ebitda (rmb mn) 265 330 520 739 sales (rmb mn) 402 539 749...

l Equity Research l

Important disclosures can be found in the Disclosures Appendix All rights reserved. Standard Chartered Bank 2014 http://research.standardchartered.com

China l Durable Household Products 22 July 2014

Ozner Water International Holding

Differentiated growth franchise

Ozner Water International Holding (Ozner) is China’s third-

largest water purifier maker, and the largest in the

commercial segment. Ozner taps a fast-growing market,

where end demand posted a 29% CAGR over 2008-12.

Ozner’s differentiated ‘lease-and-service’ model and sticky

user base makes it a good candidate for investors who want

exposure to this high-growth sector. We forecast 37%

adjusted earnings growth over 2014-16E, as we expect the

user base to triple over the period.

We initiate coverage on Ozner with an Outperform rating

and a price target of HKD 3.80, based on 27x 2014E

earnings, implying 0.75x PEG.

OUTPERFORM (initiating coverage)

Differentiated growth franchise. A leading water purifier maker,

Ozner distinguishes itself by service, technology, and an innovative

lease-and-service business model. This model allows it to source

growth aggressively while keeping complete control over customer

experience. The result is not only a sticky user base (attrition rate

of just c.1%), but also potentially good cross-selling opportunities.

In our view, such a business model, together with its relatively

large cash outlay, creates a considerable barrier to entry into the

mid- to high end segment of the market.

User base to more than triple by 2016. We expect its water

purifier user base to triple by 2016. This should drive a 37% CAGR

in net earnings over 2014-16E, before integrating any cross-selling

or advertising revenues that could represent a blue-sky scenario.

Peer comparison. Its global peer, Korea-based Coway (NR),

which has a similar business model, trades at 24.3x 2014E

earnings (Bloomberg consensus). We argue that Ozner merits a

premium to its peers, for its greater near-term growth potential. We

base our price target on 27x current-year adjusted earnings.

Key downside risks: We identify the high capital requirement,

rising competition and user defection as the main risks to Ozner’s

business.

Source: Company, Standard Chartered Research estimates

Share price performance

Source: Company, FactSet

PRICE as of 21 Jul 2014

HKD 3.19

PRICE TARGET

HKD 3.80

Bloomberg code Reuters code

2014 HK 2014.HK

Market cap 12-month range

HKD 5,587mn (USD 721mn) HKD 2.75 - 3.45

EPS adj est change NA

Year-end: December 2013 2014E 2015E 2016E

Sales (RMB mn) 402 539 749 1,075

EBITDA (RMB mn) 265 330 520 739

EBIT (RMB mn) 185 204 331 464

Pre-tax profit (RMB mn) 184 200 330 463

Net profit adj. (RMB mn) 153 211 290 392

FCF (RMB mn) (106) (218) (185) (106)

EPS adj. (RMB) 0.12 0.11 0.15 0.20

DPS (RMB) 0.00 0.00 0.00 0.00

Book value/share (RMB) 0.26 1.05 1.21 1.43

EPS growth adj. (%) 50.7 -9.0 37.3 35.2

DPS growth (%) - - - -

EBITDA margin (%) 65.9 61.2 69.3 68.8

EBIT margin (%) 46.1 37.9 44.2 43.2

Net margin adj. (%) 38.1 39.3 38.7 36.5

Div. payout (%) 0.0 0.0 0.0 0.0

Net gearing (%) -2.6 -39.5 -25.7 -17.5

ROE (%) 59.5 15.2 13.8 16.6

ROCE (%) 70.3 18.6 16.6 20.0

EV/sales (x) - 6.8 4.8 3.4

EV/EBITDA (x) - 11.2 7.0 5.0

PBR (x) - 2.4 2.0 1.7

PER adj. (x) - 22.9 15.7 11.6

Dividend yield (%) - 0.0 0.0 0.0

2.7

3.1

3.5

Jun-14

Ozner Water International Holding

HANG SENG CHINA ENT INDX (rebased)

Share price (%) -1 mth -3 mth -12 mth

Ordinary shares 3 - -

Relative to index 3 - -

Relative to sector - - -

Major shareholder Xiao Shu (25.5%)

Free float 28%

Average turnover (USD) 8,741,408

Su Zhang +852 3983 8526

Equity Research

Standard Chartered Bank (HK) Limited

2014 HK HKD 3.19

HKD 3.80

mailto:[email protected]

Equity Research l Ozner Water International Holding

22 July 2014 2

Contents

Investment case 3

Key risks 6

Valuation 7

Strong growth in the water purification market 10

Innovative business model 13

Financials 21

Appendix 24


22 July 2014 3

Investment case Ozner is China’s third-largest water purifier manufacturer in terms of retail value

(2012), with a market share of 1.1%. It is also the largest water purifier company in

the commercial segment, with a market share of 5.4%, according to a Frost &

Sullivan report. It provides water purification services to both corporate and

household users by renting out water purifiers. It also provides air sanitisation

services for corporate clients through engineering, procurement and construction

(EPC) arrangements. In 2013, water purification accounted for 78% of Ozner’s total

revenue and air sanitisation 22%.

Compared to conventional boiled water and barrelled water, water processed by

purifiers is the most hygienic and convenient solution to safe water consumption. As

Chinese households grow increasingly aware of environmental issues, consumption

of purified water from all the various points of use has grown from 1.4% to 6.8% in

commercial premises and from 4.7% to 12.2% in residential premises over 2008-12.

The water purification sector has enjoyed a 29% CAGR over 2008-12 and evolved

into an RMB 42.5bn market in 2012, including RMB 35.1bn in residential and RMB

7.4bn in commercial, according to Frost & Sullivan.

Figure 1: Water purifier market size and growth estimates

Source: Frost & Sullivan report

The water purifier market in China is fragmented, with the top 10 companies

accounting for only about 10% of the market, according to Frost & Sullivan. We

believe Ozner distinguishes itself by offering good technology and high-quality

service at an affordable total cost, owing to its unique lease-and-service model. With

its initial success in the corporate segment, Ozner believes it can take on the much

bigger household market with a high-end product positioning. The relatively large

cash outlay of Ozner’s business model and the service and technology it provides

create a reasonably high entry barrier in the mid- to high-end market that Ozner taps.

