China Governance and Ratings

8/4/2019 China Governance and Ratings

1/17

Corporates

www.fitchratings.com

China

Special Report

China: Governance and RatingsWidespread Weakness, but Incorporated in the Ratings

Chinese Ratings Discounted for Governance Issues: Fitchs ratings take intoaccount that a number of individual companies exhibit one or more transparency,concentrated ownership or financial measure features identified in this reportsfilter review, together with widespread issues of weak corporate governance.

Framework Recognised as Weak. Fitchs ratings for Chinese corporates areclustered around the BB level and below, and at investmentgrade and above forthe mainly stateowned and statesupported companies. The former standaloneratings already incorporate the overall Chinese framework of an underdeveloped

legal system and documentation standards, distinct business practices and weakcorporate governance. In this respect, the ratings already reflect the poor globalrankings of doing business in China.

At the same time, a number of Chinese companies have raised their standardsabove the local thresholds, particularly those exposed to international markets.

Low Level of Information: Chinese corporates will continue to be at an aboveaverage risk as targets of fraud allegations. Investor interest driven by high levelsof growth and the search for yield from international investors coincides with lowlevels of internationalisation and limited access to information at key issuingentities.

Liquidity as the Price of Uncertainty: Proving a negative in this case, that the

allegations of a research house may be incorrect is a task that takes time toresolve. Meanwhile, the affected company will have difficulty accessing the capitalmarkets, especially with an accompanying deterioration in investor sentimentsurrounding Chinese companies in general.

Of particular concern to Fitch is the event risk to which a diligent company, albeitadhering to local business practices, could be vulnerable most notably if theseare exaggerated claims of irregularities, which will take time to counter.

The Widespread Problem for China: A rising number of fraud allegations remindsinvestors of or, arguably, takes advantage of the poor global rankings of Chinain the World Banks Perception Indicators, with a Control of Corruption ranking in2009 of 36 (where 100 is the best). As a result, similar concerns are embodied inthe Chinese sovereigns A+ LongTerm ForeignCurrency Issuer Default Rating (IDR).

Overseas Scrutiny Self Interested, but a Force for GoodArguably, overseas investors are now undertaking the job that Chinas underdeveloped capital market has hitherto struggled to address: challenging Chinesemanagement to adopt higher standards.

Fitch does not expect the flow of accusations and investigations to slow down in thenear term, particularly if shortselling is involved. Some of the accusations will belegitimate; some will be erroneous; many will be a mixture. All have the potentialto present liquidity problems for an individual issuer and its closest peers. For China,however, it is part of a long road to stronger market governance already taken byLatin America and, in more recent years and to a more modest extent, the CIS.

Figure 1

China Optimal 100

Politicalstability

Source: World B ank Indicators, 2009

World Bank Indicators

Voice and

Gov't

effectivenessRegulatory

quality

Rule of

law

Control ofcorruption

AnalystsJohn Hatton

Group Credit Officer, APAC & EMEA+44 (0) 20 3530 [email protected]

Andrew SteelHead of Corporate Ratings Group, APAC+65 6796 [email protected]

Kalai Pillay

Head of Industrials, APAC+65 6796 [email protected]

Buddhika PiyasenaHead of Energy & Utilities, APAC+65 6796 [email protected]

Steve DuroseHead of TMT, APAC+61 2 8256 [email protected]

Matt JamiesonHead of Research, APAC+ 822 3278 [email protected]

Related Research

Fitch Street View: Corporate Governance

versus Communication in China (June 2011)

Chinas Listed StateOwned Entities Governance, Support and Bankruptcy(October 2008)

Evaluating Corporate Governance(December 2010)

CountrySpecific Treatment of Recovery

Ratings (February 2011)

Corporate Rating Methodology(August 2010)

Voice and acco untability
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=546646http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=604286http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=581405http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=411866http://www.fitchratings.com/creditdesk/press_releases/detail.cfm?pr_id=720161mailto:[email protected]:[email protected]


2/17

Corporates

China: Governance and RatingsJuly 2011 2

A Filter Review of Fitchs Rated Chinese CorporatesFor its portfolio of rated Chinese entities Fitch has reviewed representative areas oftransparency, reporting and control; many of which have varying degrees of

external scrutiny including choice of accounting standards, exchange listings, boardcomposition, and external independent valuations. The agency also lists in thisreport financial measures which can highlight or mask control and accounting issues.In particular, Chinese companies have the added disadvantage of their financialprofile evidencing significant growth making poor performance harder to spot.

This portfolio review of international ratings has shown few new areas of concern.Weaknesses, which expose companies to potential external claims of concern, arelisted in Figure 2.

