Editor's note: Standard & Poor's released their "China Top 100 Corporates: Economic Growth Propels Earnings" report last Thursday. It is a review of the country's leading listed corporations in terms of revenue, with industry commentaries and credit statistics, based on information sourced from various stock exchanges and the company's own financial database.

The following shows the list of the Top 100 corporates and a commentary on the financial trends of the corporates by Huiyi Qu, Associate Director of Corporate & Infrastructure Ratings at Standard & Poor's, together with the key findings of the report and a summary of the China sovereign rating outlook by analyst Ping Chew.

The year 2003 was another year of strong growth for many of the Chinese mainland's top corporations.

The average financial ratios for the companies covered in this report were stronger, with robust earnings growth, stronger financial coverage ratios, lower debt leverage levels, and stable liquidity.

However, it is dangerous to generalize. Not all companies are experiencing strong market conditions and for some downstream producers, the rising cost of raw material and intense competition has exerted pressure on profit margins.

A variety of industries are included in this report, although most companies are in the heavy industry sector. The largest sectors include the steel and metals industries with 22 companies, followed by petroleum and petrochemical industries with 15 companies, most of which are related to the Sinopec Group.

In terms of revenue, the picture looks a little different, with petroleum and petrochemical sectors accounting for 41 percent of the total revenue of the companies surveyed, telecommunications 16 percent, and the steel and metals sectors 14 percent.

While the trends indicated by the financial ratios in this review are useful from an analytical perspective, it is important to remember that the type and number of companies studied reflect a relatively small portion of China's corporates. These companies are some of the strongest and most competitive of all the companies in the country.

However, industries in China are usually highly fragmented and there are many companies with substantially weaker business and financial profiles.

Anecdotal evidence suggests that the credit profiles of many of the companies outside the top 100, such as unlisted State-owned enterprises, are much weaker and are experiencing more challenging market conditions.

Underlying market conditions

The rate of economic growth has increased significantly over the past few years, fuelled by strong domestic demand, the rapid expansion of bank lending, proactive fiscal policy, and buoyant foreign trade. GDP increased to 9.1 percent in 2003 from 8 percent in 2002.

Fixed asset investment rose by 26.7 percent in 2003, and by 29 percent in the first half of 2004.

In the first half of 2004, China's corporate sector's industrial value-added output increased 17.7 percent, while foreign direct investment inflows remained high.

However, investment has not been distributed evenly across all sectors. Industries such as steel, autos, aluminum, cement, and some parts of the property sector have attracted a greater proportion of that investment. Other industries, such as power and transportation, are suffering from significant under-investment.

As a consequence of this overheating, the costs of raw materials have increased. While some large upstream producers have enjoyed substantially higher operating margins because of higher commodity prices, profit margins for downstream producers are being squeezed because of the higher cost of raw materials.

Power supplies have also been a problem. Some coastal cities are facing power shortages because the construction of factories and houses is fuelling demand for electricity.

In an attempt to cool the economy, the government has increased the reserve requirement ratio for banks and imposed investment restrictions on those industries in which over-investment has occurred. While it will take time for these measures to have an effect, they are expected to exert downward pressure on investment growth and, to a lesser extent, consumption.

Key findings of the report

Revenue grew significantly in 2003, reflecting strong economic growth and higher commodity prices. In particular, the major oil companies have benefited from the currently high price of oil. Average revenue for the top 100 companies increased 29.9 percent in 2003, compared with 14.3 percent in 2002.

Earnings have been on a positive upward trend. About 86 percent of the companies in the survey achieved earnings increases in 2003. The most profitable companies are large state-owned enterprises such as PetroChina Co Ltd (PetroChina), China Mobile (Hong Kong) Ltd (CMHK; BBB+/Positive), China Telecom Corp Ltd, China Petroleum & Chemical Corp (Sinopec; BBB/Stable), and CNOOC Ltd, which have relatively protected markets.

The only company that recorded a loss was China Eastern Airlines Co Ltd, which was negatively affected by the high cost of fuel and intense competition.

The earnings of many large corporations depend on commodity prices and are therefore extremely volatile. For example, Aluminium Corp of China Ltd (Chalco; BBB/Stable), the sole producer of alumina in the country, saw its earnings fall 37 percent in 2001, before bouncing back by 253 percent in 2003, as a result of changes in the prices of aluminum and alumina.

Likewise, Sinopec's earnings fell 18 percent in 2001, before increasing by 35 percent in 2003 on the back of an improvement in the prices of petrochemical products.

The median operating margin for the top 100 companies declined to 10.6 percent in 2003 from 11.8 percent in 2002. There has been a continuing drive for efficiency improvement, but for many companies this was more than offset by an increase in the cost of raw materials and extreme competition.

For many downstream producers, manufacturing input costs are rising while their output prices are stationary or even falling because of overcapacity and intense competition.

Return on permanent capital, across all companies reviewed, improved to 15.8 percent in 2003 from 14.2 percent in 2002, reflecting efficiency gains and greater profitability.

Progress on industry restructuring continues, although the pace of change remains relatively slow. Efforts to improve technology and product quality have been mainly undertaken by industry leaders, whereas many small to midsize companies have concentrated on opportunistic capacity expansion and have yet to undergo major structural reforms.

Cash flow measures among the top 100 companies are generally stronger. For instance, the median ratio of funds from operations to debt improved to 60 percent in 2003 from 45.5 percent in 2002.

