China: Portfolio Strategy
China: Portfolio Strategy
Feedback from Shanghai trip: A visible recovery
A fact-finding trip in Shanghai
We visited government officials and 10 companies from various sectors in Shanghai in mid July to find out how corporates have been coping with the challenging environment and assess the implications from popular themes (World Expo in 2010, aim to become a financial center by 2020).
Strong recovery, buoyant property; still-robust banking system
• A domestic-demand-led recovery confirms the worst is behind: Most
companies have seen meaningful sequential growth recovery in 2Q09 from depressed levels in 4Q08 and 1Q09. However, growth momentum has been mainly driven by domestic demand while external demand continues to be weak. Home Inns (NC), an economy hotel chain serving domestic business travelers is enjoying a 90% occupancy rate vs. 50% for most 5-star hotels. • Asset appreciation but limited systemic risk: Average property prices gained 12% mom in June and transaction volume in May/June reached a 2-year high. Vanke (000002 CH, Buy, Rmb14.22) and Lujiazui (600663 CH, NC) attribute the property resurgence to sanguine investment demand as exemplified by low yields and high vacancy rates. Systemic risk for banks however seems limited given the low mortgage ratio and high proportion of govt-backed projects. • Structural stories remain valid: Govt officials think the making of Shanghai into a global financial center will further integrate China into the global arena but this will be a gradual process. The World Expo may attract 70mn visitors but not all are incremental. Infrastructure work should bode well for l-t growth.
Investment themes: Banks, domestic demand, outsourcing
1) Banks: SHPD (600000 CH, Buy, Rmb25.26) expects NIM to bottom-out in 2H09. NPL risks could be manageable if macro further improves. 2) Domestic demand: Still the most appealing theme at present.
3) High value-added outsourcing: An emerging trend given China’s cost competitiveness and rising technological skills—Wuxi Pharm (WX US, NC).
Thomas Deng, CFA
+852-2978-1062 | thomas.deng@gs.com Goldman Sachs (Asia) L.L.C. Kinger Lau, CFA
+852-2978-1224 | kinger.lau@gs.com Goldman Sachs (Asia) L.L.C.
The Goldman Sachs Group, Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification, see the end of the text. Other important disclosures follow the Reg AC certification, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S.
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Feedback from Shanghai trip: A visible recovery
As a part of our ongoing efforts to obtain micro data-points to complement our top-down market analysis, we spent a week in Shanghai in mid July and visited a number of companies from different industries, spanning property developers to a pharmaceutical outsourcing provider.
Additionally, we discussed policy direction and long-term strategic development for Shanghai with regulators to explore the long-term
investment implications, if any, from the high-profile events/plans such as the 2010 Shanghai World Expo and the aim to make Shanghai into a global financial center and shipping hub by 2020.
We highlight the key takeaways and investment ideas as follows:
(1) Growth momentum has recovered
After a very challenging 4Q08 and 1Q09, most company managements we talked to are seeing strong sequential improvement in their operating environment. For instance:
• The occupancy rate for Home Inn has increased from the low eighties in 1Q09 to over 90% in 2Q09.
•
Power generation in Shanghai has rebounded to 10% growth in June from negative territory in the first few months of 2009, according to Shenergy (600642 CH, Neutral, Rmb12.62). •
Revenue growth for Shanghai Bailian Group (600631 CH, NC), a large department store chain, was flat yoy in 2Q but better than management expectation;
•
Shanghai Pudong Development Bank (SPDB) expects net interest margin (NIM) to bottom-out in 2Q09 as the bank sees favorable deposit time shift and rising loan demand from the private sector. •
Total residential property transaction volume in gross floor area (GFA) terms reached 12mn sqm² in 1H09, equivalent to 77% of the full-year figure (15.7mn sqm²) for 2008.
(2) Growth disparity between domestic (robust) and external (weak) demand is significant
Our observations suggest that domestic demand in China is holding up surprisingly well in a global recessionary environment; however,
companies that are exposed to external demand continue to struggle. The most convincing evidence was Home Inn, an economy hotel chain mainly serving domestic business travelers, which enjoyed close to a 90% occupancy rate for its mature stores in 1Q09. Although a 90% occupancy rate is still somewhat lower than the over-100% average that the company recorded back in 2007, we think that this robust demand within China is nevertheless respectable against a challenging global macro backdrop. At the other end of the spectrum, we were told by Shanghai Jinjiang
International Hotels Development (600754 CH, NC), a hotel and restaurant operator, that the five-star hotels in Shanghai, which are focused mainly
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on overseas travelers, only achieved an average occupancy rate of around 48% in the first five months of the year. Additionally, the average price/room for 5-star hotels fell 21% yoy during the same period, translating into an average selling price of Rmb1000/night.
