluminum price US$/t RMB/t '13E net profit Chg. net profit -15% 1,796 13,236 3,299 -50.9% -10% 1,901 14,015 4,439 -33.9%

-5% 2,007 14,793 5,580 -17.0% -2% 2,070 15,261 6,264 -6.8% -1% 2,091 15,416 6,492 -3.4%

Base 2,113 15,572 6,720 0.0% +1% 2,134 15,728 6,949 3.4% +2% 2,155 15,883 7,177 6.8% +5% 2,218 16,351 7,861 17.0%

+10% 2,324 17,129 9,002 33.9% Source: BofA Merrill Lynch Global Research estimates

Alumina price Table 7: Sensitivity analysis on alumina price

Chg. alumina price RMB/t 13E net profit Chg. net profit -15% 2,235.25 7,637 13.6% -10% 2,366.73 7,331 9.1%

-5% 2,498.22 7,026 4.5% -2% 2,577.11 6,843 1.8% -1% 2,603.41 6,782 0.9%

Base 2,629.70 6,720 0.0% +1% 2,656.00 6,659 -0.9% +2% 2,682.30 6,598 -1.8% +5% 2,761.19 6,415 -4.5%

+10% 2,892.67 6,109 -9.1% Source: BofA Merrill Lynch Global Research estimates


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Electricity cost Table 8: Sensitivity analysis on power tariff

Chg. electricity tariff RMB/t 13E net profit Chg. net profit -15% 0.192 7,490 11.4% -10% 0.204 7,233 7.6%

-5% 0.215 6,977 3.8% -2% 0.222 6,823 1.5% -1% 0.224 6,772 0.8%

Base 0.226 6,720 0.0% +1% 0.228 6,669 -0.8% +2% 0.231 6,618 -1.5% +5% 0.237 6,464 -3.8%

+10% 0.249 6,207 -7.6% +15% 0.260 5,951 -11.4% +20% 0.271 5,694 -15.3% +30% 0.294 5,181 -22.9%


Production volume Table 9: Sensitivity analysis on production volume

Chg. production volume kt 13E net profit Chg. net profit -15% 1,956 5,657 -15.8% -10% 2,071 6,011 -10.6%

-5% 2,186 6,366 -5.3% -2% 2,255 6,579 -2.1% -1% 2,278 6,650 -1.1%

Base 2,301 6,720 0.0% +1% 2,324 6,791 1.1% +2% 2,347 6,862 2.1% +5% 2,416 7,075 5.3%

+10% 2,531 7,430 10.6% +15% 2,646 7,784 15.8%


Utilization rate Table 10: Sensitivity analysis on utilization rate

Chg. Utilization Rate % 13E net profit Chg. Net Profit -15% 87 5,677 -15.5% -10% 92 6,025 -10.3%

-5% 97 6,373 -5.2% -2% 100 6,581 -2.1% -1% 101 6,651 -1.0%

Base 102 6,720 0.0% +1% 103 6,790 1.0% +2% 104 6,859 2.1% +5% 107 7,068 5.2%

+10% 112 7,416 10.3% Source: BofA Merrill Lynch Global Research estimates


20

Business model China Hongqiao is a leading integrated aluminum producer in China, ranked No. 4 by capacity as of end-2012. The company focuses on aluminum smelting business with an increasing self-sufficiency ratio for alumina and electricity supply over the years. Its integrated power grid has also generated significant cost advantage over its peers. Over time, the company may also extend its business line into downstream aluminum processing and upstream bauxite mining.

Aluminum: Major source of revenue The company derived 70% of revenue from selling molten aluminum alloy locally within a short deliverable distance, 27% from aluminum alloy ingots and the rest from other aluminum products and steam.

Most of its aluminum selling price is referenced to the mean price provided by the Yangtze River Non-ferrous Metals Spot Market.

As the company only started its aluminum business in 2006, it has experienced a rapid expansion period with a five-year revenue CAGR of 41%.

Chart 27: Revenue breakdown (2012)

Molten aluminum alloy70%

Other aluminum products

1%

Steam2%

Aluminum alloy ingots27%


Chart 28: Historical revenue growth

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Rmb milMolten aluminum alloy Aluminum alloy ingot Other aluminum products Steam

CAGR: 41%



21

Cost structure Alumina and electricity together account for 75% of aluminum production cost. CHQ enjoys lower cost for these two inputs given its captive capacity and also the proximity to its major supplier (Gaoxin), which forms the company’s core cost advantage over its peers.

Chart 29: COGS breakdown (2011)

Alumina37%

Carbon anode16%

Other material1%

Electricity38%

Manufacturing ex pense

5%

Labor3%


Chart 30: Historical alumina cost

1,500

2,0002,500

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3,500

2007 2008 2009 2010 2011 2012

Rmb/t CHQ Alumina Domestic av g.