Ozner’s innovative lease and service model has allowed it to source growth more

aggressively, while maintaining control over the customer experience.

Its unique fee structure makes the otherwise expensive technologies more

affordable to corporates and households. According to a Frost & Sullivan report,

0

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2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E 2017E

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29% CAGR

24% CAGR


22 July 2014 4

the total cost of using Ozner’s models over a period of five years is 28-34% lower

than the average cost of the best-selling models of its main competitors.

All key customer functions (marketing and branding, delivery, maintenance,

service) are carefully managed in-house with the purpose of further enhancing

and monitoring the end user experience. The result is excellent user stickiness: the

company has a very low attrition rate of around 1%; 20% of its new customers

have come through ‘word-of-mouth’ references by existing customers.

Its rich mark-up (30-50%) to third-party distributors incentivises and drives new

customer acquisition while ensuring distributors’ loyalty.

Meanwhile Ozner boasts proprietary technologies that are setting the industry

standard:

The company was appointed as the deputy chief of the Industry Standard

Promulgation Panel for Water Purification-related Technical Standardisation

Committee, and was commissioned to help set national technical standards for the

purified drinking water industry in China in 2012 and 2013.

Its self-developed reverse osmosis technology allows for an over-95% recovery

ratio of purified water, compared to 20-50% achieved by competitors.

Its proprietary ozone technology is capable of generating a small volume and high

concentration of ozone with low power consumption.

The new generation of water purifiers is capable of reporting back on water quality

to Ozner. The machines can then be serviced by a network of technicians in 119

cities within 30 minutes, 24 hours a day, seven days a week.

Lastly, we believe that the combination of Ozner’s solid business platform and user

base presents strong cross-selling and offline-to-online (O2O) retailing

potential.

Ozner’s solid distribution channels can be utilised to cross-sell other environmental

home appliances, such as air purifiers and bathroom appliances, like in the case of

Korea-based Coway.

Its new generation of machines, equipped with mobile communication technology,

can add targeted marketing content and appeal to O2O retailers and service

providers, in our view. This could help Ozner to find new revenue streams in a

more capital-efficient way.

As a combined result of the above factors, Ozner’s subscriber base quadrupled and

contract sales nearly tripled to 463,000 over 2011-13. We expect its subscriber base to

more than triple by 2016 to 1.5 million. We project group turnover, after posting 98%

CAGR for the past two years, to record a 39% CAGR over 2014-16E. While we do not

expect all the top line growth to filter through to the bottom line, we project a 37%

adjusted earnings CAGR over 2014-16E.


22 July 2014 5

Figure 2: Rapid growth of installed user base

Source: Company, Standard Chartered Research

Our price target of HKD 3.80 is based on 27x current-year adjusted earnings, and

implies 0.75x PEG on net earnings CAGR over 2014-16E. Given its strong growth

potential and upward trending ROE, we believe that Ozner should trade at a premium

to its global peers’ 24.8x FY14E (Bloomberg consensus) earnings.

Its closest peer in terms of business model similarity, Korea-based Coway, trades at

24.7x 2014E consensus earnings. However, we believe that Ozner’s water purifier

business enjoys a much larger addressable market in China (12% penetration of

households) than Coway’s in Korea (40% penetration). Ozner’s subscriber base has

grown much faster (93% CAGR like-for-like over 2011-13) than Coway’s (6% CAGR

over 2008-12). In our view, Ozner can ramp up its ROE from 9% in 2014 (year-end)

to 15% in 2016 (year-end), versus Coway’s steady ROE of 28% in coming years,

according to Bloomberg consensus.

0

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300,000

400,000

500,000

600,000

700,000

800,000

900,000

2011 2012 2013 2014e 2015e 2016e

Corporate Household


22 July 2014 6

Key risks Asset-heavy business model: Ozner’s business model requires a relatively long

time to become cash flow-positive, in our view. We estimate that the company will not

become free cash flow-positive until 2018 (see Figure 3). This mismatch of operating

cash flow and capex could be an area of concern for investors at times of tightening

funding conditions.

Figure 3: Free cash flow projection


Safety issue: Safety incidents in Ozner’s water purifiers could be detrimental to its

brand and business model.

Competition: Industry leaders like Midea and Qinyuan are committing more

resources to tap this sector for its strong growth prospects. Smaller companies

backed by private equity are also gearing up for growth in this space. As such,

Ozner’s sales are at risk of plateauing early, before reaching critical size.

Contract renewal: There is no assurance that the company will be successful in

renewing contracts with end users at the end of each year. Client defection could

result in large asset impairment, i.e., write-off of the residual value of the revenue-

generating assets. Currently, Ozner books no such disposal charge, as it has no

difficulty in re-selling the returned machines. In Coway’s case, the rental assets

disposal charge fluctuates between 2-4% of revenue.

Depreciation years: The largest cost item in the COGS of water purifiers is the

depreciation of the revenue-generating assets. Ozner capitalises manufacturing cost

on the water purification side and depreciates it over 10 years, compared to Coway’s

five years. Admittedly, Coway’s product remains in use after the five-year

depreciation period. Ozner justifies its own depreciation assumption by citing an

independent certified appraiser. It says that its machines’ anti-scratch exterior and

main components are built to last for over 12 years.

-250

-200

-150

-100

-50

-

50

100

150

2011 2012 2013E 2014E 2015E 2016E 2017E 2018E

RM

Bm

FCF


22 July 2014 7

Valuation We believe that Ozner’s equity should command a fair value of 27x PER on 2014E

earnings (and 19x 2015E earnings), based mainly on peer multiples, while using DCF

valuation as a reference.

Relative valuation – Coway (021240 KS) is the most comparable peer

Global water purification peers on average trade at 24.8x FY14E PER, 8.7x

EV/EBITDA and 3.2x FY14E PBR. This reflects the unique growth appeal of this

sector, which has been boosted by the steady rise in global health-related spending.

(See Figure 4 for the valuation comps of Ozner’s global peers in water purification.)

