Key points of investment

1. One-sentence logic

Xugong Machinery: China's leading construction machinery company. The benefits of mixed reform are prominent, global competitiveness has improved, and value is expected to be re-evaluated. According to the latest Yellow Table list in 2024, XCMG Group has a global market share of 5.3%, ranking fourth in the world, ranking first in China. The company's ROE level has ranked among the highest in the industry in recent years. 2024H1's average ROE is 6.4%, higher than Liugong 5.8%, Sany Heavy Industries 5.2%, and Zoomlion Heavy Industries 4.1%. Profitability continued to increase, and the net sales margin increased from 4.5% in 2022 to 7.5% in 2024H1. As the deepening reform of state-owned enterprises drives the release of operating vitality, it is expected that there is still plenty of room for improvement in asset quality and profitability.

The inflection point of the industry is gradually approaching: excavator sales increased 11% year on year in September, and sales in China increased 22% year on year, and have been growing for 7 consecutive months. Exports increased by nearly 3% year-on-year, and have been growing for two consecutive months. The “trilogy” of the recovery of the construction machinery industry (exports, improvement in domestic expectations, start of replacement demand), the logic is gradually verified.

II. Logic that exceeds expectations

(1) Market expectations: Domestic construction machinery is still in a slump, real estate demand expectations are insufficient, and there is downward pressure. It is feared that infrastructure funding will fall short of expectations, operating rates will continue to be under pressure, and demand for new aircraft sales will be insufficient.

(2) We predict that the Ministry of Finance recently indicated that it plans to increase large-scale debt limits at one time, replace hidden debts held by local governments, and step up efforts to support local debt risk mitigation.

a) Increased financial debt is expected to increase the progress of local government projects, and projects that have already been reviewed and not implemented are expected to continue to advance to ensure physical workload. The Politburo meeting emphasized the need to stop the decline and stabilize the real estate market. It is expected that an inflection point in real estate infrastructure is expected to arrive, which is expected to drive the domestic demand rate for subsequent construction machinery and sales of new machinery.

b) The issuance of special bonds, ultra-long-term special treasury bonds, additional treasury bonds, etc., is expected to accelerate repayments to downstream customers. The company has many central and state-owned enterprise customers, which is conducive to improving the risk of the company's accounts receivable, continuously optimizing the balance sheet, and continuously improving asset quality. Domestic demand in the industry bottoms out in 2024, and the domestic renewal cycle is expected to gradually begin. The scale effect and operating efficiency are expected to be further released, driving the company's performance and valuation upward.

III. Inspection and Catalysis

1. Inspection indicators: monthly excavator sales; domestic real estate, infrastructure investment, and new construction; excavator operating rate; excavator export sales; company profitability indicators such as gross profit margin and net interest rate.

2. Possible catalysts: domestic real estate and infrastructure investment, new construction starts and favorable policies; domestic downstream workload rebounds and operating rates rise; domestic and export sales of excavators exceed expectations; release of business vitality, increase in company profitability; acceleration of international business, etc.

IV. Research value

1. Unique understanding: The market is worried that the construction machinery industry is still in a downward phase, and the company's balance sheet is under pressure. We believe that domestic and foreign demand for this round of construction machinery has gradually bottomed out and the downside risks are manageable. The benefits of the company's mixed reform have been highlighted, and profitability has improved. As the industry lays ground up, the company's overseas business is accelerated, performance is released, and asset quality is improved, and value is expected to be re-evaluated.

Judgment basis:

(1) Domestic and foreign construction machinery demand is expected to bottom up. Based on the 8-year peak excavator renewal period, domestic excavator renewal demand is expected to gradually bottom out and improve in 2024. Marginal infrastructure and real estate policies are expected to stabilize and improve. Construction machinery export data has been corrected year on year for 2 consecutive months. The boom is expected to continue along with the recovery in demand in Southeast Asia and other regions.

(2) The international layout is progressing rapidly, and the global market share is expected to gradually increase. The company's share of overseas revenue reached a record high in the first half of 2024. Overseas revenue was 27.7 billion, accounting for 44% of total revenue, up 3.4 pcts year on year; gross margin of overseas sales was 24.4%, up 1.2 pct year on year, 2.7 pct higher than domestic sales margin in the first half of the year. The overseas share of the company's major products such as excavators, loaders, rollers, and aerial work platforms all increased, and overseas revenue from excavators increased 16% year on year.

(3) Product structure optimization, high growth in emerging industries such as mining machinery. 2024H1 maintains the top position in the domestic industry for 16 types of mainframes, including truck cranes, truck-mounted cranes, and road rollers. The company's high-end product revenue increased by more than 10% year on year, accounting for more than 32% of total revenue and a year-on-year increase of 4 pcts. Recently, the company signed a strategic cooperation with global mining giant Rio Tinto and won a 0.8 billion bid, which is an important sign that XCMG mining equipment has entered world-class customers. The global mining machinery market is large and profitable. XCMG is leading the mining machinery industry in China. The company's mining machinery business achieved revenue of 5.9 billion in 2023, an increase of 14% over the previous year, and its share of overall revenue increased to 6%.

(4) With the implementation of equity incentives and other measures, profitability is expected to gradually improve. The company's equity incentive assessment requires that in addition to net profit, the assessment target is to increase profitability assessments. The 2023-2025 return on net assets is not less than 9%, 9.5%, and 10%, and not lower than the average level of the same industry or the 75th quart level of the target company.

2. A different understanding from before: balance sheet optimization+increase in dividend ratio. The company is a leading state-owned enterprise in undervalued construction machinery, and the intrinsic value is expected to be re-valued. The company's 2024H1 balance ratio was 63.3%, down 1.2 pct from the end of 2023; net inventory pressure dropped 2.16 billion from the beginning of the year, a decrease of 7%; financial lease repurchase obligation balance was 58.3 billion, down 4.6 billion from the end of 2023, a decrease of 7%; and decreased by about 12.6 billion yuan, a decrease of 18% from the same period last year, and off-balance sheet contingent liabilities continued to improve. The 2023 dividend ratio is 40%.

5. Profit forecast and valuation

The company's revenue for 2024-2026 is expected to be 91.9, 109.4, and 133.4 billion yuan, up -1%, 19%, and 22%; net profit to mother will be 6.2, 8.1, and 10 billion yuan, up 17%, 30%, and 24% year on year, corresponding PE will be 14, 11, 9 times. The compound net profit growth rate for 2023-2026 is 23%, maintaining a “buy” rating.

6. Risk Reminder

1) Investment in infrastructure and real estate falls short of expectations; 2) Exports fall short of expectations; 3) Exposure to risks such as accounts receivable