Chinese Results Season

My investment team spent much of the second half of March and into early April reviewing the 2015 numbers from Chinese companies listed in Hong Kong (and a few Hong Kong companies as well).  We saw the management of over 40 in person and reviewed albeit in less depth roughly the same number with desktop analysis and phone calls.  Generally speaking last year’s results were not too bad and guidance was not out of line for 2016.  We would like to think that is because we are following the better names, therefore our sample may not be representative. 

Naturally we tend to focus on companies that are owned in client portfolios as well as those where we are considering a purchase, though usually only if the price goes down a bit.  Still in conclusion we were mildly encouraged by what we saw and heard; and this assessment contrasts with a more negative slant and body language from companies we met at conferences in the first week of January.  It would appear that something may have changed for the better in China since the beginning of the year: too soon to tell of course but here are a few snapshots of some of the companies we met.  I must stress that what follows is not investment advice.  Anyone considering dealing in any of these shares should certainly consult their professional advisors and should not rely on anything written here.  This is our opinion only and does not constitute any sort of investment recommendation.  That said, I hope you find it useful context.  

As almost every company we track has now reported for 2015, there are too many to cover so we have to be selective, highlighting a few that stood out both positively and to a lesser extent negatively.  That first point I would like to make is that generally numbers have been pretty good.  As it turned out, the ratio of our companies that beat profit forecast to those that did not was around 2 to 1.  The main cause for missing profit was a higher tax rate and foreign exchange losses.  At the operating level, companies that showed improvement outpaced those that showed declines by around 5 to 1.  I think this is perhaps a better signal of the health of the underlying businesses, though clearly what is missing is sophisticated capital management and an understanding of certain corporate aspects at which mature market corporates excel (such as tax avoidance).  No doubt that will come in the fullness of time.

Perhaps more importantly turning to 2016, again generally the view of our companies is considerably more robust and optimistic than those of the financial markets.  You expect such.  If management cannot see good things in their own company and its business environment you would be worried.  That said there is a healthy dose of realism particularly in traditional industries. Interestingly one common theme is that though companies have rushed to rebalance their asset liability currency mismatch, nearly everyone thinks the yuan will stay relatively stable this year.  This confidence must reflect messages sent from above. Outside investors need to retain a degree of scepticism but some of the same companies that were distinctively nervous about this when we saw them in January seem more relaxed about foreign currency exposure just two months on.

On the other hand, we can say that for most industries revenue growth is going to be more of a struggle and in unit terms too it is likely to be lower than it has been in the past: thus a new emphasis on items further down the income statement such as improving operational efficiency and cost control. Administrative expenses had been left largely alone but now some companies have started to focus in on those.  I would expect 2016 to be a year when growth in operating profit and EBIT is greater for most of the companies we own than their sales growth. That will be a marked change of emphasis and one for the better.  In addition lower interest rates will help net borrowers though of course will reduce financial income for companies with net cash.  At the moment the score remains advantage to borrowers.  We tend to have a more conservative portfolio so on balance lower interest rates are a minor negative. Overall our conclusion is that 2016, barring the inevitable unexpected events, should be a year of measured growth but with more emphasis on margins and profitability and therefore Earnings Per Share growth could surprise to the upside.

Turning from macro to micro, CIFI, a developer focused almost exclusively on Tier 2 and Tier 1 cities was one of the highlights of our 2015 reporting season.  That is good because it is also one of our largest positions. The company’s revenue and sales (as defined by core operating profit not distorted by revaluation gains and losses) rose between 13% and 14%. Still the highlight was the contracted sales number for last year, up 43%, one of the best in the industry and well ahead of target with Average Selling Prices rising 20%.  These trends have persisted into 2016 with good momentum particularly in respect of price. All of this bodes well for 2017 and 2018.

