The Truth about China’s State-Owned Enterprises

Bernstein’s Michael Parker studied 123 companies and makes a case for state banks and utilities.

Michael Parker, Bernstein’s Asia-Pacific equity strategist, relishes asking questions. On the wall of his Hong Kong office hangs a picture of Queen Elizabeth II with this question in large print: Does the Queen Wear Jeans? That may have been an artist’s rhetorical query, but Parker actually would like an answer – so next to that picture is a framed reply all the way from Buckingham Palace (alas, the Queen declined comment).

Not surprisingly, Parker isn’t fond of assumptions. Many investors are skeptical about China because they assume Chinese data, companies and government are untrustworthy. But Parker and his colleagues wanted to know if that was indeed the case, and undertook a mammoth research project to find out the definitive answer.

The result is two thick reports totaling more than 350 pages on the state of China’s economy, state-owned enterprises, corruption and executive compensation. Barron’s Asia recently sat down with Parker – a Kiwi who joined Bernstein in 2009 and moved to Hong Kong in 2010 – to discuss his findings.

Barron’s Asia: Let’s hop right to it. Can you trust Chinese economic data?

Parker: There have always been concerns about Chinese data, and this notion that Chinese GDP figures, say, are something pulled out of the air. If the government is materially and consistently overstating growth, then it should be evident on the ground by now because of the compounding effect over such a long period of time.

The conclusion to our analysis is that the economy looks – using data that doesn’t rely on any information from the Chinese government – to be about the same size as the Chinese government reports it is.

Q: Can that trust be extended to SOEs, where the government is the biggest shareholder?

A: The big concern here from a minority investor’s perspective is this: Am I going to wake up tomorrow and find the SOE I’ve invested in has fundamentally changed its strategy, or is now in an area in which it has no background, or has done something else to destroy shareholder value? There are clear examples over the last decade where that has happened: Banks in the wake of the global financial crisis, or the oil and gas sector when energy prices spiked, and the power sector between 2010 and 2012 when they continued to buy coal and build power stations effectively to keep the lights on for Chinese economy. The conclusion is that the government sees this idea of “national service” by SOEs as a valid mechanism through which to manage the economy.

Q: What about SOEs’ management teams?

A: We looked at 473 managers over the last 15 years at 123 Chinese SOEs, listed in Hong Kong, to determine the superior strategy for SOE managers in terms of gaining promotion within the Communist Party. The underlying assumption is that these guys are political animals first and foremost.

Surprisingly, over the last 15 years, the superior strategy (for advancement) has been to focus on improving the share price. But between 2009 and 2013, the best strategy was to trash or expand your balance sheet, as the instruction from the government was to stimulate the economy, and that tarnished the reputation of SOEs.

However, we think the incentives are changing once again, so there is an opportunity here for investors. What’s interesting is that at the end of 2013, a statement from SASAC (the State-owned Assets Supervision and Administration Commission) said that SOEs should focus on asset turnover (or the efficiency with which a company is deploying its assets) and no longer on asset growth. So you now have a capital efficacy metric as the primary means by which the SOE managers are judged.

We have 15 years of data now that shows the instruction from SASAC actually gives a lot of information about how SOEs are going to behave. But investor perception has been that the SOEs are simply government departments within a corporate structure.

I’m not saying that from a corporate governance perspective these companies are now particularly good, because they are still not interested in minority shareholder value. They are simply interested in a metric which is consistent with the creation of shareholder value. So it’s a happy coincidence, and I think that could last for quite some time.

Q: If SOEs’ interests are now more aligned with shareholders’, which sectors and companies are most attractive at this point?

A: The logic of the last five years is turned on its head, which had been to look for high growth private-sector companies that have China exposure, ideally with non-Chinese management to avoid the trust issues. So you wanted to buy what China needs. And you had a trade for a while with companies like BHP Billiton   and LVMH (MC.FR).

Now, however, we are entering a phase where you want a big slow-growing SOE with a high profile, which is not going to participate in any kind of corrupt activities because of the massive anti-corruption crackdown, and where the capital intensity [or capital expenditure over revenue] is going to fall. Here there is cash-generation capability.

So the big and boring become the obvious sectors: banking and telecoms. China Mobile is in many ways the perfect representation of this story in that its capital spending in 2015 will be lower in absolute terms than last year. The number of customers on 4G networks is going to grow from roughly 100 million to roughly 250 to 290 million, according to Chris Lane, our telecoms analyst, over the course of this year. There is average revenue per user growth that comes as data usage increases. You are getting more revenue from the same assets with reduced capital spending, and so stronger cash generation.

It’s a similar argument for the banks, because you’re in a situation where the bad behavior is likely to decrease, and the focus on capital efficiency is likely to increase. The risk in terms of that national service is lower, and the monetary easing environment works out well for the banks too.

Q: Which state-owned banks do you prefer, and are you concerned about non-performing loans?

A: Our banks analyst Wei Hou has buy recommendations on China Construction Bank

There’s a difference between what’s priced in and what the non-performing loans are likely to be, and that’s where the opportunity is. In November last year, before Beijing cut interest rates, we looked at the 2,500 publicly-traded companies listed in Shanghai and Shenzhen – and how much of their debt was on balance sheets of companies that may not be profitable enough to pay off interest expenses, and that had EBITDA (or earnings before interest, taxes, depreciation and amortization) less than interest coverage payments.

We got to about eight trillion yuan in debt. About 6% of that was held on balance sheets of companies that were technically insolvent. We then overlaid the sectors that those companies were operating in with the exposure of the Big Four banks, and we got to an estimated non-performing loans level of about 5% to 8%.

After the rate cut on November 22nd, we recalculated and got to 5%. After the recent interest rate cut we recalculated again and we are down to 4%. So that feels to us like China is going through a credit cycle – and not through a credit crisis. But some kind of credit crisis is priced into bank stocks, and that is where the investment opportunity comes from.

Q: What other SOEs look interesting now?

A: The other group that jumps out is really utilities. But again, in a situation of weak commodity prices with a less capital-intensive program going forward, they start to look like utilities in the rest of the developed world where they pay a dividend. They’ve got a manageable balance sheet, there is a little bit of capital expenditure needed because there is still some growth going on. But the volatility is far lower. Management behavior is far more predictable, and again, you’ve got these instructions from above to focus on capital efficiency. Utilities should turn out to be as dull in China or as they are in the rest of the world.

Q: Historically, Chinese utilities traded inversely to the price of coal. Are they going to be more stable now with coal prices down?

A: Yes. Among other things, the coal price is going to be low and stable for a long period of time, and so you are effectively taking that risk off the table. The risk they face is around interest rate volatility in the balance sheet, but with strong cash generation, the debt levels should go down – so that becomes more manageable too.

Q: Are these factors – including the cap on executive compensation at SOEs – enough to ease the negative sentiment around investing in SOEs?

A: The announcements in terms of executive compensation are really important. We’re signaling a path where the SOEs really take a back seat in carrying the burden of the economy going forward, which I think is a true surprise given where we were even three years ago, when you looked at investing in China and what was dominating the economy.

But this current de-risking of the SOEs won’t last forever. Roll this forward, say, five years and you might end up with an SOE sector that becomes a lot duller, a lot more cash-generative, but which shrinks over time. If you’re at all interested in financial compensation then you’re going to be focused on the private sector (so SOEs will lose out on the brightest talent). The implication is that these companies eventually start to atrophy. They are starved of growth capital and any kind of innovative or entrepreneurial activity. Then they really withdraw from the commanding heights they have enjoyed in China for at least the last 15 years.


Source: Barron’s By Thomas Streater March 27, 2015

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