Figure 4: Global peers – Valuation comps

Company Bloomberg Ticker

Mkt Cap

EPS YoY Growth(%) P/E P/BV EV/EBITDA ROE (%)

Net gearing

(%) (USD mn) FY14E FY15E FY14E FY15E FY14E FY15E FY14E FY15E FY13A FY14E FY15E FY14E

Coway Co. Ltd (NR) 021240 KS 7,043 20.1 15.4 24.3 21.0 6.2 5.3 12.6 11.2 25.6 28.7 28.1 9.5

Nihon Trim Co (NR) 6788 JP 312 -20.9 20.7 15.6 12.9 1.9 1.6 7.3 5.8 14.7 12.4 14.6 -46.0

Shanghai Canature (NR) 300272 CH 712 23.3 21.6 34.3 28.3 3.6 3.2 NA NA 11.8 NA NA -53.7

Waterlogic (NR) WTL LN 136 26.1 NA NA NA NA NA NA NA 10.9 NA NA -27.0

Kurita water industries (NR) 6370 JP 2,864 23.6 10.5 25.1 22.7 1.3 1.3 6.3 6.0 4.5 5.3 5.3 -40.2

Average

2,213 14.4 17.0 24.8 21.2 3.2 2.8 8.7 7.7 13.5 15.5 16.0 -31.5

Source: Bloomberg, Standard Chartered Research

Among its peers, only Coway in Korea (non-rated) has a similar rental model in its

water purifier business, which accounted for 50% of revenue in 2012. Coway trades

at 24.3x FY14E PER and 6.2x PBR, and is projected by consensus to grow at an

18% CAGR with average ROE of 28.4% over 2014-15E.

Comparing Ozner with Coway, we note the following key differences:

The water purifier business has a much larger addressable market in China than in

Korea. Besides the obvious difference in the size of the economies, water purifiers

have an about 40% penetration rate in South Korea (according to Coway) versus

12% in China (according to Frost & Sullivan).

Ozner’s subscriber base has grown much faster in the past (93% CAGR like-for-like

over 2011-13) and is projected to grow rapidly (47% CAGR over 2014-16E).

Coway’s subscriber base, meanwhile, only registered a 6% CAGR over 2008-12

since it is a fairly mature player in the sector, occupying c.50% of the Korean market.

While still in the investment stage, we expect Ozner’s potential recapitalisation to

satisfy its funding needs over 2014-17. We expect its ROE to ramp up from 9% in

2014 to 17% in 2017. Coway, on the other hand, has steadier free cash flow, a

more leveraged balance sheet and a more stable ROE.

We conclude that Ozner merits a higher multiple than Coway, for its superior growth

potential and upward trending ROE. While it pales in comparison with Coway on the

free cash flow (FCF) generation and ROE metrics, Ozner could generate positive

FCF from its installed base if it ceased its growth plans. We believe that lower FCF

and ROE are normal features of a young growth franchise and arguably should not

preclude a high valuation premium for such companies over their more mature peers

(most recent sector examples are in China’s internet and renewable energy space).

We believe Ozner should command a 10% premium over Coway on current year

PER (Ozner still trades at an 8% discount on the 2015E multiple to Coway).


22 July 2014 8

Absolute valuation – DCF suggests RMB 7bn fair value

We derive a fair value of RMB 6.9bn using DCF, implying 64% upside to the current

valuation. Our key assumptions include a WACC of 9.4%, beta of 0.67 (10% higher

than Coway’s two-year average adjusted beta), risk free-rate of 3.8%, terminal tax rate

of 25%, and terminal growth rate of 3%.

Figure 5: Ozner – DCF analysis Explicit forecasts Middle Terminal

Period 2013 2014 2015 2016 2017 2018 2023

Turnover 402 539 749 1,075 1,509 1,660 2,753

Operating profit (EBIT) 185 204 331 464 636 697 1,101

Add back amortisation 8 10 10 10 10 10 10

Add back depreciation 72 116 179 265 380 418 693

EBITDA 265 330 520 739 1,026 1,125 1,805

Taxation (EBITA * tax rate) (32) (36) (58) (81) (110) (120) (278)

Less increase/add decrease in

working capital

70 59 146 303 447 (10) (5)

Less capex (447) (552) (771) (1,042) (1,374) (919) (693)

Free cash flow for the firm (FCFF) (145) (199) (163) (80) (11) 75 828

Discount rate (WACC) (%) 9.4

Discounted value (RMB mn) (144.9) (199.1) (149.2) (66.9) (8.0) 266.3 6,353.5

Derived EV (RMB mn) 6,196.6

MV net cash (RMB mn) 663

Derived market cap (RMB mn) 6,859.8

No of Shares (mn) 1,751

DCF value per share (RMB) 3.92

DCF value per share (HKD) 5.04


We believe a DCF valuation would be more relevant as a primary valuation tool when

Ozner completes its investment phase and becomes a steady free cash flow-

generating business. For now, we make a caveat that the DCF exercise still has too

many moving parts, especially the assumption of the free cash flow breakeven year.

As such, we advise investors to use DCF mainly as a reference point to gauge the

reasonableness of the valuation.


22 July 2014 9

Figure 6: Key DCF assumptions Key assumptions

Cost of equity (%)

Risk free rate (%) 3.80

Beta 0.67

Equity risk premium (%) 8.3

CAPM unleveraged discount rate 9.4

Cost of debt (%)

Average spread over risk-free rate (%) 3.0

Pre-tax cost of debt (%) 6.8

Average corporate tax rate for company (%) 20.0

Post-tax cost of debt (%) 5.4

Estimated target gearing (net debt/EV) (%) -

WACC (%) 9.4

Number of years of explicit estimates 4.0

middle period duration (yrs) 5.0

No of years to start of terminal period 9.0

Middle period assumptions

Growth rate (%) 10.0

Operating margin (%) 42.0

Capex/depreciation ratio (x) 220.0

Working capital/ turnover ratio (%) 6.0

Tax rate (%) 17.0

Terminal period assumptions

Growth rate (%) 3.0

Operating margin (%) 40.0

Capex/depreciation ratio (x) 100.0

Working capital/ turnover ratio (x) 6.0

Tax rate (%) 25.0

Source: Standard Chartered Research


22 July 2014 10

Strong growth in the water purification market

According to Frost & Sullivan, water purifiers are an RMB 42.5bn market. This

comprises RMB 35.1bn in the residential segment and RMB 7.4bn in the commercial

segment. With demand expanding for purified water, the residential segment is

expected to report a 21% CAGR over 2013-17, and the commercial segment is likely

to rise at a 32% CAGR over the same period.

