The China Inc. Annual Report 2017 - CEBC€¦ · Annual Report 2017. Thomas Gatley. August 2017. This chartbook summarizes the health of China’s corporate sector, based on two major

The China Inc. Annual Report 2017

Thomas Gatley

August 2017

This chartbook summarizes the health of China’s corporate sector, based on two major data sources: the nationwide survey of 380,000 industrial firms, and the financial reports of 3,230 listed non-financial firms. The story in brief:

Sales and revenue growth has accelerated rapidly over the past year, with commodity-related sectors rebounding on the back of rising prices and housing construction. The upturn was broad-based with consumer, healthcare and IT sectors all doing well too. Much of the sales improvement in industry, though, was driven by higher prices, and real sales growth accelerated far less than nominal growth.

Margins expanded as commodity prices rose. But excess capacity remains, and will tend to drag on industrial margins for years yet. Despite the commodity upturn, private firms and new-economy sectors retain a large advantage.

Profits turned up strongly on rising commodity prices, but the profit cycle has peaked and will fade from here. Headline profit growth will decelerate rapidly unless commodity prices rise substantially through 2H17, but most sectors will see a relatively gradual slowdown.

Expanding margins and slower investment in new assets have contributed to a rebound in return on assets. The pickup in return on equity has been smaller due to the fact that firms in most sectors are raising lots of new equity.

Corporate debt growth has picked up after the 2015-16 easing of monetary policy, but is quite a bit slower than the national aggregate, and slower too than a more inclusive definition of liability growth. A major reason for this divergence is the surge in mortgage lending since 2016.

The combination of high profit growth and lower interestrates meant that the debt servicing burden of the corporate sector declined in 2016. Profits are continuing to rise in 2017 but rates are higher, so conditions are unlikely to improve further until the next easing cycle.

While the national leverage ratio continues to rise, listed corporate leverage ratios fell in 2015 and 2016. In 2016 rising profits played a small role, but most of the deleveraging was due to a surge in new equity issuance which is now waning. This makes additional deleveraging in 2017 unlikely.

Despite an influx of funds from both rising profits and equity issuance, the capex rebound has been mild. Instead firms have continued to accumulate cash. The slower pace of capex is structural: demand growth has stabilized at substantially lower levels than 2010-11, and overcapacity issues are far from resolved. Employment and household income growth however will continue to benefit as higher profitability encourages firms to hire.

2

Outline: the state of corporate China

3

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

Utilities

Industrials

Consumer Discretionary

Consumer Staples

Energy

Health Care

Materials

Information Technology

Real Estate

Listed firms: median sales growth, last 4q

Sales: a big rebound for SOEs and old-economy firms

4

Semiconductor foundries have seen sales accelerate

along with the global cycle as a result of huge demand

by self-driving cars, AI, data processing and cloud

servers, while listed healthcare firms also saw a cyclical

uptick.

Although firms in the commodity complex (mining, oil & gas, metal and mineral processing) saw the most dramatic improvement over the past year, firms in consumer-facing sectors also saw sales accelerate. Automotive and consumer durable firms did well as housing sales grew rapidly, but food producers also saw sales grow more rapidly as meat and vegetable prices rose in 2H16.

Semiconductor foundries have seen sales accelerate along with the global cycle as a result of huge demand by data processing and cloud servers, while listed healthcare firms also saw a cyclical uptick. Firms in the technology hardware and equipment sector—producers of computer and communications equipment—have enjoyed ~15% profit growth for three years straight.

Sales: strong even outside the commodity complex

5

While there has been a reacceleration in sales growth in real or volume terms since 2015, it remains around 5%, far slower than in 2010-11, and well below accelerating nominal sales growth.

There is no definitive measure of volume sales growth for the industrial sector as a whole. I use two different measures: industrial sales deflated by the producer price index, and the median growth rate of output for 120 industrial products with regular data. Neither metric is perfect, but they point in a similar direction.