Chart 31: Historical electricity cost

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Rmb/kwh CHQ electricity cost Shandong on-grid tariff



22

Major assets Chart 32: CHQ’s major assets by 2012

Power grid

Power plant: Installed capacity 2,730MW

Alumina: 3,000kt capacity

Alulminum: 2,016kt capacity

Aluminum fabrication: 30kt capacity

upstream downstream



23

Production process Chart 33: CHQ’s main production process

Major product 2

Future development

Major product 1

Source: Company; BofA Merrill Lynch Global Research estimates


24

Shareholding structure Chart 34: China Hongqiao’s shareholding structure

Mr. Zhang Shiping

Public shareholders

Listed CompanyChina Hongqiao

1378 HK

Hongqiao Holdings

15.04%84.96%

100%


Management profile Table 11: Key management Name Title Profile

Mr Zhang Shiping The Founder, Chairman and Executive Director

Extensive experience in aluminum industry since the commencement of aluminum business in 2006 and was responsible for the overall strategic planning of the Group.

Ms Zheng Shuliang Vice Chairman and Executive Director Joined the Group in July 2009 and has been a director and vice chairman of Shandong Hongqiao

Mr Zhang Bo Executive Director and Chief Executive Officer

Graduated from Shandong Broadcast and Television University, majoring in financial accounting and obtained a bachelor degree in economics in August 1996. He has also obtained a master's degree in software engineering from Wuhan University in June 2005. He is responsible for overseeing the Group’s general operation, marketing and promotion. He has more than 12 years of management experience. Mr Zhang has four years’ experience in the aluminum industry. He is familiar with the aluminum industry.

Mr Qi Xingli Executive Director and Chief Financial Officer

Graduated as a correspondence student from Shandong Cadre Correspondence University and obtained a university diploma in financial accounting in June 1998. He also obtained a certificate as an international certified senior accountant from the International Profession Certification Association in June 2010. He oversees the Group's finance and accounting functions and has over 20 years' experience in the cotton textile industry.

Ms Zhang Ruilian Vice President Manager of the accounting department of the company, she graduated from Shandong Economic Management School of Light Industry and obtained a diploma in accounting in July 1996. She has over 10 years accounting experience.

Mr Wang Donghua Vice President In-charge of CHQ's capital markets and merger and acquisition activities, Mr Wang obtained his master’s degree in finance from the European University in Geneva, Switzerland in July 2002.

Mr Deng Wenqiang Vice President Graduated from Kunming University of Science and Technology and obtained the bachelor’s degree in non-ferrous metal metallurgy in July 1995 and is a qualified engineer. Mr Deng Wenqiang joined the Group in January 2003. He is responsible for the Group's production, research and development of aluminum products.



25

Price objective basis & risk Aluminum Corp. of China (ALMMF) Our price objective of HK$2.7 is based on 0.77x 2013E P/B, -1std of its historical average P/B, given the tough industry outlook, the uncertain global economic outlook and a more skeptical outlook on Chalco's expansion into coal and iron ore businesses. The risks to our price objective are an abrupt fluctuation in the aluminum price, uncertainties on national capacity controls, a sudden decline in raw material prices, and uncertainties in overseas expansion. Upside risk is a much stronger-than-expected recovery in economy and better-than-expected production discipline.

China Hongqiao (XCGQF) Our PO of HK$5.66 is based on DCF model by assuming 0% terminal growth and 25% WACC. Our PO implies 3.96x P/E of 2013E, 3.21x EV/EBITDA of 2013E and 0.96x P/B of 2013E and 6.3% dividend yield. The implied P/B 2013 valuation is in line with its international peers and 30% below its domestic peers. Risks to our price objective are fluctuation of aluminum selling price, surge in raw material costs, cooperation with its major supplier, success of national capacity control and potential difficulties in expanding with the same business model.

Link to Definitions Basic Materials Click here for definitions of commonly used terms. Analyst Certification I, Roy Zhang, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report.

APR - Metals & Mining Coverage Cluster Investment rating Company BofA Merrill Lynch ticker Bloomberg symbol Analyst BUY Anhui Conch-H AHCHF 914 HK Bruce Wang Banpu Pcl BPULF BANPU TB Komsun Suksumrun Baosteel BAOSF 600019 CH Yongtao Shi BBMG Corporation BMBGF 2009 HK Bruce Wang China Hongqiao XCGQF 1378 HK Roy Zhang China National Building Material Co Ltd. CBUMF 3323 HK Bruce Wang China National Materials XFCHF 1893 HK Bruce Wang China Resources Cement CJRCF 1313 HK Bruce Wang China Shanshui Cement CCGLF 691 HK Bruce Wang China Shenhua Energy Ltd. CUAEF 1088 HK Yongtao Shi CITIC Dameng Holdings Limited XCDHF 1091 HK Yongtao Shi Hyundai Steel XHDUF 004020 KS SK Shim Jiangxi Copper JIAXF 358 HK Yongtao Shi POSCO PKXFF 005490 KS SK Shim

