Capital Squeeze Forces China Brokers to IPOs Amid Slump
Chinese brokerages, undeterred by the worst performance among the world’s major stock markets, are seeking to raise more than $6.2 billion from initial public offerings as capital constraints squeeze their operations.
Guotai Junan Securities Co., China’s third-largest brokerage by revenue, is among six securities firms awaiting approval to sell shares for the first time, according to filings posted on the regulator’s website. They’ll be competing with about 600 companies seeking capital in a market where equities are trading near record-low valuations.
The IPO plans highlight their quest for capital to fund an expansion into new businesses and avert what Guotai Junan terms “a survival crisis” for the industry. China’s securities firms, which make most of their money executing trading orders for retail clients, have seen profitability plunge to about one-eighth of 2007 levels as trading commissions drop amid investors’ disenchantment with equities.
“Now is definitely not a good time to seek listings,” said Fanny Chen, a Hong Kong-based analyst at Haitong International Securities Group. “But for Chinese brokerages, low valuations aren’t the biggest concern as they’re badly in need of capital.”
The firms need the funding for new, capital-intensive services such as offering clients securities lending and margin financing. Lending securities to clients is crucial for the brokerages to facilitate short selling, or the sale of borrowed securities. Margin financing allows investors to purchase securities using credit.
Reviving the firms’ profitability and allowing their entry into these new businesses is vital for the development of capital markets in the world’s second-largest economy at a time when Chinese companies need financing and advisory services to further their global ambitions. The China Securities Regulatory Commission said May 29 it intends to “build modern investment banks” that are competitive and influential globally.
“If China wants to be a credible financial center and capital market moving forward, the ability to offer a full range of financial instruments is going to be essential,” said Bonn Liu, a Hong Kong-based partner at accounting firm KPMG China. “As Chinese corporates become bigger and more global, it makes logical sense that the investment-banking industry will follow suit.”
Policy makers in China historically have given the bulk of their attention to the commercial banking industry, which is dominated by government-controlled lenders. As a result, brokerages, many of which are also owned or backed by the state, accounted for 0.8 percent of China’s 192.9 trillion yuan ($31 trillion) in financial assets at the end of 2013, compared with banks’ 78 percent share, according to central bank data.
The brokerages’ income growth also has been muted by the lackluster performance of the nation’s equities: Market valuation as a percentage of gross domestic product -- a metric favored by Warren Buffett to gauge whether stocks are overvalued -- dropped to about 42 percent last year from 123 percent in 2007, according to CSRC data.
In the first six months of this year, the equity benchmark Shanghai Composite Index (SHCOMP) fell 3.2 percent, becoming the worst performer among the 46 developed and emerging markets tracked by MSCI Inc. Chinese equities are trading at about 10 times earnings, close to the record low in April of 9.8, data compiled by Bloomberg show.
The lack of appetite for Chinese equities by domestic investors doesn’t bode well for the firms’ biggest business or their IPO prospects.
Stockbrokerage generated about 48 percent of the industry’s total revenue last year and accounts for as much as 90 percent of income for smaller firms, according to Orient Securities Co., one of the six companies planning an IPO. The business has been under pressure as the average trading volume on China’s two main stock exchanges dropped 24 percent last year from 2009, data compiled by Bloomberg show.
Shares of the 19 publicly listed Chinese securities firms retreated an average 10 percent in the first half. Citic Securities Co. (600030), the largest by market valuation, dropped 10 percent in Shanghai trading, while No. 2 Haitong Securities Co. (600837) plunged 19 percent.
Shares of Citic Securities declined 0.9 percent to HK$17.48 at the close in Hong Kong today. Haitong advanced 0.5 percent to HK$12.30.
“Traditional brokerages are facing a survival crisis,” Zhao Xianghuai, a Shanghai-based analyst at Guotai Junan, wrote in a May 19 note. “China’s securities industry is now in a ‘big market, small industry’ situation: Its business model and asset size do not match the future growth prospects for the capital market.”
Since 2012, China’s securities regulator has eased the rules for quasi-lending businesses such as margin finance and letting clients borrow securities, giving brokerages access to a fast-growing market.
Securities lending and margin finance on the Shanghai and Shenzhen stock exchanges, China’s two main bourses, jumped almost fourfold to 347 billion yuan last year with 84 brokerages approved to engage in the businesses, according to data from the People’s Bank of China. Those operations may account for about one-fifth of the industry’s revenue in 2014, up from 14 percent last year, Liu Jun, an analyst at Changjiang Securities Co. in Wuhan, wrote in a May 5 note.
Even so, the firms are hobbled by the tighter capital requirements in place since a wave of bankruptcies rocked China’s brokerages from 2002 to 2006, according to Richard Xu, a Hong Kong-based analyst at Morgan Stanley.
China’s “securities firms are at a competitive disadvantage in this business,” Xu wrote in an April 15 note. “Very complicated and strict capital requirements mean limited room for leverage at China securities firms.”