Figure 7: China water purifier market size and growth estimates

Source: Frost & Sullivan

The main point-of-use of drinking water solutions in China include boiled tap water,

barrelled water and water processed by purifiers. Meanwhile, drinking from tap water

directly is generally considered not safe. Of the three, water processed by purifiers is

the most effective (from a purity standpoint) and convenient solution, although less

affordable and accessible than boiled tap water. Figure 8 below lists the advantages

and disadvantages of each point-of-use solution, according to the Frost & Sullivan

report.

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22 July 2014 11

Figure 8: Comparing each type of point-of-use drinking water Treatment method Advantages Disadvantages

Boiled tap water Low cost

Widely accessible

Residual bacteria, metals and chemicals

Uncomfortable taste and odour (sometimes)

Turbidity (sometimes)

Barrelled water Treated to remove bacteria, metals, and chemicals

Convenient

Widely accessible

Secondary pollution caused by contaminated container (barrel) and aging dispenser

Bacteria reproduction caused by long-term storage

Delivery required

Inconvenient to replace barrel

High cost

Unstable water quality caused by irregular maintenance

No real-time monitoring on water quality

Water processed by purifiers

Processed to remove bacteria, metals, minerals and chemicals

Fresh drinking water on demand

No secondary pollution

Real-time monitoring of water quality

Convenient

Relatively low cost

Better taste, without odour

Not widely available


Rapid urbanisation, industrialisation and rising environmental awareness should drive

strong demand growth for water purifiers in China. In 2012, approximately one-third

of China’s rivers, 40% of its major lakes and reservoirs, and 60% of ground water

were contaminated and the water unsuitable for drinking. Moreover, existing water

treatment and delivery facilities are unable to remove certain metal ions and

chemicals from water, which could be a source for secondary contamination (from

unqualified pipes, open tanks, etc). As such, tap water in China tends to have a

relatively high level of pathogenic microorganisms, metal ions and chemicals

compared with many developed countries. Increasingly aware of this issue, China’s

urban residents are becoming more willing to spend on safe drinking water,

according to Ozner.

Compared to barrelled water, water from purifiers has several advantages:

convenience, lower chances of secondary pollution, and lower lifetime cost.

According to Frost & Sullivan, water-purification services, compared to barrelled

water services, can help a factory of 300 employees save up to 60% and a family of

three save approximately 30%, of their total drinking water cost over a five-year

period.

Thanks to the advantages of purified water over other points of use, the percentage

of the consumption of water processed by purifiers has grown both at commercial

and residential premises. According to Frost & Sullivan, at commercial premises,

water consumed through purifiers as a percentage of total water consumed increased

from 1.4% in 2008 to 6.8% in 2012, and is expected to grow to 27.7% in 2017. At

residential premises, water consumed using water purifiers as a percentage of total

water consumed increased from 4.7% in 2008 to 12.2% in 2012, and is expected to

grow to 32.0% in 2017.


22 July 2014 12

Figure 9: Point-of-use drinking water at commercial

premises


Figure 10: Point-of-use drinking water at residential

premises


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Boiled Tap Water Barreled Water Water processed by Purifiers

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Boiled Tap Water Barreled Water Water processed by Purifiers Others


22 July 2014 13

Innovative business model Competition in the water purifier market is intense

The water purifier market in China is fragmented, with the top 10 companies

accounting for only about 10% of the market in terms of retail sales value (in Figure

11 below, Ozner’s retail sales in 2012 are measured as the aggregate annual service

fee paid by end users in 2012).

Figure 11: Water purifier market share

2012 market share (%)

Midea 2.2

Qinyuan 1.6

Ozner 1.1

Shenzhen Litree 0.9

Shenzhen Angel 0.9

Hefei GeMei 0.8

Pentair 0.6

Ecowater 0.6

A.O.Smith 0.6

Canature 0.6

Others 90.1

Total 100.0



22 July 2014 14

Ozner ranks number 3 in the overall water purification market, but number 1 in the

more demanding commercial segment in China. It has a 5.4% market share in

commercial, which is substantially higher than Midea’s 1.9% and Qinyuan’s 1.4%,

according to the Frost & Sullivan report. Ozner claims to be a technology and

services leader with a high-end product positioning. In addition, it is the only major

water purifier company that has a lease model, the others having a one-off appliance

sales model. Hangzhou Juxing, with a similar model to Ozner, has only 1.4% of the

commercial segment (versus Ozner’s 5.4%). We believe Ozner can grow its market

share even further over the coming years, given its competitive advantages.

Ozner has innovative products supported by patented and proprietary technologies

Currently Ozner has 26 corporate models and six household models of water-

purifying machines under the high-end brand ‘Ozner’ (see the pictures below

depicting Ozner’s key water purifiers).

Figure 12: Main corporate water purifier models

Source: Company


22 July 2014 15

Figure 13: Main household water purifier models

Source: Company


22 July 2014 16

In the water purification process (see Figure 14), we believe Ozner has competitive

advantages in the reverse osmosis membrane and ozone sterilisation technologies.

Figure 14: Water purification technology

Source: Company

Its self-developed reverse osmosis technology allows for a 95% recovery of purified

water, compared with 20-50% achieved by other advanced water-purifying models,

according to Frost & Sullivan. Meanwhile, Ozner’s ozone technology has several

distinctive advantages, including the capability to generate a small volume and high

concentration of ozone at low power consumption, the instant degradation of residual

ozone that removes harmful side effects, and a patented high-efficiency gas-water

mixing device that achieves a superior gas-water breakup and atomisation mixing.

In 2012 and 2013, Ozner was appointed as the deputy chief of the Industrial

Standard Promulgation Panel for Water Purification Industry. This is an endorsement

of its technology leadership in the industry, in our view.

Ozner recently launched second-generation water purifiers, employing its latest

reverse osmosis and ozone technology. These second-generation water purifiers can

improve the water purification recovery ratio to 95% (from 25-50%), monitor the

machines in real time, and automatically report faults to service centres. Compared to

competitors’ less “smart” models, we believe these second-generation models will be

an important catalyst to help Ozner gain market share.

