China Industrial Automation:1Q17-a strong start to the year

Manufacturing upgrades further accelerated; Buy HOLI and Inovance.

    Market dynamics by sub-segment China’s industrial automation (IA)
demand further accelerated to 9% YoY in 1Q after reverting to positive
growth in 4Q16. The acceleration in manufacturing upgrades in China
appeared to be the major driver. During 1Q, ~1,000 applications for IM
demonstration projects were submitted to the government (vs. an average
of ~200 previously). In addition, previously struggling verticals, such
as textile machinery, packaging machinery and machine tools all
recovered strongly (+15-20% YoY), suggesting manufacturing upgrades are
gaining traction in these traditional industries. We expect this strong
momentum to carry on and prefer local players, on rising import

    Market dynamics by sub-segment.

    Strong growth momentum from the OEM market sustained in 1Q (+13%
YoY), as manufacturing upgrades in China have been gaining momentum.
Demand from the project market turned to positive growth (+6% YoY) in
1Q, driven by the resumption of previously-delayed projects.

    Servo: New order growth stayed in the double digits for three
consecutive quarters (since 3Q16). Capex growth in the electronic
manufacturing sector was better than expected in 1Q while a strong
recovery in machine tools, packaging machinery and textile machinery
persisted. Channel restocking was also a key driver, in anticipation of
rising raw material costs. Local leaders like Inovance (+106% YoY) and
Japanese players (most up >20% YoY) continued to outperform, at the
expense of US and European players.

    Low-voltage inverters: Shipment growth further accelerated to the
double digit level in 1Q (+13% YoY vs. +6% YoY in 4Q16), as most
downstream verticals continued to see visible recovery, with the
exception of wind power. Local leaders like Inovance (+50% YoY) and INVT
(+c.30% YoY) continued to gain market share as import substitutions
continued. In selective verticals, like textile machinery (c.10% of OEM
market), local brands started to replace Japanese brands.

    DCS: New orders (for products only) turned to positive growth in 1Q
(+0.2% YoY vs. -7% on average in 2016) as previously-delayed projects
gradually resumed. Power (especially thermal power) continued to be
under pressure while metallurgy and chemicals seemed to have bottomed
out. 70-80% of DCS demand is now derived from retrofitting and upgrades.
This partly explains why HOLI has managed to grow its DCS new orders by
c.40% YoY during the past three quarters.

    Top picks: HOLI and Inovance; risks.

    Inovance’s IA order growth exceeded expectations in 1Q (+60% YoY).
HOLI also significantly outperformed the overall DCS market by growing
its new orders by c.30% during the last quarter. We prefer local leaders
to play China’s intelligent manufacturing theme and reiterate our Buy on
HOLI and Inovance. We use DCF to value the two companies. Key risks:
slower-than-expected IA and import substitutions.


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