2014-11-17-China Slideshare

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BY:

ASIA’S CORPORATE SECTOR

NOVEMBER 2014

CAN CHINA SURVIVE?

GILLEM TULLOCH

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BUT FIRST, WHO WE ARE• GMT Research is an independent research company based in Hong Kong and regulated by

its Securities and Futures Commission • By independent, we mean that there are no conflicts of interest, such as being part of an

investment bank or fund management operation; we are employee-owned• We run a subscription-based model and generate investment ideas to make money for

our clients, not from our clients• We have two main product lines:

1. Micro-strategy: We have developed a unique methodology to evaluate the financial health of the listed corporate sector which enables us to work out where an economy lies within the business cycle

2. Company and sector research: We write in-depth company and stock specific research with a focus on business models, balance sheets and accounting issues

• We place a lot of emphasis on the way we deliver research to clients and every research idea is delivered with a report, slide deck and short explanatory video; our website is dynamic so it works well on your smartphone and we have a mobile app

• The two principal writers are Gillem Tulloch and Robert Medd wo have lived and worked in finance in Asia for two decades or more

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HEY, BIG SPENDER!• In our report, CORPORATE HEALTH: Global Perspective, we rolled out our methodology

for evaluating the financial health of the listed corporate sector across 40 markets globally• One of the new ratios we now follow, and show here, is the level of capital expenditure

(capex) relative to depreciation• This gives us an understanding of the rate at which companies have been expanding their

fixed assets• The chart on the next page shows median capex relative to depreciation over the past

seven years (2007-2013)• In general, within developed markets capex is 0.9-1.2x that of depreciation whilst 1.2-1.5x

for emerging markets • However, some emerging markets have seen capex at 1.5-2.0x depreciation (Vietnam,

Indonesia)• Only two markets globally have managed to record capex in excess of 2.0x

depreciation over the last seven years, China (2.1x) and India (2.5x)• Interestingly, for 2013, Indonesia (2.0x) and the Philippines (1.9x) recorded the highest

capex relative to depreciation

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HEY, BIG SPENDER!CAPEX/DEPRECIATION BY MARKET, GLOBAL: LAST 7 YEARS

Source: GMT Research

Lime colour denotes Asia

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CASH IN OR OUT?• The chart on the next page shows Free Cash Flows (FCF) as a percentage of Operating

Cash Flow (OPCF) for the latest financial year (2013)• OPCF is calculated by taking net profit and adding back non-cash items (such as D&A)

plus changes in working capital; FCF flow is calculated by subtracting capex from OPCF• Free cash inflows suggest that the corporate sector is self-financing whilst outflows

suggest that external finance is required• It is extremely rare for a corporate sector to report outflows, sometimes indicating that it

is in the latter stages of a credit induced bubble• Likewise, large inflows relative to OPCF can indicate a lack of investment opportunities

perhaps stemming from political uncertainty, or a market attempting to restore solvency • Developed markets generally generate free cash inflows between 30-50% of OPCF whilst

emerging markets between 20-40%• The clear global outliers are China and India which have been hemorrhaging free

cash outflows for a number of years and which were at 50-90% of OPCF last year• Indian companies appear to have begun to cut capex in the year ended March 2014 but

financial statements won’t all be submitted until September• There has been some FCF slippage in Indonesia and the Philippines which is symptomatic

of a strong investment upswing

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CASH IN OR OUT?FREE CASH FLOWS/OPCF BY MARKET, GLOBAL: -1FY


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WHERE’S THE LEVERAGE?• The chart on page 8 shows leverage by market globally• Our favourite measure of leverage is debt/OPCF• This tells you how long it would take to repay debt if capex was taken to zero• The global average is currently 3-4x as is the global 20 year average• Given that the average loan duration is three-to-five years, this should not come as a

surprise• It is rare for debt/OPCF to exceed 6.0x as it suggests that the corporate sector is

dangerously over-leveraged and unable to meet maturing liabilities from cash inflows• The financial health of Asia's corporate sector is generally sound, in particular Southeast

Asia; however, there are a few exceptions…• China and India’s leverage is above 7x debt/OPCF, well in excess of our danger

threshold, making them some of the most leveraged markets globally• It is a concern that their leverage is the same as notoriously problematic markets such as