Ozner’s differentiated business model allows it to expand faster and creates user stickiness

Compared with major competitors, Ozner runs a unique rental model to distribute its

machines. The below diagram illustrates the fee arrangement Ozner has with its

principal and sub-distributors.


22 July 2014 17

Figure 15: Ozner’s fee arrangement with its principal and sub-distributors

Source: Company

We explain the key features of Ozner’s business model below:

Ozner maintains a pricing system (see Figure 16), which sets out the range of

annual service fees charged by distributors to end users, and the amount of annual

leasing fee charged by Ozner to principal distributors. It also implements measures

to prevent distributors from cannibalisation.

Figure 16: Ozner’s fee structure

Annual fee charged by Ozner to distributors Annual fee charged by distributors to end customers

RMB Year 1 Subsequent years Year 1 Subsequent years

Hub corporate model 5,180 2,880 6,280-7,880 3,680-4,680

Other corporate models 1,010-2,380 700-1,090 1,160-3,280 1,160-1,480

Household model 1,010-1,280 400-580 1,260-1,750 860-1,380

Source: Company

Ozner’s fee structure ensures that its otherwise expensive technologies become

more affordable to corporates and households. According to Frost & Sullivan, the

cost of using Ozner’s models over a period of five years is 28-34% lower than the

average cost of the best-selling models of its main competitors.

OZNER

End users

Delivery/installation/

maintenance

Annual leasing fee

Annual

service fee Sub-leasing fee

Contractual arrangement Service Payment

Principal distributor

Sub-distributor


22 July 2014 18

Figure 17: Expenditure comparison among selected brands

Ozner Manufacturer A Manufacturer B Manufacturer C Ozner vs avg of

competitors

Total expenditure (5 years)

Commercial 11,700 12,480 16,500 19,788 -28%

Residential 4,400 5,396 6,200 8,388 -34%

Total expenditure (10 years)

Commercial 23,200 15,580 30,250 35,788 -15%

Residential 7,800 8,396 11,200 14,388 -31%


Ozner has full control of delivery, installation, and service of the machines. For any

service request, end users and distributors can call the call centres staffed with

350-plus employees on a 24/7 basis. The requests are then passed on to 500-plus

on-the-ground engineers in 125 cities in China.

Its rich mark-up (30-50%) to third-party distributors incentivises new customer

acquisition and rental collection. Distributors do not manage inventory nor do they

provide after-sales services. Meanwhile, it allows the principal distributors, who

make an initial payment of RMB 1mn or more, to recruit sub-distributors, who

share revenue generated from end users with the principal distributor.

In return, a principal distributor is required to maintain an outstanding guarantee

deposit with Ozner against any damage or loss of the machines, and transact with

Ozner on a prepaid cash basis.

We highlight that this model has several important merits that fit well with Ozner’s

service leader strategy:

This model allows Ozner to source growth more aggressively: by incentivising

distributors solely on their capability to acquire new customers, Ozner can

potentially grow sales and its user base at a faster pace than competition.

Figure 18: Fast-growing distributor network

Number of distributors

Source: Company

-

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2011 2012 2013

Principal distributor, at end of period

Sub-distributors, at end of period


22 July 2014 19

Such a business model allows Ozner to minimise dependence on middlemen and

to directly control end user experience. This creates user stickiness: Ozner claims

a low attrition rate (1%) in its installed base; 20% of its new customers came from

‘word-of-mouth’ references by existing customers.

The large initial cash outlay and user stickiness creates a relatively high barrier to

entry.

The prepaid cash model also reduces complexity in managing cash flow: Ozner

can collect cash directly from a relatively small number of principal distributors,

versus managing a complex POS system.

Strong business platform and user base offer many growth options

Ozner’s solid business platform presents strong cross-selling potential:

Ozner’s solid distribution channels can be utilised to cross-sell other environmental

home appliances, such as air purifiers and bathroom appliances, etc, like in the

case of Coway.

Ozner’s strong service capabilities equipped with mobile communication

technology can be utilised to add targeted marketing content.

We estimate that Ozner’s water purifier rental revenue will rise at a 44% CAGR over

2014-16E, after recording a 139% CAGR over the past two years. Our model does

not integrate any cross-selling or advertising revenues, which could potentially

represent a blue-sky scenario.

Air sanitisation service not part of the core business, in our view

Ozner also designs and installs air sanitisation systems for clients through EPC

arrangements.

In these EPC projects, Ozner mainly adapts its self-developed KFT series of ozone

generating air sanitization devices to the air sanitisation projects for clients’ specific

needs. In most projects, it acts as a sub-contractor who receives sub-contracted

projects from the principal contractors. The majority of these projects are for the

electronics, food and beverage, and medical industries.

We understand that this segment lacks critical mass, as Ozner hasn’t been

committing many resources to its growth. While we do not view this segment as part

Figure 19: Water purification performance highlights –

Revenue

Source: Company

Figure 20: Water purification performance highlights –

Gross margin

Source: Company

0

50

100

150

200

250

300

350

2011 2012 2013

RM

B m

n

Revenue

77%

78%

79%

80%

81%

82%

83%

2011 2012 2013

%

Gross margin


22 July 2014 20

of its core value proposition, the company has expressed its willingness to retain this

unit for potential growth opportunities, given rising environmental spending by both

public and private business sectors.

The sales of this business fell 5% YoY in 2013 after growing 106% YoY in 2012,

mainly reflecting some timing difference in revenue recognition. Its contract sales still

grew 5% YoY in 2013 after growing 32% YoY in 2012. Our model predicts that this

segment will have 11% revenue growth per year and 30% gross margin over 2014-

2016E.

Figure 21: Air purification performance highlights –

Revenue

Source: Company

Figure 22: Air purification performance highlights – Gross

margin

Source: Company

0

20

40

60

80

100

2011 2012 2013

RM

B m

n

Revenue

0%

5%

10%

15%

20%

25%

30%

35%

2011 2012 2013

%

Gross margin


22 July 2014 21

Financials Revenue outlook

We estimate that Ozner’s revenue growth will reach a 39% CAGR over 2014-16E,

underpinned mainly by strong growth in its water purifier business.