Sales: the industrial upturn is mostly nominal

6

If key commodity prices (including steel) remain in a trading range as we expect, industrial margins will continue to benefit.

While profit growth corresponds to the YoY change in PPI, margins correspond to the absolute level of PPI, which remains at a much higher level than 2015 and 2016.

The rebound in prices has brought the aggregate profit margin of commodity sectors up by more than a percentage point in a year, closing the gap with the rest of the industrial sector, though non-commodity firms still have the edge.

Margins: a strong recovery by the commodity complex

7

Excess capacity in Chinese industry is a real phenomenon but it is very difficult to gauge accurately. The PBOC’s capacity utilization index has tended (intuitively) to follow the growth rate of industrial products in volume terms, and will likely continue to rise into 2017, though remaining well below historic levels.

Conversely, as prices and margins improve, more production capacity is coming back online despite pressure by policymakers. This will tend to drag on price and margin levels for some years yet.

Margins: overcapacity remains a problem

8

0% 2% 4% 6% 8% 10% 12% 14%

Energy

Materials

Industrials



Consumer Staples

Real Estate

Utilities

Health Care

Listed margins by sector, last 4q

Margins: private firms and new economy sectors still ahead

The profit cycle turned upwards in 2016 and remained high in 1H17. The recovery in sales volumes in 2016 was real, driven by strong housing sales and a construction rebound, but volume growth has not picked up over the last 12 months. Instead the big surge in profit growth has come from a rapid rise in commodity (and steel) prices and very favorable base effects.

Now that metals prices have stopped rising, the favorable YoY comparisons for profit growth are gradually fading, and profit growth is slowing. This loss of momentum does not mean the industrial sector is rolling over. Housing sales remain strong and low inventories mean that construction activity should continue to grow over the next year, ensuring stable demand for industrial goods.

Profits: a price-driven upswing

9

10

(10) (5) - 5 10 15 20 25 30

Utilities

Industrials

Health Care


Real Estate


Energy

Materials

Consumer Staples

Listed firms: 4q rolling median profit growth (2016)

Profits: rapid growth for all sectors except utilities

-10% -5% 0% 5% 10% 15% 20% 25% 30%

Utilities

Industrials

Health Care


Real Estate


Energy

Materials

Consumer Staples

Listed firms: median profit growth, last 4q

11

The biggest winners in new-economy sectors over the last 12 months seem to be losing momentum. Auto firms in particular are likely to see profit growth slow sharply over the next 12 months: unit sales have slowed sharply since the government cut a tax rebate in January. Food and consumer durables also look to be topping out.

The healthcare equipment and services sector has also seen a deceleration since mid-2016 despite strong sales growth, suggesting that firms may be facing pricing pressure. Tech hardware and equipment remains robust, and semiconductor profits continue to grow at a very rapid clip.

Profits: many new economy winners look to be peaking

12

SOEs and old economy sectors like energy and materials

saw the biggest ROA and ROE pickup in 2016, but both

measures remain substantially lower than those of POEs

and new economy sectors (consumer discretionary and

staples, healthcare and IT). Real estate is quite distinct:

developers have a low ROA but a high ROE, due to very

high leverage.

Industrial return on assets (ROA) has risen over the last 18 months after falling since 2011. Asset turnover, or how much revenue is generated by assets, is stabilizing in 2017 due to the boost in nominal sales, and margins have picked up nicely—both driven by rising prices. Slower growth in new assets is also helping. ROE is rising too, but less sharply due to corporate deleveraging.

SOEs and old economy sectors like energy and materials saw the biggest ROA and ROE pickup in 2016, but both measures remain substantially lower than those of POEs and new economy sectors (consumer discretionary and staples, healthcare and IT). Real estate is quite distinct: developers have a low ROA but a high ROE, due to very high leverage.