Greece and Spain and we are not sure that this is entirely appreciated by the stock market• The three previous charts therefore show that China and India have the highest

capex relative to depreciation, have recorded the largest free cash outflows and have some of the highest leverage; as such risks lie to the downside

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WHERE’S THE LEVERAGE?DEBT/OPCF BY MARKET, GLOBAL: -1FY


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THIS TIME IT’S DIFFERENT• The chart on page 10 shows debt/OPCF for China and India over the last 20 years• How is it possible for these markets to commence an investment upcycle when

companies are already experiencing free cash outflows and have high leverage?• The starting point for a sustainable investment upcycle needs to be a corporate sector

with low levels of leverage which is generating free cash inflows• As investment rises, free cash inflows turn to outflows and leverage increases • For example, India entered its last investment upcycle with debt/OPCF of 4.3x and free

cash inflows at 5-10% of OPCF; for 2012, debt/OPCF was 8.5x and free cash outflows were 90% of OPCF

• Surely India and China are more likely to experience a multi-year de-leveraging cycle, as opposed to an investment up-cycle?

• Whilst India has begun to cut capex, de-leveraging has not begun in earnest and too much is baked into the stock market with the SENSEX having risen 45% over the past year

• It is possible that new Prime Minister Modi can engineer some form of an investment upcycle, but it will be weak: look to take profits

• As for China, the correction has not even begun: UNDERWEIGHT

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THIS TIME IT’S DIFFERENTDEBT/OPCF FOR INDIA AND CHINA: 1995-2013


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PRINT, PRINT, PRINT, PRINT…..• It's quite clear why the Chinese corporate sector has such high leverage when we look at

its credit numbers• Previous credit-induced bubbles pale into insignificance compared to China today….• For example, the US economy managed to create net new credit in excess of 20% of GDP

for just one year in the run up to the Global Financial Crisis in 2006, and then it was only 22% of GDP

• Meanwhile, Thailand managed it for three consecutive years in the run up to the 1997 Asian Financial Crisis and even managed to hit 31% of GDP in 1994

• China has taken money printing to a whole new level, generating net new credit in excess of 35% of GDP for five consecutive years, as the chart on page 12 shows, even achieving 44% in 2009

• Indeed, as detailed in our report, CHINA's DILEMMA: Unpalatable Choices, credit creation, interest rates, corporate leverage and free cash flows are all flashing warning signals

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https://gmtresearch.com/research/chinas-dilemma-2/


PRINT, PRINT, PRINT, PRINT…..NET NEW CREDIT/GDP IN YEARS BEFORE CRISIS

Source: GMT Research, NESBD of Thailand, National Bureau of Statistics of China, Fitch Ratings

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BACK TO THE USSR?• China is pursuing economic growth with no regard for the quality of the assets being built or how it is financed• The Communist Party needs to decide whether it is going to continue its slide back into a Soviet-style command

economy or reverse course and pursue free market reforms• Free market reforms, such as interest rate liberalisation, are recessionary in the near term as capital is re-allocated

towards productive sectors and corporate leverage is reduced• This is clearly the party's immediate concern and why it appears loathe to cut off the credit• Still, history would suggest that only a free market economy has staying power; allowing companies to fail and capital to

be re-allocated is core to capitalism’s success• In extreme examples, this cleansing of the system manifests itself as a recession which is what Chinese policymakers are

so scared of• The alternative is to continue pumping credit into the system• Whilst this will result in low quality growth in the short-term, if unchecked it will ultimately bring down the entire system• New credit is fuelling alarmingly high corporate leverage and what remains of the free market will increasingly lose

confidence in fundamentals• To circumvent the market's negative feedback loop, policymakers will possibly have to increase the number of

nationalisations, such as bond markets, housing markets and listed companies• We can draw some interesting comparisons between China today and the Soviet Union• Its economy never once recorded a decline in GDP/capita in the post war period and outgrew the US almost every year,

as the next chart shows• Even the West's leading economists (Nobel-prize winner Paul Samuelson, Abram Bergson, etc.), lauded the Soviet

Union's centrally planned command economy• However, eventually the system broke down and when the free market was allowed to attach a value to the

economy, it was 70% below previously recorded levels, as the next chart shows• Let us hope China does not come to that but some unpalatable choices lie ahead