Sino Forest Downgrade(s) Driven by FundamentalsWeak Governance not the Root Cause

Fitchs twonotch downgrade to BB of SinoForest on 20 June 2011, whichpreceded the recent withdrawal on 14 July, was driven by a particular feature ofthe issuers business model which came to light earlier in the same month, andnot by a broader concern over governance issues. As a result, the agency doesnot regard the downgrade rationale for this issuer as indicative of likely pressureon other ratings.

Fitchs downgrade was driven by clarification from the issuer in June 2011 that ithad not taken direct possession of cash receipts for a very significant portion ofits existing revenue base. Cash receipts were instead being paid directly bycustomers to the issuers suppliers for the restocking of SinoForests inventory.While the company had been slowly transitioning away from this business modelto an onshorebased revenuecharging system, any nearterm conversion of the

business model would be likely to entail substantial additional tax payments.

In Fitchs view this represented a material difference to the position of offshorecreditors with respect to access to cashflows, which had not previously beendisclosed. Interestingly, this unusual cashflow situation was not capable of beingascertained from the accounts of the issuer, nor from its debt issuanceprospectus. There was clear reference to the risks of additional tax chargesarising in the prospectus, but the issue as to whether the company was actuallycapable of being in physical receipt of the cash recorded in its accounts was notaddressed.

The issuer is still working through a rebuttal of a series of allegations made byshortseller Muddy Waters LLC (MW). The boardled investigation may result in

few, or none, of MWs accusations being substantiated; but during the period ofthis investigation at least, the issuer is unlikely to have capital markets access.

Weaknesses Present, butDowngrades Driven by Business ModelConcernsSinoForest did, nonetheless, show up retrospectively under some of the areassuggested in this reports filter, indicating that its governance stress was evenhigher (i.e. governance levels were poorer) than the local average. Theindicators were pronounced In a number of cases, such as capex growth rates(exceeding the companys entire revenue at some points) and zero cashtaxpaid.

However, in each case, and cumulatively, they were insufficient to havewarranted the scale of recent rating actions without the fundamental weakness

associated with the lack of direct access to sales receipts.


3/17


4/17


5/17

Corporates


Limited Investor Tools in the Middle KingdomSince mid2010, there has been an increase in discussion of the potential for fraudby Chinese corporates (particularly nonstateowned companies) which have

accessed international capital markets. In this context, Fitch is referring primarilyto Chinese companies seeking equity market listings, as opposed to the far lowernumber of companies which have sought international credit ratings.

Fitch believes that this view has gone beyond a natural reflection of the increasedpresence of Chinese corporates in international markets, but is now starting toevidence the relatively lower level of standards of investor tools within China particularly when compared with other dynamic developing economic regions suchas Latin America. This includes two key areas of focus audit and accountingstandards, and data transparency.

Valid Questions on Audit StandardsIn general, companies annual accounts and the auditing process have also been

questioned. In July 2010, the Public Company Accounting Oversight Board (PCAOB)issued an alert, pointing out that some USbased firms issuing audit reports basedon work performed by others outside the United States are not properly applyingPCAOB standards. Instead, they were relying on the work of overseas auditors. ThePCAOB made a special mention of Chinese companies in its alert, in combinationwith small US auditing companies. However, some of the Big Four auditors havealso been cited in investor claims against Chinese companies with suspected fraud.

Fitch is well aware of the difficulties of assessing rated Chinese entities operatingin a centrally controlled economy with general issues of data transparency. Whilstaudited financial figures are a good foundation for credit analysis, the systemicdifficulties of operating in a country ranked below 40 in the World BanksCorruption Index including the lack of security of legal title and general

enforcement of property rights, coupled with an overlay of local business practices are all wellknown features of doing business in China.

At best, companies in this environment accessing international capital markets canchoose to operate with higher standards yet within the limitations of domesticconventions. At worst, management can rely on such vagaries to perpetuate opaquestructures and profits. Reverse mergers a practice that allows companies tobypass the scrutiny of an IPO have been of particular interest to the US SEC in itsreview of Chinese listed entities. Fitch notes that, to the best of its knowledge,other than GCLPoly in 2009, none of the 35 Fitchrated corporates examined in thisreview were the result of a recent reverse merger.

Finally, as discussed below in more detail, financial transparency and interpretation

of underlying trends is more difficult in companies exhibiting the exponentialgrowth seen in China, whether operating within an emerging or developed market.

Valid Questions on Corporate GovernanceFitch believes that corporate governance in China is also underdeveloped, with therole of independent board directors not fully comparable in most cases with theresponsibilities and resultant objective actions of their peers in developed markets.Audit committees, even where diligent, face challenges in ensuring a fullytransparent view. One frequent example relatedparty transactions (whichindependent directors have a duty to scrutinise) are often difficult to reviewdefinitively in all aspects, due to the concentrated private ownership of somegroups, or in staterelated entities where state relationships can extend far andwide through the supply chain and customer base.

