'A Happy Headache' for Corporate China

Market mania is reflected in the mainland's first-quarter earnings. As the number of investors grows, the government responds with limits

As China began a weeklong break marking International Labor Day on May 1, executives at many of the country's biggest corporations could take their holidays knowing they deserved them. Corporate earnings for the first quarter came in higher than expected, and even in China—where white-hot growth is the norm—the results were mighty impressive.

Take China's biggest steel producer, Baoshan Iron & Steel, or Baosteel, which clocked net profits of $477 million, up a whopping 156% from the same period last year. Online search engine Baidu.com (BIDU) saw profit soar 143% to $11.1 million on quarterly revenues that doubled to $35.7 million (see BusinessWeek.com, 4/27/07, "Big Numbers Give Baidu a Bump"). And No. 2 mobile-phone carrier China Unicom (CHU) reported a 41% gain of net income to $253 million while China Merchants Bank saw profits climb 87.5%.

Of course, with China's economy cranking at 11.1% growth in the first quarter, you'd expect some pretty good earnings. Frank Gong, JP Morgan (JPM) chief China economist says that robust earnings growth cuts across most sectors and company sizes. "This was stronger than our expectations and the market's expectations," he says. "China is no longer just a headline [gross domestic product] growth story, it's a profit growth story." Moreover, Gong reckons improvements in profitability are likely to continue. He figures that return on equity of the majority of companies listed on the Shanghai and Shenzhen stock exchanges has risen to 15%, compared with just 10% to 11% ROE two years ago.

Boosting the Bottom Line

What's driving these gains? With productivity rising at an annual clip of 20%, China has the highest productivity growth anywhere on the planet. That's more than enough to offset higher input prices and 10% growth in wages in the more industrialized areas along the coast. (Wages in China's less-developed interior are rising much more slowly.) Continued investment by companies and governments in improving technology and an increasingly educated workforce also lead to greater productivity gains.

Another cause for the strong corporate performance is structural: Now that most shares held by state entities and their executives have become tradable, company managers have a strong incentive to boost the bottom line. The result is a much closer correlation between profitability and share price.

But Citigroup (C) chief Asia economist Huang Yiping says that China also owes a good portion of its phenomenal growth to implicit price subsidies. He says that the 49% increase in profitability of 1,200 listed companies in 2006, on top of 23% growth a year earlier, wouldn't have been possible without cheap energy, land, natural resources, and capital. "Cost distortion is a key element of the new economic model that explains extraordinary growth," he says.

Opening-Day Triple

Even with corporate profits turning in such a strong performance, some market watchers say they can't justify the lofty levels on mainland stock markets. Qu Hongbin, chief China economist at HSBC (HBC) in Hong Kong says that China's listed companies had an average price-earnings ratio of 30 (based on projected 2007 earnings) compared with about 18 in Hong Kong—and that one-third of them have PEs in excess of 100. That means things have gotten too frothy for comfort. "The recent surge in price has gotten ahead of fundamentals and is being driven mainly by market overconfidence and liquidity," says Qu.

To get a sense of the market mania, consider the recent experience at Aluminum Corp. of China (ACH), or Chalco, which saw its shares nearly triple at the close of the first day of trading on the Shanghai exchange Apr. 30—prior to the national week of holidays—despite a company statement on Apr. 16 forecasting a 1.8% fall in profits to $1.4 trillion.

Already 90 million strong, the number of Chinese retail investors is growing at a rate of 200,000 new accounts per day, says Tony Yam, chief investment officer at Shanghai-based fund manager Simon Murray (China), which invests on behalf of foreign clients in local stocks. "It's a happy headache: strong economic growth, good corporate earnings growth, but stock prices have gone up too fast" because of the surge in liquidity, he says.

Tightening Speculative Excess

It's a headache the government is determined to cure. On Apr. 30 the China Securities Regulatory Commission published an announcement on its Web site that the watchdog would halt stocks exhibiting irregular price moves. China currently has a 10% limit on daily price movements, although previously trading would not be suspended if the price limit were reached.

There's also a likelihood that China will continue to tighten the credit tourniquet to choke off some of the speculative excesses. On Apr. 29 the central bank hiked the reserve requirement for the seventh time in nine months and is likely to increase interest rates by another 27 basis points this quarter. "Increasingly, state-owned enterprises and banks will have to adhere to the central government's determination in containing excessive investment," says Dominic Chan, banking analyst with CLSA Emerging Markets.

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