Its water purifier rental revenue is likely to post a 44% CAGR over 2014-16E, after

growing at a 139% CAGR for the past two years. We believe this will be driven by the

growing subscriber base rather than ARPU, for which we assume a gradual

downtrend. Indeed, Ozner’s subscriber base quadrupled over 2011-13, and we

project it to more than triple over 2014-16E to reach 1.5mn, thanks to its innovative

product offering and unique rental-based distribution model.

Meanwhile, we estimate that Ozner’s air sanitisation sales will record an 11% CAGR

over 2014-16E, after the 48% CAGR in the past two years, underpinned by the 10%

CAGR in contract value over the same period.

Figure 23: Installed unit assumptions Operational metrics - water purification 2011 2012 2013 2014E 2015E 2016E

New installation (unit)

Corporate 101,000 112,000 95,000 100,000 110,000 121,000

Household 6,000 27,000 59,000 100,000 200,000 380,000

Total 107,000 139,000 154,000 200,000 310,000 501,000

Installed base / subscribers (unit)

Corporate 101,000 276,000 371,000 471,000 581,000 702,000

Household 6,000 33,000 92,000 192,000 392,000 772,000

Total 107,000 309,000 463,000 663,000 973,000 1,474,000


Figure 24: ARPU assumptions (RMB) 2011 2012 2013 2014e 2015e

Contract sales per installed unit

Corporate 1,163 754 701 669 655

Household 1,242 1,093 892 798 792

Blended 1,167 790 739 706 710

Rental sales per installed unit

Corporate 503 632 758 695 674

Household 417 640 1,027 914 826

Blended 498 633 789 744 727


Margin outlook

The majority of Ozner’s COGS is the cost for EPC projects in the air purification

division. The second largest item in COGS is the depreciation of its revenue-

generating assets. While we assume that the EPC margin will remain steady (at

30%), we estimate that the gross margin for water purification is likely to decline

gradually to 73% in 2016, from 79% in 2013.


22 July 2014 22

This mainly reflects:

A staggered fee structure that allows the installed machine to enjoy a higher ARPU

in year 1 and lower ARPU in subsequent years. This is in part to avoid customer

defection, by having them commit more in year 1.

A higher depreciation charge following the rapid growth in revenue-generating

assets.

A higher depreciation charge after the capex in its greenfield Shaanxi facilities,

where the company plans to add 400,000 units of capacity over 2013-15, on top of

the existing 170,000-unit capacity. It includes 200,000 units of capacity that is likely

to start in August 2014 and 200,000 units of capacity that is likely to start in

September 2015.

Figure 25: Our gross margin assumptions GPM 2011 2012 2013 2014E 2015E 2016E

Water purification 81.8% 80.5% 78.7% 77.0% 75.0% 73.0%

Air sanitisation 24.7% 30.5% 28.9% 30.0% 30.0% 30.0%

Blended GPM 56.7% 64.6% 67.8% 68.1% 68.3% 68.1%


Figure 26: Cash flow structure (household model)

Ozner’s fee structure

Source: Company

Figure 27: Depreciation charge as % of sales


-1,660

1,145

450 450 450 450 450 450 450 450 450

-2,000

-1,500

-1,000

-500

-

500

1,000

1,500

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10

RM

B

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

2011 2012 2013 2014E 2015E 2016E

Depr'n of revenue generating assets as % of sales

Depr'n of PPE as % of sales


22 July 2014 23

We project that the adjusted SG&A and other expenses ratio (i.e., excluding one-off

listing expenses and option expenses) will remain at 23-26% in 2014-16E (2013:

23.2%). The main reason for this is that the company can achieve some economies

of scale on SG&A from its larger installed base, which can largely offset the higher

spend on marketing.

Figure 28: Adjusted SG&A and other expenses ratio


NB: the adjusted SG&A and other expense ratio has adjusted for share option expenses and listing expenses.

Cash flow outlook

We project that the company will not turn free cash flow-positive until 2018. This is

mainly due to a large cash outlay in capex in revenue-generating assets and PPE, as

Ozner is still in investment mode.

We believe such capital requirements also create a high entry barrier. With the

potential recapitalisation of the group, and with Ozner’s advanced technology and

client-centric services, the company has excellent chances of building a deep moat

around its business.

1H14 preview

We expect 1H14 revenue to grow by c.30% and clean net profit (excluding listing

expenses and option expenses) to grow by c.35%. Management confirmed that it has

signed up 200 new distributors in 1H14, versus the full-year target of 800. That said,

management was confident of achieving the target by this year-end, backed by

enhanced marketing efforts in 2H14.

We expect growth to quicken in 2H14 as the company rids itself of the distraction of

the IPO. The company usually reports 40% of sales in the first half and 60% in the

second half, reflecting seasonality in the business.

0%

5%

10%

15%

20%

25%

30%

35%

40%

2011 2012 2013 2014E 2015E 2016E

SG

&A

rat

io


22 July 2014 24

Appendix Figure 29: Porter’s five competitive forces model

Adapted from: Porter 1980 p.4 Source: Company, Standard Chartered Research

Figure 30: SWOT analysis

Strengths Weaknesses

Ozner has good service quality, technology and an innovative lease-and-service model that allows it to grow fast while retaining

control of its user base

Its competitive fee structure allows 28-34% cost savings for end

users, compared with its competitors

Its rich mark-up (30-50%) to third-party distributors drives new

customer acquisition while ensuring distributors' loyalty

Despite being a leader in the corporate segment, Ozner only has 1% market share in this fragmented and competitive sector

Risk of potential entrants is high, as this is a fast-growing area. Many large home-appliance groups (like Haier) are looking into

the opportunities in the sector

Ozner's business model suggests a high capital outlay, which

could be an area for concern at times of tightening funding conditions

Opportunities Threats

China's water purification market is vast and under-tapped (12% household penetration versus 40% penetration in South Korea)

Ozner's platform could allow it to tap cross-selling opportunities

and cooperate with O2O retailers

Competition and user defection are the main threats to its business model

Source: Standard Chartered Research

Risk of potential entrants is high, as

this is a fast-growing area and many large home-appliance groups (like

Haier) are looking into the opportunities in the sector

Ozner's high capital outlay creates

an entry barrier against smaller producers, who are unlikely to be able to replicate its strategy

Ozner is protected by numerous

patents in reverse osmosis and ozone tech;

These technologies are all well developed but are unlikely to be rendered obsolete in a commercial

way, thanks to their cost

effectiveness

Substitutes Threat of substitute products

LOW Potential entrants Threat of new entrants

HIGH

This sector is competitive, as the

leader only has 2% market share

Ozner has 1% market share overall

but a leading 5% in commercial sector, substantially higher than the rest

However, its strategy to focus more on the household sector may mean

it will face more intense competition

Industry competitors Rivalry among existing firms

HIGH

Ozner has average bargaining

power against buyers – corporates and households

There is some concentration risk

regarding its major distributors. But Ozner is keen on developing new

distributors in new regions, which will help to offset this risk

Ozner has strong bargaining power

versus component suppliers

Its capex investment should help to

consolidate its scale advantage over suppliers.