Fitchs Chinas Listed StateOwned Entities Governance, Support andBankruptcy, published in 2008, argued that effective corporate governance inChina will not be comparable with developed market standards for as long as the

Since March 2011, 30companies have had theirauditors disclose accounting

issues that arequestionableSource: FT.com, China Fraudcaps How to Profit, 25 May 2011

In May 2011, Deloitteresigned as auditor ofLongtop FinancialTechnologies, havingaudited the company forsix years, saying that weare no longer able to placereliance on managementrepresentations

KPMG said that it hadfound possibleirregularities in the booksof China Forestry. The

shares were suspended

Deloitte was no longerable to rely on therepresentations ofmanagement in auditingChina Media ExpressHoldings


6/17

Corporates


country lacks a sufficiently dispersed shareholding structure, quality information forshareholders, and an uninhibited market for takeovers.

It seems that overseas investors are currently undertaking the job that Chinasunderdeveloped capital market is not doing: that of challenging Chinesemanagement to adopt higher standards.

Appropriate Credit Ratings for the Risk ProfileWith these limitations in mind, Fitchs international ratings of Chinese corporateshave been clustered around the BB and B rating categories, whereas equivalentdevelopedmarket peers which do not have these domestic issues are typicallyrated higher. Chinese stateowned or statesupported entiites have been ratedinvestmentgrade or up to the sovereign foreigncurrency rating of A+.

Partly explaining the range between the lowinvestmentgrade and highsingleAcategories for SOEs, government involvement in companies can be a source ofsupport to enhance a credit rating, yet equally weak corporate governance for SOEs(compared with private enterprises) and weak unlisted parent companies combinedwith other transparency issues, can be a drag on the rating of the listed subsidiarySOE.

Fitchs corporate governance criteria (listed in the sidebar) describes the processof notching ratings down for countryspecific and companyspecific issues.

Fitchs Rating Process Relies Upon Audited FiguresIt is important to reiterate that Fitch relies upon published audited accounts whenanalysing companies historical financial profiles, and also relies on the trendsevidenced in these when creating the forecasts upon which it bases its ratings. Theagency may make its own adjustments in treating published figures, or request

supplemental data to help in compiling a comparable picture to that forinternational peers, but the agency does not audit the auditors.

As part of the analytical process reality checks arise, particularly in comparativeanalysis with sector peers, and further analysis of group or legal structures may alsobe undertaken. A limited site visit is usually undertaken, but site visits to everyfactory or facility, the checking of inventory levels and legal title of ownership, arebeyond the rating agencys remit.

Where Fitch has concerns over corporate governance and the robustness of datawhich make assigning or maintaining a rating impossible, ratings will either not beassigned or withdrawn.

This Publications Findings

Appropriate Ratings, but Multiple SubOptimal Practices Create ExposureIn June and July 2011, as an extra precaution, Fitch undertook a screening of itsChinese corporates to see if any elements in the portfolio exhibited a selection oftraits which could cumulatively be indicative of governance failures.

In some cases, Fitch has directly asked management to provide additional clarity,and is thereby reliant on the honesty and integrity of their responses.

The tables below highlight areas that were investigated as potential indicators ofgovernance stress. Some are observations of suboptimal practices such as theuse of local auditors, longtime serving independents, unclear ownership whichcompanies may seek to improve upon if they are serious about allaying investorsfears. Some issues arise naturally from the issuers field of activity, such as high

revenue growth, surplus cash resources, profit margins higher than their peers, orlow cashtaxpaid most of which have rational explanations.

Fitch Street View:Corporate Governanceversus Communication inChina, 30 June 2011

Evaluating CorporateGovernance, 16December 2010

(This is due to be published inMandarin by endJuly 2011)

Chinas Listed StateOwned Entities Governance, Support andBankruptcy, 29 October2010

This Reports Filters: Financial Reporting

Standards and Auditor

Exchange Listings

Ownership, or DominantPersonality Control

Corporate Governance Board Membership

Independent Valuation ofReserves or Materials

Financial Measures:

Revenue and Capex Growth

Working Capital Cycle

Low CashTaxPaid

Cash versus Debt High Profit margins


7/17

Corporates


Fitch has highlighted in the following tables where these individual indicators aresignificant for companies, with explanatory comments. Companies with numerousindicators (as summarised in Figure 2 above) are more exposed to external investors

questioning the suboptimal practices of these issuers.

Financial Reporting Standards and AuditorCompanies which adhere to international financial reporting standards (IFRS) andthe audit trail that lies behind such scrutiny would have more difficulty inperpetuating fraudulent statements compared with domestic standards. Equally, anauditor within the Big Four should give investors confidence that the figures arean accurate and consistent representation of the companys financial profile.

