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Where China's Domestic Companies Stand to Benefit

Investor concern spans China's economy, but these industries still have plenty of room to grow, especially for local firms.

Morningstar Analysts, 11/30/2011

To get an inside view of the investing landscape in China, we asked Morningstar's Shenzhenbased team of equity and credit research analysts, led by Iris Tan, to give their perspective on the sectors in China’s economy where the best opportunities lie for local, Chinese companies.

Locals Emerge in Construction Machinery
Driven by urbanization and the mass building of infrastructure, the Chinese constructionmachinery sector grew at a compound annual rate of 22.9% over the past 10 years. Sales of Chinese construction machinery are on pace to reach $78.4 billion in 2011, making it the world’s largest market. However, these one-time darlings of China-focused funds have seen their earnings quality deteriorate and orders slow in 2011.

Investors are fleeing the sector over fears of a hard landing by the economy and drastic cuts in fixed-asset investments. Domestic players are trading at 10 times their P/E ratios and three times price/book ratios, close to their historical lows. In the short term, we expect a continuing decline in orders. But over the longer term, investment in infrastructure projects—particularly in transportation and nuclear—should resume once a corruption investigation of the railway ministry is completed and concerns over nuclear safety are addressed.

Foreign companies compete on a fairly level playing field in the sector; market share is split roughly 60%/40% between multinational behemoths (such as Komastu, Hunyadi, and Caterpillar CAT) and their domestic rivals, respectively. The landscape, however, is changing. SANY, Zoomlion, and XCMG Construction Machinery are emerging local players. With ample cash from equity and debt offerings, they have quickly expanded their operations and are taking market share away from foreign competitors. We project that they will see 15% annualized growth for the next five years.

Of these emerging domestic companies, we especially like XCMG. The manufacturer specializes in cranes, compactors, and paver products. Its parent company, Xugong Group, is China’s largest construction-machinery manufacturer. Short-term capital raising and a sharp decline of investment in rail and road construction drove XCMG’s valuation down to near-historic lows. We believe that at its current valuation the stock offers mediumand long-term investors an attractive entry point to a leading player in an industry with double-digit annual growth rates.

There is no denying that XCMG cannot compete with Caterpillar and Komastu on quality, but lower prices, along with a comprehensive service network and sales channels, have won over the majority of domestic customers. In 2010, according to the company, its crane products owned a 53% market share in China. As a government-backed company, XCMG should be able to secure the funds it needs through issuing notes and bonds to finance capital expenditures and acquisitions. Additionally, revenue from its concrete truck and pump business jumped 112.2% in the first half of the year, while gross margins improved 31.22%, a 5-basis-point increase year over year. With a dedicated service and dealer network and a reputable brand, the firm’s crane truck and road-roller products remain the market’s top choices in 2011.

Insurance Business Comes to Life
A young industry in an environment with fast-growing household income, China’s insurance sector increased at a compounded annual rate of 30% from 2000 to 2005 and 24% from 2005 to 2010. By the end of 2010, China’s $214.6 billion in premium income made it the world’s sixth-largest insurance market. It’s a market in which domestic insurers have near total control. (Foreign insurers represent merely 5% of the market.) Although the market in terms of total premium income is huge, per capita it only ranks 61st in the world. Premiums as a percentage of GDP rank 39th.

China’s A-share insurance index is down 27% so far this year after an 18% drop in 2010.

The sector’s current valuation is below historical trough levels, trading at a P/E of 15 and a P/B of 2.1. Top-line growth is struggling, surrenders are mounting, investment returns are lower, and insurance reserve charges are higher because of falling valuations. To top it all off, higher interest rates have hurt insurance companies’ bottom-line results. Also, the capital strength of insurers was weakened because of mark-to-market losses on availablefor- sales investments, triggering refinancing concerns in the market.