http://research1.ml.com/C?q=Vl4LLvCp6tUKmi1DaM8Oog


26

APR - Metals & Mining Coverage Cluster Investment rating Company BofA Merrill Lynch ticker Bloomberg symbol Analyst POSCO -A PKX PKX US SK Shim Semirara Mining Corporation SRCCF SCC PM Philip Albert Felix Shougang Fushan Resources Group Ltd YULKF 639 HK Yongtao Shi Winsway Coking Coal Holdings Limited XWNYF 1733 HK Yongtao Shi Zhaojin Mining ZHAOF 1818 HK Bruce Wang Zijin Mining ZIJMF 2899 HK Bruce Wang NEUTRAL Borneo Lumbung Energy PBTLF BORN IJ Daisy Suryo Coal India Limited XOXCF COAL IN Bhaskar N Basu, CFA Hindalco HNDFF HNDL IN Bhaskar N Basu, CFA Hyundai Hysco HYUPF 010520 KS SK Shim Indo Tambangraya PTIZF ITMG IJ Daisy Suryo Mongolian Mining Corporation MOGLF 975 HK Yongtao Shi Tambang Batubara PBATF PTBA IJ Daisy Suryo UNDERPERFORM Aluminum Corp. of China ALMMF 2600 HK Bruce Wang Angang Steel ANGGF 347 HK Yongtao Shi Bumi Resources PBMRF BUMI IJ Daisy Suryo China Coal Energy Ltd. CCOZF 1898 HK Yongtao Shi China Molybdenum CMCLF 3993 HK Bruce Wang Dongkuk Steel DKUSF 001230 KS SK Shim Hidili XHILF 1393 HK Yongtao Shi Inner Mongolia Yitai Coal Co., Ltd XHRTF 3948 HK Yongtao Shi Intl Nickel In PTNDF INCO IJ Daisy Suryo Jindal Steel and Power Limited XJDLF JSP IN Bhaskar N Basu, CFA JSW Steel XJWJF JSTL IN Bhaskar N Basu, CFA Maanshan Iron & Steel MAANF 323 HK Yongtao Shi NALCO NAUDF NACL IN Bhaskar N Basu, CFA PT Adaro Energy Tbk PADEF ADRO IJ Daisy Suryo PT Bayan Resources Tbk XBAYF BYAN IJ Daisy Suryo PT Indika Energy Tbk XIDKF INDY IJ Daisy Suryo Sesa Goa Limited XSGAF SESA IN Bhaskar N Basu, CFA Steel Authority of India SLAUF SAIL IN Bhaskar N Basu, CFA Tata Steel TAELF TATA IN Bhaskar N Basu, CFA Yanzhou Coal YZCHF 1171 HK Yongtao Shi RSTR Sterlite Industries India Limited XTNDF STLT IN Bhaskar N Basu, CFA Sterlite Industries India Limited SLT SLT US Bhaskar N Basu, CFA RVW Shougang Concord International SCGEF 697 HK Yongtao Shi


27

iQmethod SM Measures Definitions Business Performance Numerator Denominator Return On Capital Employed NOPAT = (EBIT + Interest Income) * (1 - Tax Rate) + Goodwill

Amortization Total Assets – Current Liabilities + ST Debt + Accumulated Goodwill Amortization

Return On Equity Net Income Shareholders’ Equity Operating Margin Operating Profit Sales Earnings Growth Expected 5-Year CAGR From Latest Actual N/A Free Cash Flow Cash Flow From Operations – Total Capex N/A Quality of Earnings Cash Realization Ratio Cash Flow From Operations Net Income Asset Replacement Ratio Capex Depreciation Tax Rate Tax Charge Pre-Tax Income Net Debt-To-Equity Ratio Net Debt = Total Debt, Less Cash & Equivalents Total Equity Interest Cover EBIT Interest Expense Valuation Toolkit Price / Earnings Ratio Current Share Price Diluted Earnings Per Share (Basis As Specified) Price / Book Value Current Share Price Shareholders’ Equity / Current Basic Shares Dividend Yield Annualised Declared Cash Dividend Current Share Price Free Cash Flow Yield Cash Flow From Operations – Total Capex Market Cap. = Current Share Price * Current Basic Shares Enterprise Value / Sales EV = Current Share Price * Current Shares + Minority Equity + Net Debt