Many companies in this portfolio adhere to the Hong Kong Financial ReportingStandards (HKFS) which Fitch regards as nearidentical to IFRS. Fitch is able to ratea company that only produces figures using local GAAP, but this typically exposesthe company to higher restatement risk, as and when any migration to a broaderinternational GAAP occurs and (typically) with a new auditor. Fitch understandsthat Chinas 2006 Accounting Standard for Business Enterprises (ASBE 2006), usedby some companies, is quite similar to IFRS GAAP with mainly reclassification issues.

Fitch does not typically assign ratings to companies where the statements are bothin a local GAAP which is not comparable with IFRS and audited by a localaccountancy firm. Exceptions are India and Indonesia, where penetration ofinternational audit groups is insufficiently high and the rating calculus isconstructed to discount for this transparency deficit.

Of the three companies that do not have a Big Four auditor, two are SOEs (CNPCand Yangtze whereas the latters fellow Chinese independent power producershave Big Four auditors), and Shanghai Zendai uses BDO Limited, HK. TheSinochem Groups auditor has been BDO Reanda since 2005, and the rated entity

Sinochem Hong Kong (Group) Company Limited is audited by Deloitte. Althoughsuch SOEs may regard adherence to international accounting and other facets ofcorporate governance as optional, smaller companies would find it nearimpossibleto raise capital on the international markets without this level of external review.

Baoshan, as a Shanghailisted company, uses ASBE 2006, as issued by the Ministry ofFinance. CNPC (which is not listed) also uses this standard.

Audit Quality or Information Quality?Where companies have weak disclosure and transparency issues, Fitch has to judgeif gaps in information provision are warranted (eg genuinely commerciallyconfidential), or simply an information deficit on the issuers side. In the lattercase, the company may not have the management information systems in place to

collate the information, or the company may have a culture of nondisclosure whichillequips management to respond to the greater transparency demands associatedwith public debt issuance.

A change of auditor can raise questions in the event of a conflict overinterpretation of accounting principles. Baoshan states that it changed its auditor in2009 from Ernst & Young (E&Y) to Deloitte after it had completed 10 years ofauditing the company. West China Cement changed from a UKbased auditor afterits time listed on Londons AIM exchange to PWC in 2009 and in May 2011 itannounced a further change to Deloitte due to audit fee considerations. ChinaMedical refers to fee negotiations in relation to its change from KPMG to PWC.

Fitch analysts typicallyuse audited accounts thatare prepared according toInternational Financial

Reporting Standards (IFRS)or US Generally AcceptedAccounting Principles (USGAAP). If such statementsare not available, Fitchwill use accounts in localGAAP, other statementsprovided, and publishedmanagement comments tomake appropriateadjustments forcomparative analysis, ifappropriate and provided

the quality of the auditorsor other reviewing partiesemployed and disclosure is adequateSource: Fitchs CorporateRating Methodology, August2010


8/17


9/17


10/17

Corporates


In assessing the ownership of SOEs, investors may lack information on the creditquality within the levels of intermediary holding companies. Ultimate ownership isnonetheless known. Of more concern is the concentrated ownership of management

in private entities listed in Figure 6, sometimes without the accountability to anddiscipline of objective board members and high corporate governance standards.

Corporate Governance Board MembershipChinas Code of Corporate Governance comprises guidelines rather than mandatoryrequirements, and Hong Kong listing details recommend rather than require certainstandards (see Appendix 4 of Fitchs Chinas Listed StateOwned Entities for acomparison of listing requirements of the New York Stock Exchange with those ofHong Kong, Shanghai & Shenzhen, and Singapore).

BoardCompositionIt is always challenging to structure a board to effectively combine sufficientknowledge of the issuers industry to make informed decisions, with enough

external vision to offer a checkandbalance and perspective. This is doubly so incomplex, fastgrowing markets where penetration of internationalised governancenorms remains low. In China, the cultural barrier of understanding domestic (largelyunwritten) rules and methods is hampered further by the limited number ofinternational candidates with the requisite language skills.

As a result, while overseas board members can add both genuine governanceexpertise and optical credibility to a Chinese corporates board, Fitch believes thatthe board compositions of remotelylocated foreign nationals is less preferable toexperienced business persons with local knowledge, local language skills and firsthand experience of working in the country (preferably in the same sector).

The combination of chairman and CEO roles is also a suboptimal corporategovernance position by Western standards. In the Chinese portfolio where

ownership is concentrated, these roles are often combined; and even in the fewcases where they are separated, the CEO may not have executive powers in reality.Fitch believes that much of the board weaknesses cited in this report stem fromthis underlying feature.