While domestic demand seems to be the major growth propeller for China at the moment and has offset, to a certain extent, weakness in external demand, the sustainability of domestic demand rests firmly on how the social safety net will evolve in China in the years to come, according to officials from the Shanghai Social Security Fund (SSF).
Specifically, corporations and employees in Shanghai are stipulated by the Shanghai municipal government to make contributions equivalent to 37% and 11% of salaries, respectively, to fund various social security,
retirement and health care plans. However, the Shanghai government ran a deficit of around Rmb10bn last year for its social protection/retirement spending and the deficit is expected by the government officials to go even higher in the foreseeable future.
To improve/reverse the underfunded situation, government officials are contemplating three major approaches to explore funding and reduce expenditure. Approaches include: (a) Expanding the contributing population (mobile workers in particular); (b) Raising the statutory
retirement age for women from 55 at present ; and, (c) Exploring higher-return investment channels than bank deposits and government credit.
(3) Asset price appreciation amid abundant liquidity and inflation concerns
We visited China Vanke and Lujiazui. Both were surprised by the strong growth in transaction volume and property prices in Shanghai ytd. According to the developers, property transaction volume rose to around 2.5mn sqm² in May and June, which is comparable to the peak levels in mid 2007. Furthermore, average transaction price rose 12% in June from the previous month to Rmb15,000/m², which is meaningfully higher than the full-year average of around Rmb11,500/m² in 2008 and not far from the historical high of Rmb17,000/m² in mid 2007. Inventory in Shanghai has also dropped to around eight months of sales, based on their estimates. The developers highlight the following reasons for the property market boom of late:
•
New marriages and upgrade demand were the main drivers at the beginning of the year when overall property prices were still under pressure amid a murky macro outlook.
•
Investment demand for real estate picked up significantly entering into 2Q09 as banks’ credit became more accessible with the government’s looser monetary policy stance. The strong
investment demand is reflected in low rental yields (about 2% gross) and high vacancy rates (anecdote—only one-third of the flats are occupied in one suburban area of Shanghai despite the fact that the project was completed and sold out three years ago). •
Supply failing to catch-up with rising demand and very limited supply for economic housing in Shanghai.
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•
Home mortgage rates are at low absolute levels and buyers often get discounts from the nominal benchmark lending rate as banks fight for relatively low-risk mortgage business.
•
The unprecedentedly rapid credit creation in China has provoked widespread concern on inflation. Many investors choose to invest in real estate as a hedge against inflation.
•
Positive wealth effect from the A-share market, which has almost doubled ytd.
Market sentiment is certainly improving; however, developers appear relatively cautious about the near-term industry outlook. Management of China Vanke thinks that volume might have to come off if transaction
prices continue to rise as the developer believes that prices for some high-end residential properties are already at stretched levels. Also the
developer believes that land acquisition costs in first-tier cities are over-extended and says that it would prefer to go to 2nd and 3rd tier cities for growth opportunities at more reasonable profit margins.
(4) Systemic risk seems low as banks are conscious about the aftermath of easy credit
Investors are increasingly concerned about NPL risks for banks and broader systemic issues for the economy on the back of rapid new loan
creation in China, which has amounted to Rmb7.4tn ytd (200% yoy growth). We had a discussion with SPDB’s management and noted that the bank is mindful of the negative consequences of extending credit relentlessly. Indeed the bank is strictly adhering to the guidelines published by the PBOC and CBRC on risk management. Specifically, the bank is:
•
Demanding 40% down-payment for new mortgage applications across primary and secondary markets. This coincides with our finding that aggregate property-related systemic risks could be rather limited as the aggregate mortgage leverage ratio since 2000 is only around 20%, according to our calculations.
•
Targeting customers with high credit worthiness (SOEs) and loan projects with explicit or implicit government guarantees. This results in a loan portfolio skewed (about 60%) toward construction-related projects in the inland regions where
government-led infrastructure construction demand is buoyant. •
Charging higher interest rates or even rejecting loan applications from risky sectors, which include export-related manufacturing and agriculture.