The Chairman was brimming with confidence when he came through town: not just the numbers but the body language was good. He is confident that profit will rise again in 2016 by double digits and the dividend should hopefully also march along at a similar pace after a 27% increase in 2015.  Yet this payout ratio is comfortably tied to 35% of core net profit. Combined with a slowdown in land purchase in the second half of last year in part due to rising auction prices and in part because the company added sufficient land bank earlier at lower prices, there is every expectation that the balance sheet will also be better by the end of 2016: by which I mean not only will leverage improve as the NAV rises but the total net debt position is likely to decrease. So it was no big surprise to see the share price up by 19%. We have high hopes for this counter over the rest of the year as well.  The only negative in the report that I could find was a slight deterioration in gross margin. Management appeared confident that the margin would reverse direction and improve both in 2016 and 2017.

The 2015 results of BCL were a mixed bag but we knew that in advance because the company has been clear that it has been cleaning out a lot of lower end inventory at lower gross margins from projects outside its core cities.  This should position BCL to improve its gross margin over the next four reporting periods, though a return to acceptable profit levels may not fully materialise until the second half of 2017 or possibly even first half of 2018.  Still the market likes trends and 2015 should have been a bottom, so supporting evidence of a new direction is more important than the absolute amount of improvement, at least to begin with. Both the forthcoming launch programme and the land bank are more weighted to Beijing and surrounding areas than has been the case in the last couple of years.  The current contract sales backlog contains higher margin product though that shift may only become visible next year.

The numbers were no surprise.  Sales rose at a healthy clip and gross profit was up but margin was down.  Earnings Per Share was higher only because of exceptional investment gains.  Core operating profit was lower. In addition a share issue in 2015 meant that while the dividend amount being paid has gone up, the dividend per share is off 20%.  That still, however, puts the company on a yield in excess of 7% alongside a projected 2016 P/E closer to 3x than 4x with prospect of sustainable earnings and dividend growth over at least the next two years.

Meeting senior management largely confirmed our initial interpretation, though in light of last year’s margin miss they were cautious about the pace of recovery in 2016 bookings.  In contrast they were more optimistic than we are about the potential growth of contract sales, and the embedded value in their land bank.  The outlet community concept is faring better than we expected, and investment income should now grow strongly through 2021.

One disappointment was Road King, the toll road and Yangtze River Delta property company.  Toll roads went well enough last year with double digit growth. The property business was not that bad either.  The company did clear out some old inventory; and an unusually high percentage of Phase 1 sales in the mix also depressed gross margin but what hurt was the mismatch in the balance sheet with Renminbi depreciation knocking earnings down 20%. Sad to say the company decided they would reduce the final dividend by 20% as well. 2016 should be a bit brighter as the cost of debt is coming down and the ASP of property sales is rising; but they still have an FX issue and are behind the curve compared to peers in sorting it out.  Still the forward yield - estimated to exceed 8.5% - is one of the better and safer dividends around; and unlike some Road King is a consistent payer.

China Lilang, the company that likes to view itself as the Armani of China, gave us another set of decent numbers. Earnings Per Share grew over 12% on sales up over 10% along with a very slight increase in margin.  The dividend for the year increased by 7.5%. Lilang reiterated its strategy of “improving product quality without raising the price”.

The company reported a similar pattern to the broader clothing sector with a weak Q4 2015 to a large degree offset by strong same store growth in Q1 2016.  The strategy is to continue to upgrade the store mix in terms of both location and scale.  The only real negative related to working capital where turnover was down somewhat, accentuated by the weak Q4.  Guidance as with others in the sector is cautious but the company is increasing its visibility and the value of the brand is almost certainly increasing as well.  That said the weak Q4 affected the 2016 fall trade show as orders were off roughly 10%.  That should be a blip as long as Q1 sales continue to recover, but even a blip means 1H 2016 is likely to be flat to lower with growth resuming in 2H 2016.

It is hard to know what not to like about the 2015 numbers of Yuzhou Property.  Revenue increased by 32% and the gross margin was more or less constant, while the contracted sales for last year also increased 17% with positive momentum into 2016.  Earnings Per Share rose over 30%. Strip out investment gains and losses and core profit attributable to operations increased by nearly 60%.  The dividend also was raised albeit not so much; but up 12.5% is an excellent outcome in a year when many companies held dividends.  The group sets a contracted sales target for 2016 up by 14% from the level it achieved last year.  This is probably a conservative target. As with many other property companies, the cost of funding for Yuzhou is coming down from an average of 8.5% to 7% as of the start of 2016. Since year end the company has been issuing domestic debt in Renminbi with an average coupon of less than 6%.  This improves the currency balance and lowers the cost of funds going forward. The only negative was that net gearing is now nearly 80%.  That is as high as it should go.

