Photographer: Kevin Frayer/Getty Images

A Profit-Boosting Consolidation Wave Could Be Headed for China

Updated on
  • CCB International’s Cui Li says mergers aided 2000s-era boom
  • Industrial profits have surged as manufacturing strengthened

Consolidation is underway in almost half of China’s economy and is accelerating, helping companies boost earnings, regain pricing power, and ease debt-servicing burdens.

That’s according to Cui Li, head of macro research at CCB International Holdings Ltd. in Hong Kong. She said the country’s last wave of mergers and closures of moribund state enterprises, in the late 1990s under then-Premier Zhu Rongji, cleaned up corporate balance sheets, raised efficiency, and paved the way for the following decade’s economic boom.

"Growth is more sustainable as a result," said Cui, who previously worked for the Hong Kong Monetary Authority and Goldman Sachs Group Inc. "Supply reforms and industry consolidation has helped to improve the balance sheet of the corporate sector and reduced debt risks to the financial sector."

Policy makers are trimming capacity from bloated state enterprises, which helps sustain the rebound in factory inflation and boost corporate profit margins. Premier Li Keqiang has said reductions, which include aims to curb steel capacity by 150 million tons by 2020, are exceeding expectations and that new growth drivers are replacing old ones. 

That means that while the survivor firms have better profit margins now, the world’s second-largest economy is also laying the groundwork for better returns in the long term. History in the U.S. shows consolidation delivered shareholder value in most cases, along with higher productivity and profitability in subsequent years, Cui said.

She said recent China data signal investment in older heavy industries like mining and metals, which are typically state-owned enterprises, is falling even as earnings increase. Consolidating industries account for half of total fixed-asset investment, she said in a note.

Profits, Prices

Industrial profits surged 21 percent in the first seven months of this year and the manufacturing purchasing managers index remains close to a five-year high. Still, industrial output rose 6 percent in August, the slowest pace this year, even as prices jumped.

Weaker construction-related demand and stricter environmental protection rules are driving consolidation, along with the government’s drive to rein in the risk from rising debt, Cui said. The materials sectors, including iron and steel, have been hardest hit, she said.

Consolidation will weigh on growth in the near term but remain manageable, Cui said, adding that there’s no sign softening in old-economy industries is stifling the rest of the economy.

Merging bigger state-owned enterprises and closing smaller, less-efficient companies may ease the rising debt burden on many factories and mines. Fewer players and less production aid pricing power of the remaining ones, which tend to be bigger, cleaner and more efficient.

An example is Baoshan Iron & Steel Co.’s 2016 acquisition of Wuhan Iron & Steel Co. to form the world’s second-largest steelmaker after Europe’s ArcelorMittal SA.

Read More: China Puts Finishing Touches on Steel Behemoth

The metal industry may see consolidation accelerate as the government calls for reforms at state enterprises, and new rules could send small-scale producers into the arms of larger companies to cut capacity, according to a report by Bloomberg Intelligence analyst Zhu Yi.

"Reforms may or may not make SOEs become more efficient in the long run, but they’ll very likely help strengthen SOE financial positions by boosting their market share and pricing power," said Yao Wei, chief China economist at Societe Generale SA in Paris. "That alone helps debt deleveraging."

The wave of consolidation is also washing into consumer and services industries, Cui said, citing car dealers, paper producers, brewers, budget hotels and air conditioner makers. The trend has longer to run, and sector-wide winners will be good investment opportunities.

Examples include Shanghai-based China Lodging Group Ltd. buying Beijing-based boutique operator Crystal Orange Hotel Holdings Ltd. this year, and acquisitions by Shanghai Jinjiang International Hotels Development Co. in both 2015 and 2016.

Focus Shift

"Consolidation is gathering pace and will continue to do so," said Rob Subbaraman, chief economist for Asia ex-Japan at Nomura Holdings Inc. in Singapore. "Many signposts are already in place to suggest China is starting to focus on quality over quantity of growth."

One side-effect of consolidation may be a continued slowing in fixed-asset investment, but that may prove a short-term setback on the road toward longer-term economic benefit. "Slower expansion now implies better returns to capital in coming years," Cui said.

— With assistance by Kevin Hamlin, and Xiaoqing Pi

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