•
Working very closely with the regulators to ensure loans are being appropriately deployed and not used for speculative investment purposes. However, the bank admits that a portion of the discounted bill loans could have gone into the stock market.
In terms of operating trend, management believes that NIM is likely to bottom out in 2Q as: (1) The recent trend of deposit shifting from time deposits to demand deposits should help lower funding costs; (2) Loan growth should moderate in 2H09 as Chinese banks have tended to front-load their lending capacity in anticipation of stricter loan quotas from the
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PBOC in 2H09. This could raise banks’ bargaining power in loan pricing; and (3) Rising loan demand from the private sector could also help
improve margins as loans to private enterprises tend to be more profitable than loans to government-affiliated entities.
(5) The making of a global financial center: An avenue to the global market
In response to the recent announcement by the State Council regarding its plan to turn Shanghai into a global financial center and shipping hub by 2020, we discussed with policymakers and participants from the private sector the policy implementations and strategic positioning for Shanghai in the long run.
We were told by the government officials that the plan to develop
Shanghai into a global financial center is not the end-game; rather, it is a reflection of the government’s pursuit of an eventual market-based
economic setup, which helps further integrate China into the global arena and allow Chinese companies to compete on a global basis. More
specifically, it was suggested that the essence of a global financial center is predicated on the conditions that: (a) price factors, such as interest rates and exchange rates, are transparent and are driven by market forces; and, (b) A liberalized capital account is in operation which allows free flow of international capital.
Various government bodies are collaborating on this long-term mission and actual policy implementations are revolving around three key aspects: (a) A strategic, long-term urban plan to lay out the foundation for the future development in Shanghai; (b) Attracting and retaining talent
through various subsidy programs; and, (c) Refining regulatory framework and improving the quality of financial products and services to ensure global compatibility. The entire agenda consists of 93 individual projects, which include index futures, stock lending and margin financing, bond market development, interest rate benchmark creation, capital account liberalization, A-share listing by foreign firms, and offshore RMB-trade settlement.
The 2010 World Expo is another international event that has caught investors’ attention after the 2008 Beijing Olympics. Based on the
government’s estimate, the event could attract as many as 70mn visitors to Shanghai (equivalent to 3.7x of Shanghai’s population). However, none of the Shanghai-based companies we met believe the event and the resulting traffic will have much positive impact to their business given that foreign traffic is expected to be lackluster (3.5mn by government estimates) and not all of the 70mn will be incremental visitors to Shanghai (they will come to Shanghai regardless of the Expo).
(6) Entry barriers remain low for manufacturers but service outsourcing could be the emerging trend
We visited Suntech (STP US, NC), the world’s 3rd largest photovoltaic cell and module manufacturer, to better understand the industry dynamics and business model of this relatively young sector in China.
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The selling price for solar modules has been on a downtrend in tandem with the falling commodity (oil) prices. However, the company had signed a handful of long-term raw material contracts when prices were at elevated levels last year and hence margins are under pressure.
At present, solar energy is still not economically viable and the industry globally relies on heavy government subsidies. Company management is expecting economic profits in 2 to 3 years time as technology further advances to cut production costs. The company is mainly focusing on
scale economy and R&D investment in an attempt to keep the costs down. Overall, we think that this is a thematically-appealing sector in an energy-hungry world but the low-tech manufacturing business nature, low-barriers to entry and potential over-capacity in the sector make it difficult to generate sustainable returns for investors, at least in the foreseeable future.
For investors who are searching for emerging trends and themes, it seems to us that the high value-added service outsourcing sector would fit the bill. We had a detailed discussion with the CEO of Wuxi Pharmaceutical, which has managed to grow its revenues from US$33.8mn in 2005 to 254mn in 2008. The firm charges its customers, major global drug companies, either on a FTE (full-time-equivalent) or pay-as-you-go model when the drug companies need its service to test and develop new drugs.
Unlike the conventional manufacturing sector in China, the firm competes not only on cost (labor and land) but also on quality in this niche market as most of the employees are highly-educated scientists.
Generally speaking, against a backdrop where multinational firms are still striving to improve cost efficiency and the rising number of high-quality, cost competitive workers in China, we believe the trend is favorable for Chinese outsourcing service providers.
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China: Portfolio Strategy
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