In addition to last year’s results, it is also worth mentioning Yuzhou’s contracted sales progress for 2016 so far compared to 2015.  While we only have the numbers for the first two months, and those are generally two of the weakest months of the year, total sales value for this period increased by a multiple of 2.7x, a dramatic uptick.  This was to an extent driven by an Average Selling Price increase of 45% YoY.  These are very encouraging metrics heralding improved sales and better margin in 2017.

The results of Dream, the manufacturer of plush toys and plastic figurines, ticked a lot of boxes.  While revenue rose by less than 10% gross profit was up nearly 20% and admin costs were tightly controlled.  Thus Earnings Per Share rose by more than 20%. In addition the balance sheet was tight.  Inventory was down – another tick, receivables rose by less than would be expected given the growth in turnover - yet another tick, and the net cash was up. However there was one cross right at the end of all the good news. The company decided not to pay a final dividend.

Getting to grips with Dream’s plans over the next two years, one can sympathize with this hiatus.  Demand is strong. The latest Star Wars movie helped. The company won several important new accounts particularly in plastic figurines. Industry leaders Hasbro and Mattel - who have not been customers for a while - are trialling Dream for plush toys as that is where their line-up is weak.  Even ride-on toys might be profitable in 2016.  After five years of loss several firms who had been customers are starting to place orders again now production has moved to Vietnam.  One decent size win would suffice to put this category back in the black.

The company needs to add capacity in every category.  Capex for 2016 will have to be much higher than for 2015, and will continue to be high in 2017; but it is all customer driven capex.  Working capital too cannot be milked any further. It will grow. In addition the company has plans to start producing dolls. This should generate a whole new revenue stream by year end, with a profit contribution in 2017.

When you add up all these growth investments, it is hard to model a scenario where the company will not grow its earnings more in each of the next two years than it did last year.  So we should see earnings growth in excess of 20% per annum.  Yet the stock stands on a current P/E of only a little over 6x.  Dream is deeply undervalued but needs a programme to go on the road and tell its story.  It is not clear yet whether they are ready to do that. I will be meeting the Chairman in June to discuss how it could be done.

In an environment of easy and cheap money, Dream should borrow to build new production lines.   Senior management, however, is very conservative.  I understand their point, but this is not the right time to stay net cash.  With strong positive cashflow from operations, the company could recommence dividends again as early as an interim this year and has every intention to do so by the end of 2016; but nothing is decided. Some shareholders will be disappointed with a lower dividend.  Yet as the company moves from consolidation and net cash generation to a new growth phase, Dream has a clear and convincing path to substantially greater profit at a time when few companies can paint such an attractive picture with such a high degree of certainty.  A pity so few people know about the company.

I want to mention a couple of interesting trends that have emerged from the results we have reviewed, particularly those in China.  In addition to all the names we own, we have tracked a further 40 or so companies covering a wide variety of sectors.  Our sample is not scientific but I think it is sufficiently large to draw certain useful generalisations, especially when combined with an overlay from talking to analysts following an even larger group of companies at investment firms and brokerages we do business with.

2015 was a tough year.  Q4 in particular was bad for manufacturing. There was a drop off both in business volumes and ASPs in the last 3 months of last year.  In part that reflected the cost plus nature of many businesses where commodities are a large component of the total cost structure.  Inevitably if copper or iron is 30-40% of the total cost of the end product and its price goes down say 30% the maths is easy to follow.  It does not quite work in such a simplistic way but generally speaking your ASP will be down 10%.  Gross margin may stay roughly the same, but operating profit will also be down 10% or more depending on where plant overhead comes in.  That decline puts pressure on all costs below the operating level.

