China's galloping earnings are beginning to be reined back. Most of the country's top 200 companies reported strong but slowing earnings growth in 2005, according to Standard & Poor's Rating Services' most comprehensive survey to date. The top performers maintained their pricing power in an economy that revved up 9.5% last year due to rapid growth in fixed asset investments, a high savings rate, and a major inflow of foreign direct investment. Oil and gas companies once again top our revenue-based rankings, while downstream manufacturing and utilities companies have dropped the greatest number of places, due to rising raw material costs.
This year our coverage has doubled to 200 of the largest companies listed on China's three principal stock markets: Shanghai, Shenzhen, and Hong Kong. Unlisted large companies, such as state-owned enterprises, are not included, but form a significant part of the economy. Smaller companies outside our top 200 are likely to find market conditions more challenging.
Topping The Earnings Ladder
Earnings for the top 200 companies grew 20.8% in 2005. Although strong, the growth rate had slowed slightly. About 59% of the companies in our study reported higher earnings and only 9% recorded losses (see table 1).
Resource companies led the way, spurred by high oil prices. PetroChina Co. Ltd., which produces about two-thirds of China's oil and gas, saw sales climb 34% to Rmb552 billion and net profit soar 30% to Rmb133 billion. CNOOC Ltd. (A-/Stable/--), the country's largest offshore petroleum company, reported a 56% spike in net profit to Rmb25.3 billion. China Petroleum & Chemical (Sinopec; BBB/Stable/--), China's biggest petrochemical company, had a record year, with net profit leaping 14% year-on-year to Rmb40.9 billion. Sinopec was prevented from making even larger gains by the government's cap on refined oil prices, which kept them well below international levels in order to suppress inflationary pressure. (See table 2.)
Real estate companies posted double-digit earnings growth, reflecting accelerated urbanisation. Hopson Development Holdings Ltd. (Hopson; BB+/Stable/--), one of China's new breed of real estate developers, saw net profit soar 181% to HK$1.21 billion in 2005 from a revised HK$432.8 million a year earlier, while revenue surged 54% to HK$6.13 billion. Last year, the company delivered 1.04 million square meters of property, up 40% on 2004. The net profit of nation-wide developer China Overseas Land & Investment Ltd. (BBB-/Stable/--) rocketed 43% year-on-year in 2005.
Some of the larger steel companies also shone, following major capacity expansion. Baoshan Iron & Steel Co. Ltd. (Baosteel; BBB+/Stable/--), China's biggest steel manufacturer, said in its 2005 annual report that it sold 18.8 million tons of steel and steel products last year, up more than 62% from 2004, due in large part to an asset infusion from its state-owned parent. Baosteel's net profit grew 34.8% in 2005 to Rmb12.7 billion. Shipping companies also benefited from improving export growth. China COSCO HoldingsÆ net profit in 2005 came in at Rmb5.45 billion, up 31.1% from a year earlier. The company's container shipping volume reached 4.53 million TEUs (twenty-foot equivalent units) in 2005, up 19.7% year-on-year.
Mainland telecommunication companies had a mixed year. China Mobile (A/Stable/--), the world's largest phone operator by subscribers, reported a 27% rise in net profit to Rmb53.5 billion in 2005. This was largely attributable to a higher aggregate subscriber usage volume of 903.1 billion minutes, up 36.6% year-on-year. China Unicom, the country's second biggest mobile operator, wasn't able to keep up with the subscriber growth rate of its bigger rival China Mobile, but still managed to increase its net income by 10%. In contrast, China Telecom, China's leading provider of fixed-line telecommunications services, posted a slight decline in earnings in 2005. Growth is slowing as the mainland's telecom market matures and fixed-line operators are losing share as more people go wireless.
Not All A Bed Of Roses
Disappointing results were mostly confined to downstream manufacturing, airline, and utilities companies. Higher coal prices hit high energy consumers, such as power producers, cement, low-end steel, and aluminium companies. The earnings of Huaneng Power International (BBB/Stable/--), for example, slid 8% in 2005. Management attributes the significant margin squeeze to a rise in coal costs last year. Surging fuel prices and an increasingly open domestic aviation market hit airline companies. China Southern Airlines, for example, the country's biggest carrier by fleet size, reported a net loss of Rmb1.79 billion in 2005.
Guangdong Kelon Electrical Holdings (Kelon) and TCL Corp were among the worst-performing downstream manufacturers. Kelon, once the biggest home appliance manufacturer in China, reported a 12% slump in revenue in 2005 and significant operating losses following accounting irregularities. Its auditor gave a qualified opinion, citing its inability to obtain the books and records needed to verify part of Kelon's results for last year. This underlines continuing concern about corporate governance quality in China. TCL Corp. booked a net loss of Rmb320.24 million in 2005, compared with net profit of Rmb245.21 million a year earlier, due to a steep drop in mobile handset sales and business integration costs after making several overseas acquisitions.