Profitability: ROA and ROE are improving

13

0% 2% 4% 6% 8%

Materials

Industrials

Real Estate

Energy

Utilities



Health Care

Consumer Staples

Listed ROA by sector (aggregate, 2016)

Profitability: return on assets is picking up

0% 1% 2% 3% 4% 5% 6% 7% 8%

Materials

Industrials

Real Estate

Energy

Utilities



Health Care

Consumer Staples

Listed ROA by sector (aggregate, 2016)

14

0 2 4 6 8 10 12

Industrials

Materials

Health Care



Consumer Staples

Real Estate

Median listed ROA (2011-16 average), SOE vs private by sector

SOE POE

While SOEs have a big presence in cyclical heavy industry sectors, this does not explain all of their under-performance relative to private firms.

In fact SOEs tend to underperform their private peers across all sectors, The exception is real estate, where state firms seem to be equally if not more successful. This is possibly due to the importance of government connections for property firms.

Note: Privates-sector firms account for less than 5% of sales in the listed energy and utilities sectors, so these are not shown in the chart.

Profitability: SOEs systematically underperform

15

0% 2% 4% 6% 8% 10% 12% 14%

Energy

Materials

Industrials


Utilities

Health Care

Real Estate


Consumer Staples

Listed ROE by sector (aggregate, 2016)

Profitability: return on equity is also picking up

0% 2% 4% 6% 8% 10% 12% 14%

Energy

Materials

Industrials


Utilities

Health Care

Real Estate


Consumer Staples

Listed ROE by sector (aggregate, 2016)

16

Corporate debt growth has been slower than national private-sector credit growth for some time, as firms have cut back on capex. The slowdown has come primarily from SOE-dominated heavy industrial sectors; private firms absorbed 58% of new debt raised by listed firms over the last four quarters.

Overall private-sector (corporate & household) debt growth is now being driven by mortgages. One reason why listed liabilities growth is faster than listed debt growth is that housing presales show up as a non-debt liability for developers.

Debt: corporate debt growth slower than national

17

New rules prohibit firms from going back to the market

for secondary issuance within an 18m period, and cap

the amount of fundraising permitted at 20% of existing

market cap. While IPO activity has been reasonably

strong this year it is much too small to make up for the

downturn in SEOs.

The cost of debt funding has increased substantially since last year, with bond yields and short-term interest rates alike rising rapidly. At the same time, a crackdown since February by the China Securities Regulatory Commission on secondary equity issuance has radically reduced the amount of equity financing available to listed firms.

New rules prohibit firms from going back to the market for secondary issuance within an 18-month period, and cap the amount of fundraising permitted at 20% of existing market cap. While IPO activity has been reasonably strong this year it is much too small to make up for the downturn in secondary equity offerings.

Debt: both fundraising channels are getting squeezed

18

On a national level China’s interest coverage ratio (here calculated as the inverse of the debt servicing cost share of GDP) continues to fall, as rising debt means larger interest payments. Until 2016 the corporate ratio fell along with the national ratio, but in 2016 a combination of lower rates and rebounding profits combined to raise the interest coverage ratio for the corporate sector.

Interest coverage ratios rose for both private and state firms across sectors in 2016, though POEs and new-economy firms continue to maintain a large advantage in this area. These improvements have led to less concern about “zombie” firms so far this year. 16% of firms were unable to pay interest costs out of profits in 2016, down from 19% in 2016.

Debt servicing: national coverage ratio still deteriorating

19

Balance sheet: interest coverage ratio

0 2 4 6 8 10 12 14

Health Care

Cons. Discr.