Independent Directors

Figure 7

Board MembershipLongserving Independents Common CEO and Chairperson

Chalco Chair and CEOChina Medical since 2005 and 2007 Chair and CEOChina Mobile since 20012003

China Oriental Since 20032004 Chair and CEOChina Power since 2004 with some moderate churn Chair and CEOChina Telecom since 2005 Chair and CEODelong Chair and CEOFranshion since 2007Fufeng since 2007GCLPoly some since 2007 Chair and CEOLDK Solar some since 2007 Chair and CEONine Dragons since 2006 Deputy Chair and CEOSunac Chair and CEOShimao since 2004 and 2006 Chair and CEOShanghai Zendai since 20022005SinoForest Chair and CEOSinochem Chair and CEOWinsway Chair and CEO

NB: Some company disclosures do not g ive the date of when board members started their service

Source: Fitch and companies annual accounts


11/17

Corporates


Fitch acknowledges that corporate governance is less robust in China, and thetemplate of three or four independent directors has rarely been vocal inchallenging managements decisions to the benefit of all stakeholders. A pool of

professional independent directors with corporate experience has yet to developfor China. Founders of companies with concentrated ownership probably regardsuch forms of objective shareholder representation as an unnecessary expense,whereas external debt providers may think otherwise.

Particularly where dominant ownership issues are evident, Fitch regards theindependent status of directors as suboptimal where they have stayed on the boardfor over five years and rotation has not occurred. For example, in the case of NineDragons, the independents have now served on the board since 2006.

Independent Valuation / Reporting of Reserves or MaterialsAs the Chinese legal system has issues of documentation robustness unaided byweak security and enforcement of legal ownership, Fitch questions the extent ofinventory or sales that could be manipulated to take advantage of this weakness inreporting and thus be prone to fraudulent activity over a sustained length of time.Some industries have raised their standards by undertaking independent evaluations,others not.

HousebuildersFitch believes that the Chinese housebuilders, which regularly churn their stock,would find it difficult to maintain cash flow and sales figures from misstatedinventory, as units are presold soon after construction and before commencementof the next project.

Concerning the legal title of undeveloped land, property companies acquiredocuments and forms of permits from the authorities with regard to the rights ofland use. Given the volume of units sold to date, the provision of property

ownership certificates to unit purchasers is evolving as a Chineseequivalent legalpackage. Undeveloped land which has been bought is regularly booked into the costof the goods sold (COG) at cost (rather than revalued), and typically represents10%15% of the average selling prices (ASPs) of housing units. Nevertheless,compared with other countries legal regimes and precedents, Chinese legal titlelacks precedent and is not as sturdy, a factor which contributes to theconcentration of the sectors ratings within the speculativegrade category.

Property companies have published independent valuations from internationalvaluers for their investment (incomeproducing, nontrading) portfolios, but theseare not a large proportion of their balance sheets at this stage.

Fitch believes that the potential for overstatement of profits is not significant for

its rated housebuilder universe. This is despite the property sector across mostcountries being prone to the effect of shifting valuations on its financial statements,occasionally exacerbated by opaque jointventure structures. Again, the Chinesestandalone housebuilder ratings are clustered around the low end of the BB range,and are discounted for this countryspecific context.


12/17

Corporates


Oil & Gas

Figure 8

Oil & Gas Entities Independent Assessments of AssetsCNOOC 88% of reserves: thirdparty consulting firms, including Ryder Scott Company,

Gaffney, Cline & Associates and RPS. SEC reporting standardsCNPC Given its ownership of PetroChina, CNPC consolidates the PetroChina assets (see

below) constituting above 90% of its reserve base. The remainder are internallyassessed

MIE Ryder Scott Company LP, Louisiana using SPE/WPC/AAPG/SPEE standard (commonlyused in the Petroleum industry) for reportingChapman Petroleum Engineering for prospective Kazakhstan assets

PetroChina Onshore PRC assets: DeGolyer and MacNaughton; SEC reporting standardsSinopec Offshore includes thirdparty assessment for some fields.

Onshore assets no international thirdparty assessmentSEC reporting standards

Source: Fitch and companies annual reports

All entities use independent assessments for the majority of their reserve bases,however the standards used for reporting these reserves varies (as is also the casefor a number of major oil and gas producers globally). PetroChina, Sinopec andCNOOC use SEC reserve reporting standards, an internationally acceptedmethodology for reserve statements but which does not guarantee theindependence of the initial verification or valuation of reserves. MIE uses someother commonly accepted international reserve reporting standards. Generallyreporting standards adopted tend to reflect exposure to international investors andthe standards they expect in the sector (the higher the exposure to internationalinvestors and/or less dominant market position, the more likely to adoptinternational reserve reporting standards).

IndustrialsShort of physically checking the stock of the industrial manufacturing companies,Fitch has assumed correct representations of the size of these companies, and thatgroup sales are derived from consistency of product sales (as opposed to lumpsumsales of headoffice properties).