After a decade of tremendous growth, the sector has hit a bottleneck. A whopping 91.6% of life insurance policies sold in China are participating policies, most of which are designed to emphasize investment returns. Insurance companies overly rely on policies that purchasers consider substitutes for bank deposits. Such a strategy fared well in a low-inflation environment, where banks attracted ample deposits at low costs. However, with rising labor costs and China’s gradual, and struggling, economic transition, investors are expecting a rather sticky inflationary environment in the medium to long term. If inflation pressures remain, bond- and stock-market performance will continue to depress insurance rates of return, making savings-type insurance products unattractive compared with other financial products. Meanwhile, we expect that the insurance market will become more crowded with intensifying competition. Seven listed banks (including the five largest state-owned banks) have established insurance arms, and five leading insurance companies and groups are waiting in the IPO pipeline.

Despite a dim near-term outlook, our longerterm view for the sector is brighter. We believe that there’s still plenty of room to grow in the market. Given their market dominance, leading assets scales, and large customer bases, the top life insurers should be able to be the pioneers in broadening their distribution channels (including telesales, online sales, and intermediary markets) and optimizing their products by specializing in emerging niche markets, such as pension and health insurance. However, it will be a gradual process, and the return to the fast growth of the past decade will take years and require government support.

For a long-term play on the sector, we like Ping An Insurance. Its revenues and net profit increased by 38% and 33%, respectively, from a year ago, with new business value growing by 18% and net book value and embedded value growing by 20% and 16%, respectively, from the end of 2010. The increase in net book value is mainly because of a CNY 16 billion ($2.5 billion) private placement in March. Though Ping An’s growth in its life premium business remained strong in the first half of the year, we’re concerned about the quality and sustainability of the growth. The company experienced a 6% drop in the first-year regular premiums in its highly praised agency channel, which represents more than 80% of Ping An’s life insurance income. Ping An increased its force of agents by 15% from mid-2010, but sales per capita merely inched up 1.6%. This feeds into the market’s worries about the insurer’s ability to further drive its life insurance sales through adding new staff and increasing first-year premiums per agent. However, Ping An is one of few financial conglomerates in China with a balanced business structure. Its property-and-casualty insurance business has delivered robust growth of 36% this year, as its strong auto insurance business surged more than 90% and represented 24% of the company’s propertyand casualty-insurance income.

Ping An is trading at a forward P/B and P/E of 2 and 12, respectively—levels even lower than those in the 2008 trough. So, even with its uncertainties, given the company’s advantage in agency channels and its strong cross-selling synergies as a leading integrated financial-services conglomerate, Ping An’s valuations are attractive.

Drink Makers Get in the Spirit
The spirits sector in China has enjoyed remarkable growth, with more than 30% annual compounded revenue growth over the past three years. Because of cultural and dietary habits, local white spirits is the main driver in the market; imported foreign liquors make up less than 0.3% of total production volume. The overall spirits market is fragmented. Market share of the top five players combined is less than 20%. However, only a few competitors dominate the high-end, first-tier market, where brand matters the most. The top two high-end names are Kweichow Moutai and Wuliangye Yibin, which have consistent market share around 12%. The midprice market is more competitive with many players competing through more-efficient distribution channels.

First-tier companies are trading at 20 to 25 times their P/Es, near historical lows. We forecast 20% to 30% EPS growth for these companies over the next three years. We think that they are slightly undervalued, considering their very positive earnings outlook, and worth investors’ attention. Second-tier companies are trading above 30 times P/E, which we think is slightly overvalued.

Important socially, China’s spirits makers will benefit from economic growth and a consumption boom. For the past few years, consumer spending on alcoholic beverages grew steadily at around 14% annually, the same pace that personal disposal income grew. We believe that disposable income will grow more than 15% annually for the next five years, which will fuel the growth of spirits consumption. Also, luxury spending in China is growing (more than 30% in 2010), and because of the scarcity of high-end spirits, we believe that an increasing number of wealthy people will consume and collect these brands.

For companies, we think that pricing power and distribution techniques will determine growth and profitability. Moutai and Wuliangye are the top first-tier names in the sector with the strongest pricing power. We think that their ex-factory prices (prices at the factory) will continue to grow at a moderate rate. The difference between ex-factory prices and retail prices for these firms is widening, indicating that demand still outstrips supply.