IT

Industrials

Cons. Staples

Real Estate

Materials

Energy

Utilities

Listed firms: median interest coverage ratio, 2016

POE SOE

Debt servicing: coverage ratios are improving for listed firms

20

Balance sheet: Zombies

Financial stress: the zombie horde is shrinking

0% 10% 20% 30% 40% 50% 60% 70%



Health Care

Consumer Staples

Materials

Industrials

All sectors

Energy

Real Estate

Utilities

Share of firms with interest expenses > EBITDA, 2016

SOE POE

21

The materials sector was in dire straits in 2015. The sector as a whole lost money, and was driven to paying interest costs out of cash reserves. In 2016 rebounding profits meant the sector was able to once again pay its way.

Four of the five most vulnerable sectors saw interest coverage ratios and cash coverage ratios (cash/interest costs) rise in 2016. The fifth—utilities—did not see much improvement in 2016, as input costs (coal prices) rose sharply.

Financial stress: vulnerable sectors are doing better

22

While total national leverage continues to rise, corporate leverage has stabilized. This top-down measure of “corporate” debt also includes local government financing vehicles.

In fact, industrial and listed company data show deleveraging has been going on for some time.

Industrial firms have seen falling leverage since 2010, and industrial SOEs since 2015, while listed firms have been deleveraging since 2014. This reflects both slowing capex, and for listed firms, also a huge surge in equity issuance in 2015-16.

Leverage ratios: national vs corporate

23

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50

Real Estate

Industrials

Utilities

Materials


Energy


Consumer Staples

Health Care

Listed leverage by sector (aggregate, 2016)

Leverage ratios: corporate leverage is falling

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50

Real Estate

Industrials

Utilities

Materials


Energy


Consumer Staples

Health Care

Listed liabilities/equity by sector, aggregate, 2016

24

With profits rebounding, retained earnings were bolstered by RMB741bn in 2016, up 39% from 2015.

However, this equity increase from profits accounted for only 27% of the total increase for the year. The rest came from surging new equity issuance, the vast majority of which was driven by secondary equity offerings.

With regulators cracking down on malpractice in secondary offerings, however, new equity issuance has slowed substantially. This in turn will make further deleveraging in 2017 tough to deliver.

Leverage ratios: decline mostly driven by new equity issuance

25

Fixed-asset investment growth and capex by listed firms rebounded in 2016 after years of deceleration on the back of an uptick in investment in both real estate and capital equipment. The improvement remains quite mild by historical standards, in part because despite rebounding profits materials and energy sector capex continued to shrink. Commodity prices remain low compared to the boom years, and policy pressure against investment in “overcapacity” sectors is fierce.

Use of funds: capex recovery remains pretty mild

-20% -10% 0% 10% 20% 30% 40%

Energy

Materials

Health Care

Utilities


Consumer Staples

Industrials


Real Estate

Listed capex growth by sector (2016)

Aggregate Median

Fixed-asset investment growth and capex by listed firms rebounded in 2016 after years of deceleration. The improvement remains quite mild by historical standards, in part because despite rebounding profits, materials- and energy-sector capex continued to shrink. Commodity prices remain low compared to the boom years, and policy pressure against investment in “overcapacity” sectors is fierce. On the whole, Chinese firms are using improved profits to repair balance sheets rather than expand aggressively.

26

Rising interest rates and a squeeze on listed equity financing has probably discouraged investment at the margin, and slowing credit growth is certainly not encouraging for capex. But the availability of external funds is far from the only constraint on the corporate appetite for investment: companies invest in response to demand, and demand is slower.

According to a quarterly survey of 2,000 firms by Gan Jieof the Cheung Kong Graduate School of Business, only around 3% cite financing as a constraint on investment. Instead, 71% of the firms surveyed cited a lack of orders as their major concern. Firms are still getting used to a much weaker demand growth environment, and capex will remain structurally slower as a result.

Use of funds: capex growth will be structurally slower

27

Cash balances grew sharply in 2016 as profit growth surged while firms remained cautious about fixed asset investment. SOEs tend to be able to cushion themselves during downturns by extending payables much longer than receivables, effectively using their smaller (usually private) suppliers as a source of credit. For the last 12-18 months firms in all sectors have been holding onto cash.

