Monday, September 03, 2007

Chinese PER & Earnings Growth

At the end of August, 852 Shanghai-listed companies and 487 Shenzhen-listed firms reported their earnings for the first half of this year. The aggregate net profit of the Shanghai companies was 290.3 billion yuan (US$38 billion), up 69.2 percent year on year, while their aggregate income was 2.69 trillion yuan, up 24.9 percent. Shenzhen-listed firms reported a combined 99.23 percent increase in aggregate net profits at 47.52 billion yuan, while aggregate income was up 28 percent at 754.52 billion yuan.

Blue-chip companies reported the best performance, with their aggregate net profits accounting for 77.4 percent of the total in Shanghai. The aggregate net profit of the top 30 Shenzhen firms jumped 77.23 percent to 27.47 billion yuan, 57.8 percent of the total for all listed firms. Companies in the financial, non-ferrous metals, excavation and real estate sectors performed well. Seventeen Shanghai-listed companies in the financial sector enjoyed a combined net profit growth of 74.1 percent.

That's the often uttered fundamental factor in explaining high PERs accorded to China firms. Its the sustainability and quality of growth which are needed to be examined further. Now, a simple analysis would show a disparity in Revenue & Net Profit growth patterns. Herein lies the pandora's box.

Revenue Growth / Net Profit Growth

Shanghai 24.9% / 69.2%

Shenzhen 28% / 99%

You cannot have such disproportionate jumps - but you can I guess, if the employees all agree to have their salaries reduced by 40% every year; or you can manufacture a product 30% cheaper with every progressive year. Some disproportionate jumps can be explained via "extraordinary gains" such as asset sales, disposal of subsidiaries at a profit or even "revaluation gains" of land and buildings - all of which are one-off and non-operating, hence non-important (sic).

The magic elixir is investment income contributed most to profit jumps. The total investment income was 10.4 billion yuan on the Shenzhen exchange, 15.33 percent of the total. I believe the proportion for Shanghai listed firms could even be higher, closer to 25% of total. That may not sound like sizable but this is the actual percentage following a 70%-99% jump in base value. In other words, the investment income in 2007 as a % of 2006 total net profit should be in the region of 35%-45%!!!

Sure, the operating performance is still solid after you strip out investment income from their net profits, but it goes a long way to challenge the sustainability of earnings growth and the quality as well. Investment income is NOT recurring income, it could be huge losses (really big ones) in one of two financial years ahead though.

To be fair, what we have in China corporate profits is part earnings driven and part investment income driven. When investment income make up a sizable portion of net profits, many silly decisions get made:

a) over reliance on trading and investments
b) misallocation of capital towards trading and investment at the expense of funding organic growth, necessary capital investments and r&d expenditure

c) over-reliance on local investments will cause many to stay domestic, and not consider to go global to expand their reach

d) the exponential domino knock-on effects of a 30%-40% correction will be very severe, and could cause many companies to kill off otherwise healthy businesses

Just a reminder, just a reminder ... till then, China bull is alive and well... still. But don't paint the bull up more than what it deserves to be, just a bull, who will die someday.

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