Buyers Bargaining power of buyers

MED Suppliers Bargaining power of suppliers

LOW


22 July 2014 25

Figure 31: Company milestones Year Company history

2005 Mr. Xiao Shu and Mr. Chen Xuejun established Shanghai Comfort

2008 Shanghai Comfort was acquired by Hong Kong-listed Chaoyue Group

2010 Mr. Xiao Shu founded Ozner Group

2010 First round of pre-IPO investment by SAIF Partners

2010 Shanghai Comfort became one of the drinking water suppliers for the Shanghai Expo

2011 Second round of pre-IPO investment by Ares

2011 Ozner became one of the drinking water suppliers to 26th Summer Universiade

2012 Ozner acquired Shanghai Comfort; it provided drinking water for Beijing Aerospace Control Centre

2012 Third round of pre-IPO investment by Goldman Sachs

2012 Ozner was appointed as the deputy chief of the Industry Standard Promulgation Panel in the water purifier industry

2013 Ozner received awards for Chinese enterprises that had the most growth potential, issued by the Fudan University and Ernst & Young

Source: Company

Figure 32: Management profile

Name Age Position Date of joining

the Group Background

Xiao Shu 39 Chairman, CEO and

Executive director

1-Jan-11 Founded Shanghai Comfort in 2005

Inventor of the main patented water and air purification technology owned by the group

2001-2002: R&D management in Shanghai Oasun

1993-1999: Director of production in Sinorate Enterprise

Zhu Mingwei 46 Vice Chairman, Deputy CEO, Executive director

1-Jan-11 Overseeing management and strategy and technology and management of air purification

2002- 2005: Director and engineer of Shanghai Fangxin Plastic Mold

2000-2002: Design supervisor of Shanghai Oasun

1992-1995: Engineer of China Jiangnan Aerospace Industrial Group Company

He Jun 39 Executive director 1-Jan-11 Responsible for sales and marketing of water purifiers

2002- 2005: Development and expansion in Shanghai Fangxin Plastic Mold

1999-2001: Sales & marketing in Shanghai Oasun

Tan Jibin 32 Executive director 6-Apr-11 Financial controller and vice president of the Group

2009-2011: Associate finance manager in China Aoyuan Property (3883 HK)

2004-2009: Senior Auditor in Deloitte Touche Tohmatsu

Xiao Lilin 39 Executive director 1-Jan-11 Overseeing the production and the construction of the production sites

2007-2009: Deputy general manager of Guangdong Dongguan Hou Street Xitou Longteng Toy Factory

2002-2006: Production manager of Dongguan Leshi Electronic Plastic

1996-2002: Production supervisor of Yongsheng Dongguan Group

Source: Company


22 July 2014 26

Figure 33: Post-IPO shareholding structure

Source: Company

Mr Xiao Shoo (25.5%)

Mr Wang Xiao gang (6.4%)

SAIF Partners (19.1%)

Owner Water International Holding Limited (Cayman)

(100%)

Owner Water Group Limited (BVI) (100%)

HK Fresh Water (100%)

Shaanxi Haze Environmental

Technology (100%)

Shanghai Haze Environmental

Technology (100%)

Park Wealth (100%)

Shanghai Comfort (100%)

Ares (13.4%)

Goldman Sachs (7.9%)

Other public shareholders

(27.7%)


22 July 2014 27


Income statement (RMB mn) Cash flow statement (RMB mn)

Year-end: Dec 2012 2013 2014E 2015E 2016E Year-end: Dec 2012 2013 2014E 2015E 2016E

Sales 290 402 539 749 1,075 EBIT 124 185 204 331 464

Gross profit 187 273 366 512 733 Depreciation & amortisation 33 80 126 189 275

SG&A (59) (102) (171) (195) (273) Net interest 0 (2) (4) (1) (1)

Other income 2 21 17 25 20 Tax paid (0) (3) (34) (56) (79)

Other expenses (7) (7) (8) (11) (16) Changes in working capital (6) 70 59 146 303

EBIT 124 185 204 331 464 Others (1) (15) 0 0 0

Net interest 0 (2) (4) (1) (1) Cash flow from operations 150 305 333 586 935

Associates 0 0 0 0 0

Other non-operational 0 0 0 0 0 Capex (276) (411) (552) (771) (1,042)

Exceptional items 0 0 0 0 0 Acquisitions & Investments (8) (36) 0 0 0

Pre-tax profit 124 184 200 330 463 Disposals 0 0 0 0 0

Taxation (22) (31) (34) (56) (79) Others 0 0 0 0 0

Minority interests 0 0 0 0 0 Cash flow from investing (284) (447) (552) (771) (1,042)

Exceptional items after tax 0 0 0 0 0

Net profit 102 153 166 274 384 Dividends 0 0 0 0 0

Issue of shares 0 0 1,348 0 0

Net profit adj. 102 153 211 290 392 Change in debt (60) 197 (515) 0 0

EBITDA 157 265 330 520 739 Other financing cash flow 192 0 0 0 0

Cash flow from financing 132 197 833 0 0

EPS (RMB) 0.08 0.12 0.09 0.16 0.22

EPS adj. (RMB) 0.08 0.12 0.11 0.15 0.20 Change in cash (1) 54 615 (185) (106)

DPS (RMB) 0.00 0.00 0.00 0.00 0.00 Exchange rate effect 0 0 0 0 0

Avg fully diluted shares (mn) 1,266 1,266 1,920 1,920 1,920 Free cash flow (126) (106) (218) (185) (106)

