This will never work (Vol 1, No 32)
Everyone is talking about the trade war and everyone is talking about the strength of the USD. What hasn’t received nearly as much play is the decline of the Reminbi.
As the DXY has strengthened from its mid-February low of 88.59 to 95.21 (up 7.5%), not only have the JPY and EUR weakened, so has the Rmb.
The Rmb was strongest on April 11, 2018 when it was trading at 6.26759 to one USD. Since then, it has weakened by 3.4% to 6.49086.
Airlines and Developers are Supposed to be Hurt by Strong USD
Conventional thinking has it that when the USD strengthens, Chinese airlines and Chinese developers get hurt. It basically comes down to a currency mismatch between their assets and liabilities (Chinese developers) and revenues and expenses (for Chinese airlines).
Let’s look at a HK$347bn market cap example
In order to put more flesh to why Chinese developers are hurt by a strong USD, let’s take a look at the 13th largest company on the Hang Seng Index. Country Garden has a market capitalisation of HK$347bn (or US$44.2bn). It is the second largest developer on the Hang Seng Index, just a shade behind SHKP’s HK$354bn market cap.
Over the past five years, as Country Garden’s revenues have grown, so has its balance sheet. Net debt has grown from Rmb20bn in 2012 to Rmb66bn. Considering its current market cap of HK$347bn, this level of net debt does not seem that large.
Rmb215bn gross debt and Rmb148bn of cash
However, if one were to split its net debt figure into the cash and gross debt component, we see that Country Garden’s gross debt has increased from Rmb36bn in 2012 to Rmb215bn in 2017. Meanwhile, as of December 31, it also carried cash balance of Rmb148bn. I guess when you have trade payables of Rmb331bn, you need a big float.
Net USD liabilities of Rmb50.0bn
For many Chinese developers, offshore USD bonds have been a key source of financing. Since 2012, Country Garden’s USD net liabilities have increased from Rmb14.9bn to Rmb50.0bn. In the context of a company that generated contract sales of Rmb550.8bn in 2017, Rmb50.0bn of USD-denominated liabilities may not seem much but numerically speaking, the 3.4% drop in the USDCNY has now increased this liability by Rmb1.7bn.
If one were to compare Country Garden’s USD exposure to its shareholders’ funds, this has gone from an average of 44% between 2012-2015 to 50% over the past two years.
Substance over form – Interest costs are going up
Due to an accounting quirk that allows Chinese developers to capitalise interest from borrowings, the combination of Rmb215bn of gross debt and Rmb148bn of cash results in net finance income of Rmb3,276mn (made up of Rmb146.6mn finance costs and Rmb3,422.7mn finance income).
But as they say in accounting circles, let’s focus on substance over form. You can call it capitalised interest or cost of goods sold but what matters is cash flows. If one were to look at actual interest paid, this has increased from Rmb3bn in 2012 to Rmb10.8bn in 2017.
Again, for a company that generated Rmb550.8bn in contract sales, the bulls would argue that this is just chump change.
But bear in mind that interest rates have fallen significantly over the past five years. Dividing interest paid by average gross borrowings, Country Garden’s cash interest costs had fallen from 8.2% in 2013 to 5.4% in 2016.
But you see that little uptick to the right? In 2017, Country Garden’s cash interest costs have already started to rise, moving to 6.16%.
Unless one is prepared to pay down debt with surplus cash (and again this is a company with Rmb550.8bn of contract sales), the combination of the US Fed hiking rates as well as widening yield spread means interest burden is likely to rise.
The timing of when interest rates reset may vary but against a gross debt position of Rmb214.7bn, a 1% rise in effective interest costs works out to Rmb2.1bn.
A rising tide better lift all boats
The good news is that unlike 2012 to 2015, the company is finally able to generate positive cash flow from operations.
For the Chinese airlines, the combination of a rise in oil prices and a strong USD, their share prices have fallen by 30% off their 52 week lows.
But for the Chinese developers, they have been more resilient (only down 18%). Perhaps the market is anticipating that the ever rising tide of contract sales will see another wave of monetary easing.
As a final contrast, let’s consider the price-to-book ratio of the two biggest property companies on the Hang Seng Index. SHKP is at 0.7x. Country Garden is at 3.0x.
This will never work