In contrast nearly every company we spoke to thinks 2016 will be better. Analysts are always optimistic about Earnings Per Share at the beginning of the year and consistently downgrade forecasts during the course of the year. 2016 will be no different in that respect.  We have already seen downgrades.  Yet alongside generally cautious guidance from management many of whom recognise they were over enthusiastic about their ability to do better than their market last year, we have heard specific examples of businesses that have begun to see better order flow since Chinese New Year.  Of course part of that reflects commodity price increases that may prove no more than a bounce.  Still it could be more.  The NCP committed to a number of significant policy measures that should be beneficial for infrastructure and the housing market.  The feed through to a wide range of industries is obvious even if it takes a few months to gain traction.

That said the Chinese property market is in a position that is different from its previous history.  There has always been differential price movement and volume growth city by city but the gap between underperforming to outperforming markets has never been greater. In Shenzhen prices in my opinion have gone mildly bonkers. Affordability measured by traditional yardsticks no longer applies.  Shenzhen is still cheaper than Hong Kong but the influx of better jobs particularly related to tech has seen ASPs of projects rise 50% or more over the last 12 months.  Prime locations in Beijing and Shanghai are also selling out fast at record prices. Good locations in those cities are seeing significant double digit like for like appreciation. Guangzhou, the other Tier 1 city, has been somewhat late to the party but starting this year prices are showing decent single digit gains.

The Tier 2 market is more of a mixed bag.  Some cities are seeing decent growth both in volume and ASPs.  Well located projects built by reputable companies sell fast and customers find it easy to get bank finance. The reverse can be true of badly located projects with weak sponsorship.  Out in Tier 3 and even more so in Tier 4 cities, the picture is muted and in some places remains downright dismal.  There is still a huge property overhang in many of those cities. In contrast the inventory issue for Tier 1 has all but disappeared.  The government is talking about buying up completed housing and using it for social programmes with subsidised rents to get it off the market.  Companies operating in these areas face flat to declining ASPs and negative growth.  Thus the market is deeply divided.  It is all the more important to pick individual stocks carefully.  There will be a chasm in earnings growth between winners and losers.  When you read about how dreadful the Chinese property market is, it is important to recognise that only some places are awful.  There are other places where things are going so well that the biggest risk is a return of some kind of government intervention to suppress prices.

Meanwhile the mantra from the NCP is that growth once again is more important than reform.  We had gone through a patch where talk was that the quality of life should be important than the quantity.  Thus reforms that will stimulate spending in renewable energy sit alongside programmes to downsize heavy industry with overcapacity (which will be pursued erratically with some but relatively modest success), and alongside promotion of high tech industries, domestic consumption and renewed emphasis on higher value added industrial growth. So Chinese businessmen in the better companies, and listed companies for most part are among the better companies in China, enjoy a policy environment that gives encouragement for most of them that 2016 should see profit growth for their business.  That plus more attention is being paid to capital structure in part because of concern over the renminbi that had not featured as an issue before 2015. Reversal of the one way rising renminbi currency trajectory has forced companies to relook at how they finance their business.  Thus Return On Capital and even Return On Equity are playing a greater part in management thinking.  This can only be a good thing for outside shareholders.

I do not want to say that all is rosy: far from it.  On the other hand I do want to suggest that the negative interpretation about what is going on in China is also off base.  As in most things a balanced view is appropriate.  With the economy growing more mature selective stock picking becomes more important.  That is why we have been able to outperform local benchmarks.

One other trend that emerged in the Hong Kong / Chinese results season, as opposed to any other country in Asia, was higher tax rates. Some of this can be explained by product mix, some by more non-deductible expenses. Some tax holidays have been expiring in particular in relation to initial startup periods for “technology” ventures in China. This trend got missed by most analysts, though we always make a point of asking about tax changes as there are so many moving parts.  If I had to pick one issue that depressed after-tax profit more than any other in the 2015 reporting season, it would be this and not anything related to the business.  That is frustrating because it means more companies missed net profit forecast than usual as brokers tend not to focus on tax.  On the other hand most of these adjustments are a one-time shift.  While businesses affected are likely to end up facing on average higher tax rates going forward, they are not likely to be rising relative to the 2015 base the way 2015 did to 2014.  This removes one potential depressant on 2016 earnings growth.