Balance sheet (RMB mn) Financial ratios and otherYear-end: Dec 2012 2013 2014E 2015E 2016E Year-end: Dec 2012 2013 2014E 2015E 2016E

Cash 169 221 836 650 543 Operating ratios

Short-term investments 0 0 0 0 0 Gross margin (%) 64.5 67.8 68.0 68.4 68.2

Accounts receivable 38 51 81 112 150 EBITDA margin (%) 54.2 65.9 61.2 69.3 68.8

Inventory 39 37 51 84 122 EBIT margin (%) 42.7 46.1 37.9 44.2 43.2

Other current assets 51 49 49 49 49 Net margin adj. (%) 35.0 38.1 39.3 38.7 36.5

Total current assets 296 358 1,017 896 866 Effective tax rate (%) 18.0 16.7 17.0 17.0 17.0

Sales growth (%) 183.9 38.6 33.9 39.1 43.4

PP&E 490 849 1,296 1,904 2,701 Net income growth (%) 343.1 50.4 8.4 65.1 40.3

Intangible assets 70 95 92 89 86 EPS growth (%) 343.1 50.4 -21.6 65.1 40.3

Associates and JVs 0 0 0 0 0 EPS growth adj. (%) 415.9 50.7 -9.0 37.3 35.2

Other long-term assets 5 7 7 7 7 DPS growth (%) - - - - -

Total long-term assets 566 951 1,395 2,000 2,794

Efficiency ratios

Total assets 863 1,310 2,411 2,896 3,660 ROE (%) 99.9 59.5 15.2 13.8 16.6

ROCE (%) 117.7 70.3 18.6 16.6 20.0

Short-term debt 0 213 105 105 105 Asset turnover (x) 0.4 0.4 0.3 0.3 0.3

Accounts payable 37 58 79 132 213 Op. cash/EBIT (x) 1.2 1.6 1.6 1.8 2.0

Other current liabilities 638 699 373 531 830 Depreciation/capex (x) 0.1 0.2 0.2 0.2 0.3

Total current liabilities 675 970 558 769 1,149 Inventory days 121.1 106.6 92.9 104.0 110.4

Accounts receivable days 30.4 40.0 44.5 47.0 44.6

Long-term debt 0 0 0 0 0 Accounts payable days 142.2 133.6 145.6 162.9 184.3

Convertible bonds 0 0 0 0 0

Deferred tax 7 7 7 7 7 Leverage ratios

Other long-term liabilities 0 0 0 0 0 Net gearing (%) -93.7 -2.6 -39.5 -25.7 -17.5

Total long-term liabilities 7 7 7 7 7 Debt/capital (%) 0.0 62.5 5.7 5.0 4.2

Interest cover (x) nm 100.3 46.8 258.8 362.9

Total liabilities 682 976 564 776 1,155 Debt/EBITDA (x) 0.0 0.4 0.4 0.2 0.1

Current ratio (x) 0.4 0.4 1.8 1.2 0.8

Shareholders’ funds 181 334 1,847 2,121 2,505

Minority interests 0 0 0 0 0 Valuation

EV/sales (x) - - 6.8 4.8 3.4

Total equity 181 334 1,847 2,121 2,505 EV/EBITDA (x) - - 11.2 7.0 5.0

EV/EBIT (x) - - 18.1 10.9 8.0

Total liabilities and equity 863 1,310 2,411 2,896 3,660 PER (x) - - 26.6 15.2 10.8

PER adj. (x) - - 22.9 15.7 11.6

Net debt (cash) (169) (9) (730) (544) (438) PBR (x) - - 2.4 2.0 1.7

Year-end shares (mn) 1,266 1,266 1,751 1,751 1,751 Dividend yield (%) - - 0.0 0.0 0.0


22 July 2014 28

Disclosures appendix The information and opinions in this report were prepared by Standard Chartered Bank (Hong Kong) Limited, Standard Chartered Bank Singapore Branch, Standard Chartered Securities (India) Limited, Standard Chartered Securities Korea Limited and/or one or more of its affiliates (together with its group of companies, ”SCB”) and the research analyst(s) named in this report. THIS RESEARCH HAS NOT BEEN PRODUCED IN THE UNITED STATES. Analyst Certification Disclosure: The research analyst or analysts responsible for the content of this research report certify that: (1) the views expressed and attributed to the research analyst or analysts in the research report accurately reflect their personal opinion(s) about the subject securities and issuers and/or other subject matter as appropriate; and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views contained in this research report. On a general basis, the efficacy of recommendations is a factor in the performance appraisals of analysts.

Where “disclosure date” appears below, this means the day prior to the report date. All share prices quoted are the closing price for the business day prior to the date of the report, unless otherwise stated.

SCB has managed or co managed a public offering for this company within the past 12 months, for which it received fees: Ozner Water International Holding

2.79

2.91

3.04

3.16

3.29

3.41

Jun-14

HKD Recommendation and price target history for Ozner Water International Holding

Date Recommendation Price target Date Recommendation Price target Date Recommendation Price target

Source: FactSet prices, SCB recommendations and price targets

Recommendation Distribution and Investment Banking Relationships

% of covered companies

currently assigned this rating % of companies assigned this rating with which SCB has provided

investment banking services over the past 12 months

OUTPERFORM 55.8% 10.4%

IN-LINE 33.0% 10.1%

UNDERPERFORM 11.2% 8.1%

As of 30 June 2014 Research Recommendation

Terminology Definitions

OUTPERFORM (OP) The total return on the security is expected to outperform the relevant market index by 5% or more over the next 12 months

IN-LINE (IL) The total return on the security is not expected to outperform or underperform the relevant market index by 5% or more over the next 12 months

UNDERPERFORM (UP) The total return on the security is expected to underperform the relevant market index by 5% or more over the next 12 months

SCB uses an investment horizon of 12 months for its price targets. Additional information, including disclosures, with respect to any securities referred to herein will be available upon request. Requests should be sent to [email protected].

Global Disclaimer: Standard Chartered Bank and/or its affiliates ("SCB”) makes no representation or warranty of any kind, express, implied or statutory regarding

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22 July 2014 29

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