Lenovo Group Ltd. (Lenovo) was another large company that struggled in 2005. For the full fiscal year, Lenovo reported net profit of only Rmb181 million, down from Rmb1.2 billion a year earlier. The company incurred significant restructuring costs at the personal-computer (PC) business that it acquired from IBM last year, and has had to carry substantially higher interest costs. Lenovo is also being hit by competitive pressures from Dell and Hewlett-Packard, especially in the Asian and US markets.
New Entrants, Fast Movers
New entrants in the survey include China Shenhua Energy, which came in at number 12 after a successful IPO in 2005, and GOME Electrical Appliances, which jumped into the number 50 slot. Other newcomers include Titan Petrochemicals Group Ltd. (BB-/Negative/--) at number 79 and Hopson at number 135. Lenovo was one of the fastest-growing companies on the list, with hefty revenue growth of 353% in 2005 following the acquisition of IBM's PC business. The company has moved to number 6 from number 23 last year. Conversely, several companies tumbled down the list. Kelon made one of the more notable falls, dropping to number 126 from 88 in 2005.
Sound Credit Metrics
Despite weakening, the overall median financial ratios of China's top 200 corporates were relatively strong in 2005. Median Ebitda interest cover was 7.6x, from 9.4x a year earlier. This can be attributed to a combination of strong operating earnings and China's relatively low interest rate environment. From a debt perspective, the median ratio of total debt to capital was 33%, compared with 32% in 2004. Many of China's large listed corporations have high levels of cash and liquid investments. Of the 200 companies included in this report, 41% ended 2005 in a net cash position. A lot of this cash will be used to pursue asset acquisitions and other growth opportunities.
Steel, utilities, and transportation were the most heavily geared sectors. Some telecommunication companies, such as China Telecom and China Netcom Group, also held a lot of debt. This reflects heavy spending on industry consolidation and capacity expansion. For example, Huaneng Power, the largest listed independent power company in China, has nearly doubled its generation capacity in the past five years. Airline companies are also aggressively increasing and updating their fleets, reflecting continued growth in passenger and cargo volumes.
Credit Issues To Watch
The strong economic growth in 2005 and the first half of 2006 will gradually slow down. Structural constraints, tighter bank lending policies, and a downturn in business sentiment in some sectors are likely to limit growth, but not to a damaging degree. Accelerating industrialisation and urbanisation should lead to further growth in private investment and domestic consumption over the long term. In its recent quarterly report, the World Bank predicted that GDP in China would grow by 10.4% for the whole of 2006.
Important credit issues need to be closely monitored, however:
- Recently introduced austerity measures will hit real estate-related sectors. Regulators have tightened bank credit and imposed curbs on property investment to rein in excessive spending. Small developers, with limited financial flexibility, will be particularly vulnerable. The winners are likely to be larger developers with low-cost land banks and deep pockets.
- High input costs and increased price competition due to overcapacity will cause more margin compression for some downstream sectors. The danger of excessive investment is that it could spawn overcapacity, which may lead company profits to fall. Some recently released interim results show signs of more difficult market conditions.
- Given the emergence of overcapacity and input-cost inflation, we expect consolidation to speed up. In particular, the pace of merger activity in China's steel sector may quicken over the medium term. For example, officials in Shandong province in eastern China are weighing up a plan to merge two major steelmakers, Jinan Iron and Steel and Laiwu Steel, to create one corporation with an annual production capacity of more than 30 million tons.
- Chinese companies are increasing outward investments, such as Lenovo's acquisition of IBM's PC business and the state-owned oil companies' investment in offshore energy projects. Many of the biggest Chinese companies have built up cash war chests through equity issuance and free cash-flow generation, and they're eager to spend the money overseas. It is natural for more enterprises to look overseas for new markets and resources, but such activity can expose companies to significant operating risks that could compound financial risk arising from higher debt leverage. The difficulties TCL and Lenovo have had with their overseas acquisitions are examples of the risks of entering new markets.
- China's sustainable earnings growth could also be challenged by uncertain global economic factors, triggered by lower demand from the US. It's important not to overstate this issue, as a growing proportion of GDP growth in China now comes from domestic demand, such as consumption, investment, and government spending.
Overall, there are many reasons to be cautiously optimistic about the long-term outlook for China. But it remains a classic emerging market, with all the hidden dangers and opportunities. Some companies will not survive the race, others will emerge as internationally competitive companies. The competitive forces unleashed by these globally competitive Chinese companies could have significant ramifications in shaping offshore markets.
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