Struggling Chinese groups pad out bottom lines; Asset shuffles and share placements bolster results

April 1, 2014 2:40 am

Struggling Chinese groups pad out bottom lines

By Tom Mitchell in Beijing

China’s largest shipping company avoided a third consecutive annual loss and a mandatory delisting from the Shanghai stock exchange last week, but the reprieve for China Cosco Holdings does not mean the tide is finally turning for the country’s heavy industry sector.

China Cosco, which eked out a profit of Rmb235m ($38m) for 2013 after losing more than Rmb20bn combined in 2011 and 2012, was bailed out by a series of asset sales to its parent company, highlighting a common theme among some of China’s largest industrial groups.

“They are not improving their operations to achieve profit, but just reorganising and selling assets,” says Zhang Wenkui, deputy director of the State Council’s Enterprise Research Institute. “They are only deceiving themselves.”

“The most important problem everyone is focusing on is what we do this year,” Guo Huawei, China Cosco’s board secretary, told the Financial Times. “We will work very hard to achieve a good result, but sometimes men need help from heaven.”

Chinese companies are already among the most indebted in Asia, with average debt to equity of 85 per cent, according to Standard Chartered research. While that is comparable to rates in India and Thailand, China Inc also tops the tables with business borrowings equivalent to 125 per cent of gross domestic product.

On Monday Rongsheng Heavy Industries, a privately held shipbuilder, announced an annual net loss of Rmb8.9bn and said it had reached an agreement with 10 Chinese banks to postpone repayment of debts totalling more than Rmb10bn. Rongsheng added that its ability “to continue as a going concern” would depend in part on bondholders not demanding their principal back, as they are entitled to when the company’s shares fall below a certain level.

“The top-line [debt] rates suggest that corporate China is the most leveraged corporate sector in Asia and within that state-owned heavy industry has the most stressed debt levels,” says Standard Chartered’s Stephen Green.

As economic growth threatens to fall below 7.5 per cent in the world’s second-largest economy, China Cosco and its heavy-industry peers are emerging as key tests of Beijing’s ability to reform the state sector and also move to an economy less dependent on debt and investment

That transition is well under way, with the profits of consumer goods firms exceeding those of heavy industry groups for the first time since 2003.

“This changing of the industrial guard has been driven by a combination of stagnant growth in heavy industry and continued steady gains by consumer goods,” Thomas Gatley at Gavekal Dragonomics wrote in a research note. “We do not think this is a temporary phenomenon . . . Heavy industry’s margins have been in structural decline since 2004.”

However, the asset shuffles and other intra-group accounting treatments engineered by China Cosco and its peers over the past year suggest Beijing’s tolerance for pain is limited. A review of just five Chinese state-owned shipping and shipyard companies by the Financial Times found Rmb25bn worth of related-party asset disposals, share placements and other mechanisms to pad out bottom lines for the current reporting season.

“Shipping companies and shipyards have been in multiyear recessions because of the huge amount of excess orders that were placed before and after the global financial crisis,” says Janet Lewis, head of industrials research at Macquarie. “They still haven’t figured out how to get these companies on to a profitable business model.”

The same pain and convenient remedies employed to transform losses into profits are evident in many other sectors as well in China, from aluminium to steel.

Aluminum Corp of China returned to profitability in 2013 after two years of losses only after reaping more than Rmb8bn from the sale of a fabrication business and a majority interest in a large but delay-plagued iron ore mine in Guinea to its state-owned parent. Like Cosco, Chalco is struggling with a cyclical downturn that hit as it was attempting to digest large projects. It also has a higher cost base than most of its smaller competitors.

In China’s steel sector, analysts at Macquarie Commodities Research say profits have plummeted to historic lows, with surveyed mills reporting contractions in orders across the board.

For investors and analysts, concerns about asset shuffles and other related-party transactions are compounded by the lack of transparency that often surrounds them.

“You don’t have a lot of insight into the asset disposals, especially with Chinese state-owned enterprises,” says Jon Windham, Hong Kong-based head of infrastructure and transport research at Barclays. “SOEs have a lot of assets on their balance sheets that are carried at very low values, particularly any SOE that owns property. They tend to carry their corporate headquarters at book value from 20 years ago.”

Such transactions can also lead to easy profits for the parties involved, potentially at the expense of minority shareholders. In September, Hong Kong-listed Guangzhou Shipyard International placed Rmb2.24bn worth of new shares to two related parties and Baosteel Resources, a unit of one of China’s largest steel companies.

The placement, at HK$7.29 per share or a 2.3 per cent premium to its undisturbed price level, represented a 60 per cent dilution of the company’s issued share capital and was used in part to fund the purchase of a shipyard from its parent.

Guangzhou Shipyard said the transaction would guarantee it uninterrupted access to a deepwater facility that could construct and service large ships including military vessels.

By the time the placement was completed in February, Guangzhou Shipyard’s share price had surged, allowing Baosteel to flip its portion of the placement for a quick Rmb120m profit.

Guangzhou Shipyard declined to comment.

Additional reporting by Wan Li and Lucy Hornby

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Tearing down the east wall to repair the west wall

It has been referred to as chai dongqiang, bu xiqiang, or “tearing down the east wall to repair the west wall”.

The habitual use of related party transactions to flatter the bottom lines of Chinese state-owned enterprises grew out of the parent company-listed company structures used to float so many companies.

The original genius of the parentco-listco model, pioneered in the 1990s, was that it allowed investment bankers to hive off unproductive assets – such as company hospitals and kindergartens – that overseas investors didn’t want any part of. The group’s productive assets were concentrated in the listco, which then paid dividends back to the parentco that could be used to fund its unproductive assets.

However, over time the cosy deals this structure can give rise to came to be seen as a barrier to further reform of China’s state sector.

In the late 1990s, China’s “big four” state banks pioneered another model known as zhengti shangshi – or “entire-entity listing”. After selling their non-performing loan portfolios to specially created asset management companies, each bank was listed as a single entity.

So while in the shipping sector the Chinese government wholly owns Cosco Group, which in turn controls Hong Kong- and Shanghai-listed China Cosco Holdings, in the finance sector Beijing controls Hong Kong- and Shanghai-listed Bank of China.

“There’s now a strongly expressed preference [among Chinese policy makers] not to have this parentco-listco structure but instead have just one corporate entity,” says Andrew Batson, research director at Gavekal Dragonomics in Beijing. “That was one of the better governance things that they did at the banks.”

The problem of the parentco-listco model, he adds, is that “once the structure is established it’s very cumbersome to change it”.

Last week Citic Group, a state-owned investment conglomerate, said it would stuff its $36bn worth of assets into a Hong-Kong listed subsidiary valued at $6bn, effectively achieving a zhengti shangshi structure through a backdoor listing.

But for struggling firms such as China Cosco and Chalco, which need money from their parent rather than more assets they can’t afford anyway, the parentco-listco model can eventually become a trap.

“They don’t have any other ways to raise money because the market doesn’t have any more faith in them,” says Wang Jun, an economist at the China Center for International Economic Exchanges. “All they can do is sell assets.”