An exception to this is the case of China Medical, whose assets consist mainly ofintangible assets a result of technology platform acquisitions that the companysubsequently commercialised. Fitch relies on the opinions of China Medicals auditorsregarding the book value of these intangibles, but, as with the agencys approach tothe housebuilders, takes some comfort from the companys ability to generaterelatively strong operating cash flows from these assets. China Medicals B+ ratingreflects this business model, together with its small size and high financial leverage.

Financial Measures Significant Revenue andCapex GrowthCompanies with low stable growth or static yearonyear financial figures normallyoffer less scope for financial misstatement than companies exhibiting exponentialgrowth where a mixture of partialyear contributions, new facilities coming onstream, and rapid changes in the mix of different activities profit margins makescomparative analysis difficult. Less profitable and less cashgenerative activitiescan be much more difficult to spot.

Figure 9 highlights companies from Fitchs rated portfolio with either a 30%+ growthin turnover, or 30%+ growth in capex spend, or both, as an annual average over thepast three to four years. Where both measures exist, Fitch has doublechecked thatthe companys investment rationale is robust and that capex has not simplyfinanced sales. In the case of the housebuilders, significant increases in turnover

reflect the housing boom, and capex reflects the investment in building stock.


13/17

Corporates


Figure 9

Significant Revenue and Capex GrowthRevenue Growth >30% p.a. Capex Growth >30% p.a.

China Power 31ENN 37Fufeng 38 >100GCLPoly >100 >100Huadian 33LDK Solar >100 >100Liansu 43 57Shanshui Cement 38 66SinoForest 37 37West China Cement 70 30Winsway Coal >100 >100ZTE 32 30

China HousebuildersEvergrande 44 Franshion 101

Road King >100Shanghai Zendai 33Shimao 49


Financial Measures WorkingCapital CycleThis financial measure looks at the workingcapital cycle of companies for irregularmovements and unlikely behaviour of the workingcapital cycle. Overstatement,noncash transactions and unusual timing can all be masked in an income statement,but should in many cases be highlighted instead through changes in the issuerscustomer receivables, inventory or trade creditor positions.

Fitch reviewed companies working capital days (proportionate to sales and COGs)for any potentially counterintuitive activity. The agency also checked whether anegative workingcapital cycle (current liabilities greater than current assets)was representative of sector dynamics, or a possible indicator of problems in thefunding structure. The converse is represented by the Chinese housebuilders whichhave significant inventory (units and land) unfunded by trade creditors.

Figure 10

Working Capital CycleNegative working capital Lumpy movements

China Mobile and China Telecom Appropriate for business model

Yangtze, Datang, Huadian, Huaneng, Appropriate for business modelENN, MIE, CNOOC, Sinotech, CNPC Appropriate for business model

SinoForest Turning W/C negativeWest China Cement, Shansui Cement Appropriate for business model

in ChinaLDK Solar, GCL Poly Energy explained by volatile polysilicon

selling prices, and growthChina Medical explained by changing product

mixWinsway explained by the change from

building infrastructure torampingup of operations

Source: Fitch and companies

MIE has large payables. This is due to the Production Sharing Contract (PSC)

business model it has with PetroChina dating back to 199798, which requires MIE tofund its share of oilfield development costs until revenue flows and profits areshared accordingly. PSC details, including the selection of/payment to suppliers,are approved and controlled by the jointmanagement team comprising both MIE


14/17

Corporates


and PetroChina. MIE also benefits from favourable supplier terms, which includespayments in instalments and payment flexibility in times of depressed oil prices.

The workingcapital cash conversion days of the two cement producers, West ChinaCement and Shanshui Cement, was surprisingly short at a net minus5 to plus10days, compared with a net one month for international peers. These Chinesecompanies receivables are low, since they sell to distributors who pay cash or aregiven shortdays credit. Their high payables also reflect customer advances tosecure volumes. Lumpy movements may be due to government sales with higherreceivable days.

The lumpy movements yearonyear for the solar panel manufacturers (LDK Solar,and GCLPoly) can be explained by both the skyrocketing price of their polysiliconproducts, very rapid growth and expansion via acquisition.

Fitch expected the Chinese power producers to have a negative working capitalposition, as customers pay for their electricity immediately yet the power

producers have the clout to pay for feedstock (less so for hydro operators) onextended days (3040 days). The same rationale applies to the Chinese telecomscompanies, and the low cashconversation days for the oil & gas sector entities.

Financial Measures Low CashTaxPaidThe PRC Enterprise Income Tax Law imposes a unified enterprise income tax rate of25% on both domestic enterprises and foreigninvested enterprises. Some companieshave preferential tax rates due to investments in certain areas or certainindustries, which reduces their rate of income tax over a set period of years. Somecompanies also have tax benefits under the Western Development Plan, althoughthese were due to expire at end2010.

There are many other mechanisms by which companies in all markets and with all

levels of governance quality seek to minimise their corporate tax burdens, fromtransferpricing to jurisdictionshopping. Tax rates significantly below the localaverage can, however, also be an indicator of unusual transaction patterns if theyshow that profit is distanced from creditors at the same time as being distancedfrom the tax authorities.