Regulators shut 19 firms from 2004 to 2006, while others collapsed or were sold to overseas investors following years of industrywide losses, embezzlement and corruption.
As part of that overhaul, Goldman Sachs Group Inc. and UBS AG were allowed to acquire assets and securities licenses from ailing brokerages, making them among the first foreign investment banks to gain a foothold in China. They remain the only overseas firms whose joint ventures have a license for brokerage and trading activities in the domestic market, while other Wall Street companies are restricted to underwriting.
Stringent requirements imposed since then on debt ratios and capital levels, combined with the slump in trading commissions, have eroded the profitability of Chinese brokerages. Return on equity dropped to 5.8 percent last year from 46.3 percent in 2007, according to data from Tebon Securities Co. That compares with an average ROE of 19.5 percent last year for 15 publicly traded Chinese lenders.
The CSRC, which in December ended a 15-month freeze on IPOs in China, plans to allow about 100 first-time share sales from June through the end of the year, Chairman Xiao Gang said in a May 19 statement.
The six securities companies may raise a combined 38.7 billion yuan from their IPOs, according to data compiled by Bloomberg based on the firms’ reported 2013 earnings-per-share figures, the number of shares they propose selling and the average price-to-earnings ratio of the 19 publicly traded brokerages as of July 18.
Guotai Junan, based in Shanghai, may account for more than half of that by raising 21.7 billion yuan, the data show. Press officers for the company didn’t respond to e-mailed and faxed queries seeking comment.
Created in 1999 by the merger of two firms and controlled by the government of Shanghai, Guotai Junan plans to use the IPO proceeds to fund an expansion of its underwriting and asset-management operations as well as financing new businesses such as securities lending and margin finance, it said in its draft prospectus published April 22.
Stockbrokerage accounted for 40 percent of Guotai Junan’s revenue in 2013, the company said in the prospectus. Its credit businesses accounted for 16 percent, while securities trading and investments accounted for 16 percent and investment banking 10 percent.
“Becoming listed firms will provide them more financing options, and those with capital ready will have the first-mover advantage,” said Du Changcun, a Shanghai-based analyst at Northeast Securities Co. (000686) As competition heats up in capital-intensive businesses, companies that “fail to keep up with the development may not survive,” he said.
China’s securities firms are already small and fractured in comparison with global peers. Total assets of the nation’s 115 securities firms -- led in revenue by Citic Securities, Haitong Securities and Guotai Junan -- climbed 20 percent last year to $334 billion, according to the Securities Association of China. That’s only about one-third of the $912 billion at New York-based Goldman Sachs.
Orient Securities, Citigroup Inc.’s Chinese partner in an investment-banking joint venture, may get 7.27 billion yuan when it sells as many as 1 billion shares in Shanghai, based on information in a draft prospectus filed to the Chinese securities regulator on April 22.
The fundraising will ease a “capital bottleneck” and make the firm more competitive, Orient Securities said in its application. A press officer at the firm declined to comment.
Dongxing Securities Co., based in Beijing, and Huaan Securities Co. in Hefei in eastern China, may raise 5.1 billion yuan and 2.2 billion yuan respectively, data compiled by Bloomberg show. Zheshang Securities Co. may get 1.97 billion yuan, based on its June 20 filing.
First Capital Securities Co., which is JPMorgan Chase & Co.’s Chinese partner, could get 531 million yuan on the Shenzhen exchange, where smaller companies typically list their shares, according to data in its May 19 offer document.
“The securities industry is a capital-intensive business,” Shenzhen-based First Capital said in its prospectus. “The size of net capital is an important factor that determines the size of the business of a securities company.”
Press officers at First Capital and Huaan Securities also declined to comment, while Dongxing Securities didn’t respond to e-mailed and faxed queries seeking comments.
The CSRC’s listing-review commission hasn’t set dates to approve any of the six IPO applications. Once that process is completed, the brokerages would need to await a written authorization from the regulator for the share sales. The process may take months, especially if the CSRC opts to reduce the number of IPOs to bolster the equity market.
Raising capital through equity financing such as IPOs may only ease brokerages’ capital constraints temporarily while further diluting their ROEs, said He Zongyan, a Shanghai-based analyst at Shenyin & Wanguo Securities Co.
“The securities companies are in an awkward position,” said He. “The ROEs are low so they won’t get a good valuation if they go public now. And the ROEs will only go lower when the credit business becomes larger and growth slows.”
Profitability also won’t see any meaningful improvement if the government doesn’t relax the stringent requirements on brokerages’ leverage levels, He said.
The State Council in May said it would accelerate the pace at which it develops China’s capital markets, which it described as “still immature.” Among the proposed measures was an easing of restrictions on brokerages’ debt financing and leverage, though specific details weren’t provided.
That’s a positive signal for investors in Chinese brokerages, said Haitong’s Chen.
“China is embarking on financial reforms, and a lot of the financial innovations have to be undertaken by the securities industry,” she said. “If you are just looking at this year, there may not be too many positive surprises. But the long-term prospects are still good.”
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