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How dangerous is the credit bubble in China's heavy equipment sector?
07/05/2012 5:58 pm EST
Call this Nortel-squared.
Remember back to 1999-2000 and the collapse of U.S. technology companies and technology shares. One of the problems, investors discovered, was that some large capital equipment makers were keeping sales up, even while customer demand was flagging, by financing customer purchases of equipment on such favorable terms that customers were willing to buy stuff they didn’t actually need at the moment. Eventually, this process collapsed of its own weight—even with the financing from the manufacturer, customers weren’t willing to buy an infinite amount of stuff that they didn’t need in the foreseeable future. When the collapse came, companies like Nortel Networks saw revenues plunge as sales fell back to a level sustained by real customer demand.
There’s evidence that something like this capital equipment “bubble” is now at work in China.
For example, everybody knows that activity in the construction sector has slumped. In the residential real estate market, for instance, there are simply fewer buildings being built because restrictions on mortgage lending and the tightening of credit standards have meant slower sales. There’s evidence that this slow down is moderating—revenue in 10 major cities from land transfers was up 106% in June from May—but activity is still well below last year’s level. Land transfer revenue, which tracks land sales and is a good proxy for future construction, is still down 38% from June 2011, according to E-house China R&D Institute.
Despite this slump, sales of equipment such as excavators, bulldozers, and cranes have actually increased. Zoomlion Heavy Industry Science & Technology Development (1157.HK in Hong Kong), for instance, reported an 8% increase in sales in the first quarter of 2012.
If you’re wondering how that’s possible, remember how Nortel kept sales growing during the latter stages of the technology bubble. Companies such as Zoomlion, Sany Heavy Industry, and Xiamen Xiagong Machinery have offered increasingly generous financing to keep customers buying.
How “generous?” and how fast is this generosity increasing? A recent post on Caixin Online (http://english.caixin.com/ ) cited a heavy equipment customer who bought his first excavator in July 2010 with a standard loan that required 25% down. In the fall of 2011 this customer bought a second machine with lease financing that required no down payment and no payments for six months.
Which makes companies like Zoomlion look a lot like Nortel Networks. (Zoomlion has been among the most heavily shorted stocks in Hong Kong recently.) The construction equipment maker has asked shareholders to approve a new $22 billion credit facility—which should make investors very nervous given that Zoomlion’s total market capitalization is about $12 billion. Lease financing by Zoomlion grew by 4 billion yuan to 20 billion yuan last year, according to the company’s annual report. But that doesn’t include the 13 billion yuan in new loans that had been sold or factored to banks.
But some of the customers at Zoomlion and at other equipment makers have taken this already shaky tower of credit to new even riskier heights. In this Nortel-squared credit bubble, customers who buy equipment on generous terms, such as a zero-down-no-payments-for-six-months lease, are then turning around and using that equipment as collateral for loans from banks and other less formal lenders. Small companies in China have felt a real credit squeeze lately as the country’s big banks have met the government’s pressure to lower loan volumes by keeping the cash flowing to big, politically-connected or state-owned companies while squeezing loans to smaller businesses. For some of these companies, getting a loan by pledging new equipment bought on credit as collateral has been the only way to survive. Half of the equipment sold by Zoomlion in the first quarter has never been turned on, estimates investment bank Jefferies.
Now this tower of credit doesn’t have to come tumbling down. Makers of construction equipment are trying to raise capital so that they can keep on financing customer purchases and their own operations too. Sany Heavy Machinery, for example, is looking to raise $2 billion in a Hong Kong initial public offering (IPO) in August. With the backing of Commercial Bank of China, CITIC International, Morgan Stanley, Bank of America, and Citigroup, it’s likely that the offering will go.
At the same time, the government has started to ease loan quotas and that has started to make it easier for small companies to finance their business without relying on loans backed by equipment purchased on credit.
But the timing on all this is very tight. If China’s economy is growing at a slower rate than official numbers inflated by these “collateral” sales indicate, Beijing’s economic stimulus could be too little and too late. If customer demand, created by generous financing, falls faster than the economy recovers, some of the over-extended leaders in the equipment sector will wind up needing a government bailout. And if top-down loosening of credit doesn’t happen quickly enough for hard-pressed smaller companies, then many of these will go under without any prospect of a government bailout.
In short, even if you’re an optimist on the ability of the Chinese government to stimulate growth before the slowdown gets much more serious than it is (and I am), I would still stay away from China’s heavy equipment sector.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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