Losing Their Grip

Can China's CFOs keep their companies from growing out of control?

You don’t have to look far for problems that can arise under these conditions. Consider Hunan Xiangquan Group, which went bankrupt last year. From its start in the spirits business (the company’s flagship business was Jiugui Liquor) Hunan Xiangquan diversified widely. It got involved in tea, ceramics, leasing, printing, workforce training, museums, medicine, animal feeds, five-star hotels, and other businesses. Analysts blamed the failure on bad investment decisions — the hotel business, for one, created a heavy debt load. The CEO had partly funded the expansion by pulling capital out of Jiugui, causing losses in the core business.

Rampant Speculation

Difficult times for other Chinese companies may not be far off. Jerry Lou, Morgan Stanley’s China equities strategist, sees trouble ahead. “We think that the A-share market is producing not only a multiples bubble, but an earnings bubble as well,” he says. (So-called A shares are issued for domestic investors by companies listed on the Shanghai or Shenzhen stock exchanges, while B shares are available to domestic and foreign investors alike.)

Lou cites speculative investments as a particular cause for concern. The survey of CFOs found that corporate speculation is indeed rampant. Among A-share companies, 66 percent invest in either the stock market or in real estate (other than property used in company operations). According to a Morgan Stanley analysis of the most recent financials of Chinese listed companies (excluding insurers), investment income is 17 percent of absolute market earnings per share. That’s possible because of an accounting rule change in 2007 permitting companies to reflect the change in the value of assets on their income statements (see “The Great Experiment,” CFO Asia, May 2007).

More startling is that investment gains account for a disproportionate part of earnings growth — 36 percent. Core earnings, meanwhile, account for just 54 percent of overall growth.

Some companies are even taking out bank loans to invest. Last year, regulators cited China Nuclear Engineering & Construction and China Shipping for diverting loan money into the stock markets. China Shipping, for example, received $356 million in loans from six banks and used $324 million of it to participate in IPOs.

The trouble, says Lou, is that as stock-price gains begin to slow (as they have recently), earnings growth will brake sharply. That’s what happened on the Tokyo Stock Exchange in 1989, he points out. “[Investors] had included a lot of investment income in their forecasts. So when the market started coming down, the earnings cut was moving faster than the market, which created a snowball effect.”

Submerged Risks

Urging caution during a time of euphoria isn’t easy. And the kinds of changes advocated by consultants require a determination that’s hard to muster in the absence of an immediate threat. “It’s the classic problem,” says Nigel Knight, a managing partner with IBM Business Consulting Services in Shanghai. “Until things go wrong, it’s hard to change. You need a ‘burning platform,’ and in many of these companies that may be a major problem resulting from not managing risk effectively.”


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