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BACK TO THE USSR?GDP/CAPITA (REBASED) AND CHANGE IN GDP/CAPITA

Source: UN Statistics Division, GMT ResearchSource: UN Statistics Division, GMT Research

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ONE GIANT RECEIVABLE• It is said that the payment transmission mechanism slowly ground to a halt in the Soviet Union which is

what finally brought the system down; in other words, the economy became one big receivable• This is not surprising when there is no effective pricing mechanism to decide how to allocate resources • After all, prices and profits when freely established are simply a process to discover where there are

surpluses and shortages• It is, therefore, worrying that accounts receivable days have deteriorated by 40% in China over

the past seven years, as the next chart shows • This is unprecedented in Asia and suggests that profits have been materially over-stated• Energy and industrials sectors are the worst affected with receivables deteriorating by 70-110%• We're not saying that this is a sign of an immediate collapse but it does suggest that companies are

recognising profit for which they are not getting paid• It also suggests that credit stimulus is going into increasingly less productive projects for which

suppliers and creditors are finding it increasingly difficult to get paid• A recession need not be calamitous for China. As mentioned in our report, FOREIGN DEBT IN ASIA:

Where Monsters Lie, China's corporate sector has a fairly stable capital structure with a low level of foreign debt relative to equity, the exception being the property sector

• This means that they can devalue the currency to stimulate exports without damaging the solvency of large parts of the corporate sector

• As such, a recession would likely be over in a relatively short period of time• There is a huge amount of capital tied up in working capital and if sales declined, this would be freed

up and lead to accelerating debt repayment

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https://gmtresearch.com/research/foreign-debt-in-asia/


ONE GIANT RECEIVABLECUMULATIVE % CHANGE IN RECEIVABLE DAYS SINCE 4Q07


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SAME-SAME BUT DIFFERENT• Nowhere is the lunacy of China's credit induced bubble more obvious than in its property

sector• In the next two charts, we show debt/profit and free cash flow/profits for property sectors

across Asia• We have replaced our preferred OPCF metric with profit given that property companies

book land bank acquisitions as working capital as opposed to an investment - as such, OPCF is often negative, rendering our leverage analysis meaningless

• Different levels of corporate leverage in Asia reflect the maturity of various markets and differing business models

• China's property sector has the best terms of trade in Asia with companies receiving 100% of the sales proceeds upfront from the consumer

• In a rising presales environment, this suggests that companies should generate huge quantities of free cash inflows and have low levels of leverage

• Instead, we find that Chinese developers are generating the largest free cash outflows in Asia and have the highest leverage

• Interestingly, Indonesian property companies have the same business model as Chinese ones and yet they manage to report free cash inflows and have the lowest leverage in Asia

• Is it that Chinese property developers are being recklessly run following multiple government bailouts? We certainly think so

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SAME-SAME BUT DIFFERENTPROPERTY SECTOR DEBT/PROFIT AND FCF/PROFIT BY MARKET IN ASIA: -1FY

Source: GMT ResearchSource: GMT Research

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CONCLUSION• There is much to be found that is good across Asia corporate sector• Barring a few rotten apples, corporate sectors look in fine fettle, especially in

Southeast Asia (OVERWEIGHT)• Whilst our rhetoric on India might sound negative, there have been positive

developments, namely companies having begun to cut capex • However, it is difficult to envisage a strong investment upswing until further de-

leveraging has taken place and the stock market appears to have got ahead of itself (TAKE PROFIT)

• Still, China has not even begun this process of corporate de-leveraging and it is here that the downside risks still remain the greatest in Asia (UNDERWEIGHT)

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AUDITING FRAUD III: Baffling Banks

FOREIGN DEBT IN ASIA:Where Monsters Lie

SCANNING FOR TROUBLE: Check Your Stocks

CORPORATE HEALTH:Global Perspective

EVALUATING INDIA: Rotten to the Core

AUDITING FRAUD II: Property Problems

EVALUATING ASIA: Growing Pains

AUDITING FRAUD: Tomorrow’s Scandals?

CHINA’S DILEMMA: Unpalatable Choices

PROFIT MANIPULATION:Deferred Tax Liabilities

GMT RESEARCH: Who we are and what we do







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