Gearing for most of the 100 companies is not high and has actually fallen over the past few years. Total debt to capital declined steadily to 24.2 percent in 2003 from 28.4 percent in 1999.
A characteristic indicative of many large listed corporations is the amount of cash and liquid investments they have.

Of the 100 companies included in this report, 47 percent ended 2003 in a net cash position. Much of this cash will be used to pursue asset acquisitions and other growth opportunities in line with government restructuring initiatives. Average net debt to net capital was only 3.8 percent in 2003.

Economic growth is expected to remain strong in 2004, although it is likely to cool in 2005. The pace of investment is slowing, with the downward trend likely to continue into 2005. No collapse is expected. Consumption growth is expected to remain strong for 2005.

Growth in corporate profitability is expected to slow as commodity prices stabilize and loan restrictions on certain over-invested industries start to take effect.

Transportation bottlenecks and power shortages are expected to restrict the level of growth of some industries.

The squeeze in downstream producers' profit margins may act as a catalyst for further consolidations and structural reforms.

However, on the accounting side, the problem of limited disclosure is compounded with problems of compliance. In the case of major companies with offshore listing requirements, the quality of accounting standards is quite good. But the adequacy of disclosure by smaller companies that do not employ major accounting firms to audit them is a concern.

Although China's accounting system has achieved some success in moving towards standardization, the quality of domestic financial statements is still a long way from meeting international standards. The country's accounting profession is in its infancy and there is a shortage of well trained auditors. Professionalism takes time to form.

Robust growth but slowing down

The financial ratios of most of the companies in this report are expected to moderate over the next 12 months, as the government's measures to slow the economy take effect.

Higher deposit reserve requirements have restricted the ability of banks to extend credit. This, combined with the efforts of regulators to discourage exposure to steel, aluminium, cement, property, auto, and other overheated industries, has curbed growth in total credit.

Overall, growth remains on the fast track. The country's economy expanded by 9.7 percent year-on-year in the first half of 2004. However, lending growth fell to about 16 percent in the second quarter 2004 from 20 percent in the previous quarter. Key commodity prices-except for that of oil-declined in May 2004.

Nationwide fixed asset investment growth halved to 22.3 percent in the second quarter of 2004 from 43 percent in the first quarter of the year.

Standard & Poor's expects the earnings growth of large state-owned enterprises to remain solid in 2004, particularly for those companies whose market positions are protected, while small to midsize private enterprises could suffer.

The 2004 interim results of some of the large State-owned enterprises indicate solid financial performances. For example, China's largest oil and gas producer, PetroChina, reported a 17 percent net profit increase in the first half of 2003 as a result of increases in the price of oil.

Chalco, the leading manufacturer of aluminium, saw its net profit more than double to 3.4 billion yuan (US$410.6 million) in the first half of 2004. Chalco's growth is expected to slow in the second half of 2004, because the prices of both alumina and aluminium have peaked.

As State-owned enterprises are continuing the restructuring, their credit profiles are likely to change. For example, in July 2004, CMHK obtained countrywide geographical coverage by acquiring 10 provincial subsidiaries in western and northern China from its parent, China Mobile Communications Corp.

The acquisition has given CMHK a further 25 million subscribers and is expected to substantially increase the company's revenue and profitability.

In August 2004, Baoshan Iron & Steel Co Ltd (Baosteel Ltd; BBB/Stable) announced that it would acquire steel-related assets from its parent, Shanghai Baosteel Group (BBB/Stable).

The acquisition is expected to increase Baosteel Ltd's annual steel production by more than 40 percent to more than 16 million tons and increase its projected net profit for 2004 by more than 50 percent to about 13 billion yuan (US$1.6 billion).

Ongoing structural reforms

China's ongoing economic restructuring, including reform of the banking sector and State-owned enterprises, has produced an incremental, but long-lasting improvement in the country's economy.
Over the years, commitment to reform has been steadfast, notwithstanding the difficulty in isolating parts of the economy for reform.

The State sector has boosted its profitability, spurred on by a booming domestic economy and high commodity prices.

The government's banking system reform program, including a US$45 billion capital injection at the end of 2003 to enhance the balance sheets of two State-owned commercial banks, is designed to turn the banks into commercial entities.

Progress over the past few years has created a more market-oriented economy that is less reliant on government spending to maintain GDP growth.

These developments, combined with tax reform and tighter administration, have increased tax intake, with general government revenue at about 19 percent of GDP in 2003, from 13 percent in 1998.

This improved revenue growth, complementing measures being implemented at the level of local government social security funds, will allow the government to increase the social safety net to cushion fallout from further SOE restructuring. It will also help to absorb bad debts in the banking system.

Standard & Poor's raised its credit ratings on China to 'BBB+/A-2' from 'BBB/A-3' on February 18, 2004.

The upgrade reflected greater resilience in the economy as a result of persistent progress in structural reforms and the government's improving revenue base.

The outlook on the ratings is positive, which reflects expectation of an accelerating pace of economic reform in China.

A strengthening of market institutions will sustain growth and raise the country's potential.

Continued reform of the State sector will also lower the contingent liabilities of the government.

Of particular importance is the establishment of a better financial system that would curb non-preforming loans, allocate resources more efficiently and boost monetary flexibility. Ratings on China could be raised if such developments occur, and if tax revenues grow to overcome spending burdens.

(China Daily November 1, 2004)