Furthermore, given that tax authority documents are a main source of auditing inChina, it would seem that cashtaxpaid is a reasonable figure for assessing thescale of a companys activities (assuming no preferential tax incentives).

Tax bills do have limits as predictors, however. The absence of corporation taxpayments on SinoForests cash flow is consistent with the position of an issuer usinga taxminimising structure for a substantial portion of onshore cash flows, whichpassed through a BVI structure. It did not, however, reveal the picture established byFitch in June 2011 that the cash flows did not in fact pass to SinoForest, but wereinstead redeployed to purchase more supplies directly from timber growers.

Figure 11

Low Cash Tax PaidChina Medical Cash taxes vary significantly from year to year, due to acquisitions of new

platforms with varying tax holidays and Preferential tax ratesFufeng Preferential tax rate expires in 2010, some subsidiaries until 2011GCLPoly Preferential tax rate expires in 2012LDK Solar Preferential tax rate expires in 2011, then full 25% tax rateNine Dragons Preferential tax rates exist. Deferred tax liabilities from PP&E investmentSinoForest This company has zero cashtaxpaid (see commentary in text)West China Cement Preferential tax rates under the Western Development Plan, together with a

50% tax reduction period which ends in 2011

Winsway Recent change to higher cash paid due to more profit being recognised asincurred in the PRC

Source: Fitch


15/17

Corporates


Financial Measures Large Cash versus DebtEven for companies in developed markets, Fitch would question why cash balancesare persistently at high levels of 80% to above100% of debt. This could indicate

trapped cash (offshore funds, used as collateral for other lending, cash lodged in anoncontrolled entity or which can only be accessed by incurring taxes or othercosts) which is not available for liquidity purposes, including debt reduction.

Some AsiaPacific corporates have high levels of cash for additional liquidityrequirements, often because of reliance upon shortterm debt or a limited ability toestablish committed bank facilities in the local banking market. At this stage intheir development, many Chinese companies have also raised debt ahead ofgrowthled capex requirements and in anticipation of Chinese banks reducingtheir lending capacity.

For Hong Konglisted companies, there is also the issue of whether the cash is onshore or offshore, and the capital controls that can impede US dollars beingtransferred onshore or into Chinese Yuan, and repatriated offshore for bondrepayments. This will be the subject of a forthcoming research piece by Fitch.

For some companies, high cash balances often combined with low leverage maybe a function of strong free cash flow generation (and managements inability tospend the cash on core acquisitions) rather than regularly tapping the markets tofund sales.

Some companies also have high cash balances related to committed capex plans.

Figure 12

Cash versus Debt >= 1.0xYearend cash versus debt (x) 2007 2008 2009 2010

China Mobile 1.9 2.1 2.4 2.8

CNOOC 2.2 2.4 2.3 1.5CNPC 1.9 1.1Liansu 1.9 1.0SinoForest 1.0Winsway 2.2ZTE 1.0 1.1 1.1 1.1

Chine Mobile Low leverage, significant cash flow, and limited capex (China Mobileleases the facilities from its parent) has resulted in cash piles

CNPC, CNOOC Low leverage and significant cash flows have resulted in cash piles

Liansu Significant capex requirements in 201112. High cash has alsoresulted from an IPO in June 2010, thereby affecting the Dec 2010year end

SinoForest SinoForest has regularly tapped the bond markets and thus

accumulated cash ahead of plantation acquisitionsWinsway Winsway has a CNY3bn investment plan over FY1114, together with

other expansion opportunitiesZTE The large cash balances relative to debt benefit from amounts

received just before the year end


Financial Measures Significant EBITDA Profit MarginsWhere possible, usually at the time of the initial rating, peer analysis would haveshown if the profit margins of the Chinese activities are comparable with overseaspeers and if not, why. Higherthannormal profit margins could also be anindicator of governance issues.


16/17

Corporates


Figure 13

Significant EBITDA Profit MarginEBITDA Margin >30% (%) FY07 FY08 FY09 FY10

IndustrialsChina Medical 58 53 35 48GCLPoly 71 40SinoForest 30 36 30 30West China Cement 42 40 48 46

TelecomChina Mobile 54 52 50 n.a.China Telecom 50 32 36 n.a.

Chinese IPPYangtze 85 74 79 n.a.

Chinese HousebuildersFranshion 44 43 43 41Shanghai Zendai 37 39 31

Shimao 29 39 36 28

Oil & GasCNOOC 55 55 54 54MIE 57 70 67 n.a.