Non-financial firms now hold RMB6.5trn in cash, equivalent to 14% of their assets, up from RMB4.1trn (12% of assets) two years ago. New economy sectors all have higher cash holdings relative to their assets (20% for consumer, healthcare and IT) while the more fixed-asset intensive utilities and energy sectors have the lowest ratio of cash to assets (6% and 8%).

Use of funds: firms of all kinds are hoarding cash

28

Accelerating sales and profits tend to translate, with a lag, into employers picking up the pace of hiring. While firms remain wary of investing in a lot of new capacity, fatter margins and higher profitability encourage them to hire more workers to make the most of existing capacity.

This faster rate of hiring tilts the labor market balance in favor of employees who can thus demand higher wages. The bumper profits of 2H16 and 1H17 should support employment and income growth over the next year or so, which in turn bodes well for household consumption.

Use of funds: higher profitability boosts hiring

29

Appendix: a note on data and sources

30

The shape of corporate China

Primary(9%)

Secondary(40%)

Tertiary(52%)

Mining, Manufacturing & Utilities(33%)

Construction & Real Estate

(13%)

Public Services(15%)

Commercial Services excluding Real Estate

(28%)

Monthly data is available for these sectors from a survey of 380,000 large and medium-size firms

Quarterly data is available for a broader range of sectors from the earnings reporting of China’s 3,300 listed firms

9% of China’s GDP is produced by the primary sector, 40% by the secondary sector, and 52% by the tertiary sector. Corporations play a small role in the primary sector, dominate the secondary sector and produce most of the services delivered by the tertiary sector, with the partial exception of education, healthcare and other public services.

The most timely data on the corporate sector comes from the industrial survey, which provides basic income statement and balance sheet data for mining, manufacturing and utilities firms on a monthly basis. These sectors comprise a minority of GDP, but tend to contribute most of the volatility. Information on a smaller but broader sample of 3,300 firms is available on more a lagged basis from the quarterly earnings of listed firms. The data in this chartbook excludes the financial sector: my listed non-financial sample comprises 3,230 firms.

31

Where are the state-owned firms (SOEs)?

The industrial survey covers 383,000 firms “above designated size” (sales of more than RMB20mn). Surveyed firms have aggregate assets of RMB102trn, revenues of RMB111trn and employ 98m people.

Only 5% (19k) of these firms are SOEs, but they account for 39% of assets, 22% of revenues and 18% of employment.

There are 3,230 listed non-financial firms (A-shares) on China’s equity markets, with aggregate assets of RMB47trn, revenues of RMB27trn and employing 17m people.

33% (1,092) of these firms are SOEs, accounting for 73% of assets, 74% of revenues, and 61% of employment.

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Energy

Utilities

Industrials & Materials

Automotive

Real Estate

Consumer Services

IT

Other Consumer Goods

Healthcare

Listed sectors, % SOE by revenues

SOEs Private Firms (POEs)

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Utilities

O&G

Mining


Mining & Metals

Machinery

Chemicals

Consumer Staples

Industrial sectors, % SOE by revenues

SOEs POEs

32

Contact and disclaimer

This presentation was prepared by

Thomas Gatley, China corporate analyst

[email protected]

All research is available online at research.gavekal.com

Copyright © Gavekal Ltd. Redistribution prohibited without prior consent.

This report has been prepared by Gavekal mainly for distribution to market professionals and

institutional investors. It should not be considered as investment advice or a recommendation to

purchase any particular security, strategy or investment product. References to specific securities and

issuers are not intended to be, and should not be interpreted as, recommendations to purchase or

sell such securities. Information contained herein has been obtained from sources believed to be

reliable, but not guaranteed.

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Documents

The China Inc. Annual Report 2017 - CEBC€¦ · Annual Report 2017. Thomas Gatley. August 2017. This chartbook summarizes the health of China’s corporate sector, based on two major