Wuliangye is the sector’s largest company by revenue and production capacity. Although its focus is on high-end spirits, it offers a diverse set of products across the price spectrum.
High-end spirits account for 80% of Wuliangye’s revenues. Its growth there will be dependent on how well it adjusts its distribution channels to adapt to fierce competition in the retail market. In the midprice market, growth will be dependent on distribution power. We see positive signs of distribution improvement from the company’s recent results. Top- and bottom-line revenues have grown this year by 39.8% and 49%, respectively. The company’s major midprice products recorded volume growth of more than 30%. Gross margins have declined a bit, but in September, Wuliangye announced it was raising ex-factory prices by 20% to 30%. We think that this will improve gross margins in the fourth quarter.

As the most prestigious spirits brand in China, Kweichow Moutai is essentially the official drink of China’s political and military gatherings. More than half of its products are supplied to government, military, and big corporate groups through direct sales. Moutai’s demand story is best explained by its flying retail price. The price of a bottle of Moutai is more than CNY 1600 ($252), far exceeding its ex-factory price of CNY 619 ($97).

In the first half of 2011, Moutai recorded volume growth around 20%, while top- and bottom-line revenues were up 49.2% and 57.8%, respectively. Gross margins stayed the same, and profit margins expanded by 2.9%. The company recently launched another brand,

Hanjiang, which is priced at CNY 699 ($110), and it is likely to be another growth engine. We believe that Moutai’s pricing power will keep its margins stable and that 25% is an achievable revenue growth rate for the company.

King Coal
Coal is very important to China’s energy security. Driven by economy’s fast growth, the production of coal, which makes up 70% of China’s primary energy resources, grew at a compound annual rate of 8% for the past five years. During the same period, the country’s GDP grew at an 11.2% rate, so 1 percentage point of coal-production growth brought about 1.4 percentage points of GDP growth. China’s coal production and consumption reached 3.24 and 3.18 billion tons, respectively, in 2010, making the country the largest coal producer and consumer in the world. More than 50% of China’s coal is burned to generate power.

China’s coal supply and demand is balanced in terms of total volume, but not by regions. More than 60% of China’s coal is produced in its west, and most energy demand is along the coastal regions of south and east China. The country’s railway transportation capacity is insufficient, however, making it difficult to transport coal from west to east.

Worries over a hard landing in the economy, which would drive down coal demand and prices, have investors fleeing the industry. The sector is trading at 13 times 2011 forward P/E and 3 times P/B, close to their historical lows. In the short term, we expect continuing pressure on the sector because of a gloomy economic outlook. But in the long term, investing in China’s major coal miners is still a good option, given the country’s reliance on coal and its positive long-term growth prospects.

Under the direction of the Chinese government, the consolidation of the coal sector is intensifying. The government has closed mines with small production capacities and allowed large coal miners to acquire smaller miners. State-owned coal companies have acquired the best-quality mines, crowding out private capital. Today, the major players in the coal sector are all state-owned enterprises.

China Shenhua is the largest listed coal-mining company in China. We believe that Shenhua has formed a narrow moat. The company has created a distinctive, integrated business portfolio covering coal mining, power generation, and coal transportation. Its vast transportation network, composed of proprietary railways and ports, is the envy of its peers. Shenhua’s five railways connect major mining areas in Shanxi and Shaanxi, a pair of proprietary ports, and the Daqin Railway, China’s east-to-west coal transportation artery, forming a network that gives Shenhua direct access to China’s most developed regions. Coal produced by Shenhua is first shipped to its own ports and the Port of Qinhuangdao by railway, and then to eastern and southern China by sea.

Meanwhile, Shenhua’s own power plants further leverage the core, competitive advantages conveyed by its transportation network, given the Chinese coal-mining sector’s transportation capacity shortage. The synergies created by Shenhua’s integrated business portfolio have helped reduce costs and boost coal sales, thereby translating into higher profitability.

According to our models, Shenhua has a 2011 forward PE of 11.7, the lowest among all the A-share coal companies. We forecast the company’s 2011 revenue and EPS to grow by 29% and 15%, respectively, mainly driven by the fast growth of the company’s coal production and strong coal prices. The company’s strong cash flow and reasonable leverage lay down a solid base to weather any potential slowdown.

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