The profit margins of the Chinese housebuilders are expected by Fitch to be at orabove 30%, particularly for Franshion given the sale of land within its businessmodel. The higherthanpeeraverage EBITDA margin of West China Cement isattributable to its dominant market share (including its pricing power and lowertransport costs) in southern Shaanxi. China Medicals profit margins being higherthan those of its global peers, are attributable to its lowcost manufacturing base.

The high profit margins for the telecoms entities are understandable due to theirsignificant market shares, absolute subscriber levels, and hence economies of scale.China Telecoms sudden decrease in profit margin to around 30% in 2009 reflectsindustry restructuring and the inclusion of the former China Unicoms mobilebusiness. This business was acquired by China Telecoms parent company, ChinaTelecoms Communication Corporation, which owns the licence and undertakescapex in return for an annual fee from China Telecom amounting to 28% of mobileservice revenue.

The volatile profitability in GCLPolys figures reflects the change in business from2007, with high polysilicon prices in 2008 followed by a sharp fall in 2009. Suchvolatility also exists in fellow peer LDK Solar, but starting from a lower, negative,base.

Of the independent power producers (IPPs), Yangtzes high margins benefit from itbeing a hydropower generator. The profit margins of the oil & gas companies are inline with comparables, particularly the upstream (higher 55%70% margin) businessactivities of MIE.


17/17

Corporates

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READTHESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK:HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS . IN ADDITION, RATING DEFINITIONS ANDTHE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEB SITE ATWWW.FITCHRATINGS.COM. PUBLISHED RATINGS, CRITERIA, AND METHODOLOGIES ARE AVAILABLE FROMTHIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST,AFFILIATE FIREWALL, COMPLIANCE, AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSOAVAILABLE FROM THE CODE OF CONDUCT SECTION OF THIS SITE.

Copyright 2011 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.Telephone: 18007534824,(212) 9080500. Fax: (212) 4804435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rightsreserved. In issuing and maintaining its ratings, Fitch relies on factual information it receives from issuers and underwriters and fromother sources Fitch believes to be credible. Fitch conducts a reasonable investigation of the factual information relied upon by it inaccordance with its ratings methodology, and obtains reasonable verification of that information from independent sources, to the extentsuch sources are available for a given security or in a given jurisdiction. The manner of Fitchs factual investigation and the scope of thethirdparty verification it obtains will vary depending on the nature of the rated security and its issuer, the requirements and practices inthe jurisdiction in which the rated security is offered and sold and/or the issuer is located, the availability and nature of relevant publicinformation, access to the management of the issuer and its advisers, the availability of preexisting thirdparty verifications such as auditreports, agreedupon procedures letters, appraisals, actuarial reports, engineering reports, legal opinions and other reports provided bythird parties, the availability of independent and competent thirdparty verification sources with respect to the particular security or inthe particular jurisdiction of the issuer, and a variety of other factors. Users of Fitchs ratings should understand that neither an enhancedfactual investigation nor any thirdparty verification can ensure that all of the information Fitch relies on in connection with a rating willbe accurate and complete. Ultimately, the issuer and its advisers are responsible for the accuracy of the information they provide to Fitchand to the market in offering documents and other reports. In issuing its ratings Fitch must rely on the work of experts, includingindependent auditors with respect to financial statements and attorneys with respect to legal and tax matters. Further, ratings areinherently forwardlooking and embody assumptions and predictions about future events that by their nature cannot be verified as facts.As a result, despite any verification of current facts, ratings can be affected by future events or conditions that were not anticipated atthe time a rating was issued or affirmed.

The information in this report is provided as is without any representation or warranty of any kind. A Fitch rating is an opinion as to thecreditworthiness of a security. This opinion is based on established criteria and methodologies that Fitch is continuously evaluating andupdating. Therefore, ratings are the collective work product of Fitch and no individual, or group of individuals, is solely responsible for arating. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch isnot engaged in the offer or sale of any security. All Fitch reports have shared authorship. Individuals identified in a Fitch report wereinvolved in, but are not solely responsible for, the opinions stated therein. The individuals are named for contact purposes only. A reportproviding a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by theissuer and its agents in connection with the sale of the securities. Ratings may be changed or withdrawn at anytime for any reason in thesole discretion of Fitch. Fitch does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold anysecurity. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the taxexempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, otherobligors, and underwriters for rating securities. Such fees generally vary from US$1,000 to US$750,000 (or the applicable currency

equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by aparticular insurer or guarantor, for a single annual fee. Such fees are expected to vary from US$10,000 to US$1,500,000 (or the applicablecurrency equivalent). The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use itsname as an expert in connection with any registration statement filed under the United States securities laws, the Financial Services andMarkets Act of 2000 of Great Britain, or the securities laws of any particular jurisdiction. Due to the relative efficiency of electronicpublishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers.
http://www.fitchratings.com/creditdesk/public/ratings_defintions/index.cfm?rd_file=intro

China Governance and Ratings

Documents

Transcript of China Governance and Ratings