Pascal Quiry

The Shanghai index has increased by four-and-a-half times since January 2006 and Chinese shares are valued at historically high price/earnings ratios – around 50. Growth in earnings could justify these high ratios: it is vibrant at 26 per cent a year since 2002.

But it is worrying that the cost of capital is not being covered at 73 per cent of Chinese listed companies, according to data on nearly 1,000 provided by Infinancials, a supplier of data and models on listed companies. They are destroying value, but their shares are nevertheless rated at a price-to-book ratio (PBR) of around 4.9. This is sustainable only if return on capital employed (Roce) improves dramatically.

Given that free cash flows, after financial costs, have been negative over recent years, they are loading themselves with debt and vulnerable to a slump. While they experience strong growth, low Roce, negative free cash flows and high PBR, the situation looks very similar to that in Europe in the early 1970s.

Industrial facilities are being built and market share won without concern for return.

The main difference, however, is macro-economics. Until very recently, inflation in China was under control, unlike 1970s Europe when debts were eroded by inflation. This means Chinese companies are not enjoying the benefit of negative real interest rates or debt reduction. This may change: inflation is on the rise.

In September 2007, the Shanghai and Shenzhen stock exchanges listed 1,497 Chinese companies. Excluding those with market capitalisations below $100m and those in banking, insurance and real estate (because their accounts are different), there are 993 for which audited accounts are available. They are three-quarters of the capitalisation of the Shanghai and Shenzhen stock markets – $2,600bn.

In 2006 the sales of these Chinese companies amounted to $778bn, the equivalent of the sales of Shell, BP and Daimler, the three biggest non-financial European companies by sales. Two of the companies are very large (Petrochina and China Petroleum) accounting for 28 per cent of sales and a quarter of market capitalisation. They are excluded from our sample.

Unsurprisingly, the biggest Chinese companies are the most efficient: the top 20 per cent ranked by market capitalisation account for 70 per cent of sales, 86 per cent of earnings before interest and tax (Ebit) and 60 per cent of the workforce with median sales of $765m, Ebit of $90m and a headcount of 6,400. The bottom 20 per cent account for 3 per cent of sales, 1 per cent of Ebit and 5 per cent of the workforce.

Growth has averaged a strong 27 per cent year-on-year since 2002. This reflects volume increases as, over the same period, Chinese inflation was running at 2 per cent. This means listed companies have been growing at two-and-a-half times the rate of the Chinese economy.

Because the rising price of raw materials has not yet been passed on to customers, Ebit fell from 11.5 per cent of sales in 2002 to 10.7 per cent in 2006 (10.9 per cent in Europe), despite an impressive increase in productivity per worker: sales have risen 27 per cent year-on-year with the workforce growing only 8.7 per cent year-on-year, to 5.1m in 2006.

Since 2002, management of capital employed has improved. The explanation behind this is better management of working capital: from 26 days of sales in 2002 to nine days in 2006, as well as better use of fixed assets.

Nevertheless, since 2003 Chinese companies have generated negative free cash flows – after financial expenses – which they have financed mainly by taking on debt.

Consequently the financial structure of listed Chinese companies is changing quickly: net debt rose from 23 per cent of equity in 2002 to 36 per cent in 2006 and from 1.1 times earnings before interest, tax, depreciation and amortisation (Ebitda) to 1.3 over the same period.

This level of 1.3 would not typically be a cause for concern but is troubling because these companies are not generating free cash flows. Consequently, they can repay debt only by cutting capital spending or taking out loans, unless they issue equity, which, given the high valuations at which their shares are trading (historic PE ratio of 47) is not very costly. Chinese financial directors have been well advised to raise as much equity as debt, taking advantage of the booming stock market, fuelled by high savings rates of Chinese households and restrictions on investing outside China.

So with Roce (after tax) at 8.5 per cent in 2006, listed Chinese companies earn less than the weighted average cost of capital (WACC) – about 10 per cent. This compares poorly with Europe where companies generated Roce of 11 per cent in 2006 versus a WACC of 7.5 per cent. Only 27 per cent of listed Chinese companies earned more than their cost of capital in 2006: the median Roce for the others is 4 per cent.

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