China reform

China SOE reform: winners and losers

Equity analysts are scouring China’s reform plans to unearth potential beneficiaries. The swelling list so far includes the likes of China Telecom, Sinopharm and CNBM.

Equity analysts are unearthing potential stock market beneficiaries as China steps up reform of its bloated state-controlled companies, including Hong Kong-listed units of China Telecom, Sinopharm and China National Building Materials (CNBM).

China is overhauling its state-owned enterprises (SOEs) to make these linchpins of the economy more efficient, including potentially introducing private capital and discipline into all sectors.

The government has said it may relinquish control of SOEs to the private sector in the so-called pillar industries of autos, equipment manufacturing, iron and steel, surveying and design, construction, IT, non-ferrous metals and chemicals.

“Introducing private sector ownership at the parent group level is unprecedented, which could potentially allow entrepreneurs to run SOE groups,” said Steven Sun, head of China equity strategy at HSBC in a research note.

On Tuesday, China’s SOE supervisor the State-owned Assets Supervision and Administration Commission (SASAC), announced China’s largest pharmaceutical distributor by market share, Sinopharm, and CNBM are next in line for further privatisation.

CNBM operates in the highly fragmented and competitive basic materials sector, while Sinopharm's core businesses of distribution, logistics, retail, scientific research and manufacture of healthcare products are also largely market-oriented, so they fit the pattern expected by the market.

Many of CNBM and Sinopharm’s subsidiaries are already partly privatised via public listings as well as private equity placements.

SASAC also earmarked CNBM and Sinopharm, alongside China Energy Conservation and Environmental Protection (CECEP) and Xinxing Cathay International for a management overhaul, which will involve their boards of directors having more independence from SASAC to hire new executives, shake up performance reviews and create more effective financial incentives.

“This, in our view, could be the most important reform measure to improve corporate governance, as the boards at the SOEs are generally more consultative in nature, rather than a decision-making body,” said HSBC’s Sun.

For CNBM, which is battling with a slowdown in demand for cement across China, the news gave a boost to its Hong Kong listed unit.

“A market-oriented performance appraisal and incentive scheme is positive for CNBM,” said JP Morgan analyst Daniel Kang.

Goldman Sachs analyst Julian Zhu was more cautious on CNBM and estimated any reform measures would require SASAC’s approval and may take up to six to eight months to roll out.

Goldman expects reforms to initially focus on further reduction of state ownership in CNBM’s subsidiaries, such as United Cement and South China Cement, by introducing private capital and the establishment of a management incentive scheme.

Turning to Sinopharm, Deutsche Bank’s analyst Jack Hu said: “Assuming sufficient management incentives, we expect improvement on all three fronts, revenue growth, cost-saving and cash flow management.”

Jeffries analyst Jessica Li said that the fillip from SASAC will “unleash significant potential”. She expects Sinopharm to speed up M&A in retail pharmacy and potentially collaborate with leading MNCs.

Limits to privatisation
However, China is highly unlikely to relinquish control in industries it considers critical to national security, economic growth or social stability, such as defence, power generation, oil, civil aviation and telecoms.

“Reforms for SOEs in strategic sectors are likely to be comparatively slower,” said Ying Wang, a director at credit rating agency Fitch, partly due to concerns that breaking up state monopolies could result in state asset losses or would de-stabilize the socialist system.

But even here the government is willing to countenance some SOEs selling minority equity stakes or making asset disposals. Sinopec is selling up to 30% of its retail unit by the third quarter; PetroChina is looking to sell more of its pipelines; while in aviation five privately run airlines have won licences to operate.

In the telecoms sector the government is willing to open up some monopolies to competition and is deregulating tariffs and setting up a national tower company.

“China telcos are undergoing profound changes driven by its biggest shareholder SASAC to improve efficiency and ROIC,” said Sydney Zhang, a research analyst at Bank of America Merrill Lynch who recently upgraded his recommendation to investors on China Telecom to “buy” and raised his price target to HK$95.

Zhang expects China Telecom to significantly improve its 2014/2015 net profit due to pressure and help from SASAC and to realize a large gain from the telecom tower monetisation. 

“We will explore various capital structures to bring in the required capability, capital, innovation and vitality,” was the emailed response to questions sent by FinanceAsia to the office of China Telecom’s chief executive Wang Xiaochu, embracing the government’s concept of mixed ownership.

Vested interests fight back
Some sectors may fail to reap the benefits of reform due to resistance from vested interests that have gained significant political and economic influence through the years.

An official at the Ministry of Commerce said in October that Chinese car makers must prepare for the day when the rule limiting foreign ownership to 50% of a joint venture is lifted but the Chinese car makers’ association hit back saying that competition would crush local brands.
General Motors, for one, is keen to acquire a controlling stake in its successful joint venture with state-owned Shanghai Auto, which makes and sells Chevrolet, Buick and Cadillac across China, according to a person familiar with the discussions.

Shanghai is supportive of GM’s ambition to own more than its 50% in its profitable joint venture with Shanghai Auto, called Shanghai GM, according to the person familiar with the talks.

Neither spokespeople at GM in China nor Shanghai Auto responded to repeated calls for comment. However, one autos banker said China might not change the foreign ownership rules in the short term due to the vociferous vested interests.

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