+ Other LT Liabilities Sales

EV / EBITDA Enterprise Value Basic EBIT + Depreciation + Amortization iQmethod SMis the set of BofA Merrill Lynch standard measures that serve to maintain global consistency under three broad headings: Business Performance, Quality of Earnings, and validations. The key features of iQmethod are: A consistently structured, detailed, and transparent methodology. Guidelines to maximize the effectiveness of the comparative valuation process, and to identify some common pitfalls. iQdatabase ® is our real-time global research database that is sourced directly from our equity analysts’ earnings models and includes forecasted as well as historical data for income statements, balance sheets, and cash flow statements for companies covered by BofA Merrill Lynch. iQprofile SM, iQmethod SM are service marks of Merrill Lynch & Co., Inc.iQdatabase ®is a registered service mark of Merrill Lynch & Co., Inc.


28

Important Disclosures XCGQF Price Chart

0.001.002.003.004.005.006.007.008.009.00

10.00

1-Jan-11 1-Jan-12 1-Jan-13XCGQF

B : Buy, N : Neutral, U : Underperform, PO : Price objective, NA : No longer valid, NR: No Rating

27-Sep:BWang

PO:HK$7.1019-Jan

PO:HK$8.4011-Mar

PO:HK$8.60

21-AprZhang

PO:HK$5.40

Review Restricted No Coverage

The Investment Opinion System is contained at the end of the report under the heading "Fundamental Equity Opinion Key". Dark grey shading indicates the security is restricted with the opinion suspended. Medium grey shading indicates the security is under review with the opinion withdrawn. Light grey shading indicates the security is not covered. Chart is current as of March 31, 2013 or such later date as indicated. Investment Rating Distribution: Non-Ferrous Metals/Mining & Minerals Group (as of 31 Mar 2013) Coverage Universe Count Percent Inv. Banking Relationships* Count Percent Buy 78 46.71% Buy 58 74.36% Neutral 40 23.95% Neutral 27 67.50% Sell 49 29.34% Sell 25 51.02% Investment Rating Distribution: Global Group (as of 31 Mar 2013) Coverage Universe Count Percent Inv. Banking Relationships* Count Percent Buy 1677 49.32% Buy 1226 73.11% Neutral 826 24.29% Neutral 600 72.64% Sell 897 26.38% Sell 570 63.55% * Companies that were investment banking clients of BofA Merrill Lynch or one of its affiliates within the past 12 months. For purposes of this distribution, a stock rated Underperform is included as a Sell.

FUNDAMENTAL EQUITY OPINION KEY: Opinions include a Volatility Risk Rating, an Investment Rating and an Income Rating. VOLATILITY RISK RATINGS, indicators of potential price fluctuation, are: A - Low, B - Medium and C - High. INVESTMENT RATINGS reflect the analyst’s assessment of a stock’s: (i) absolute total return potential and (ii) attractiveness for investment relative to other stocks within its Coverage Cluster (defined below). There are three investment ratings: 1 - Buy stocks are expected to have a total return of at least 10% and are the most attractive stocks in the coverage cluster; 2 - Neutral stocks are expected to remain flat or increase in value and are less attractive than Buy rated stocks and 3 - Underperform stocks are the least attractive stocks in a coverage cluster. Analysts assign investment ratings considering, among other things, the 0-12 month total return expectation for a stock and the firm’s guidelines for ratings dispersions (shown in the table below). The current price objective for a stock should be referenced to better understand the total return expectation at any given time. The price objective reflects the analyst’s view of the potential price appreciation (depreciation). Investment rating Total return expectation (within 12-month period of date of initial rating) Ratings dispersion guidelines for coverage cluster*

Buy ≥ 10% ≤ 70% Neutral ≥ 0% ≤ 30%

Underperform N/A ≥ 20% * Ratings dispersions may vary from time to time where BofA Merrill Lynch Research believes it better reflects the investment prospects of stocks in a Coverage Cluster.

INCOME RATINGS, indicators of potential cash dividends, are: 7 - same/higher (dividend considered to be secure), 8 - same/lower (dividend not considered to be secure) and 9 - pays no cash dividend. Coverage Cluster is comprised of stocks covered by a single analyst or two or more analysts sharing a common industry, sector, region or other classification(s). A stock’s coverage cluster is included in the most recent BofA Merrill Lynch Comment referencing the stock.

Price charts for the securities referenced in this research report are available at http://pricecharts.ml.com, or call 1-800-MERRILL to have them mailed. In the US, retail sales and/or distribution of this report may be made only in states where these securities are exempt from registration or have been qualified for

sale: CHQ. BofA Merrill Lynch Research personnel (including the analyst(s) responsible for this report) receive compensation based upon, among other factors, the overall

profitability of Bank of America Corporation, including profits derived from investment banking revenues.


29

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