State-Run Giants Hide Losses With Asset Games
A new report in the Chinese media nicely illustrates why I seldom write about big state-owned enterprises (SOEs) in this space, and shows more broadly why even many of the nation’s entrepreneurial firms are often suspected of misleading accounting. The report details an ongoing scramble among SOEs like shipping behemoth COSCO (Shanghai: 601919; HKEx: 1919) and aluminum giant Chalco (HKEx: 2600; Shanghai: 601600) to sell off assets to make themselves appear profitable and avoid possible de-listing on the Shanghai stock exchange. The report also reveals some other tricks these companies are using to hide their losses and look more attractive to Chinese investors, many of whom often lack the sophistication to look beyond a company’s bottom line.
The report in the China Daily specifically focuses on a group of major state-run firms in traditional industries, all of which reported losses last year and are in danger of being de-listed under Chinese stock market rules if they report losses again this year. (English article) The group facing de-listing also includes China Shipping Container Lines (Shanghai: 601866 HKEx: 2866), China Shipping Development Co (Shanghai: 600026; HKEx: 1138) and Huadian Energy (Shanghai: 600726), among others.
The report is quite enlightening about how big SOEs do business, as they try to appear like real companies despite their strong government ties. It says the group of 7 companies are trying to sell a collective 28.4 billion yuan ($4.66 billion) worth of assets by the end of this year so they could post one-time gains that would help them record net profits for all of 2013. The report didn’t say who the buyers are, but I suspect that in many cases they are other big SOEs that have been instructed to purchase the assets through China’s vast network of guanxi among major state organizations.
In a similar bit of accounting magic, the report also detailed how Chalco is selling a stake of itself to its state-owned parent for 5 billion yuan, which will help it to report an annual profit by hiding its 1.85 billion yuan in losses in the first 3 quarters of the year. In any other market, this kind of accounting trick would immediately draw suspicion and widespread criticism from shareholder rights advocates and investors in general. But of course this is China, where such practices are common and as it’s extremely difficult to make informed investment decisions.
Unfortunately, this kind of crafty accounting isn’t just limited to big SOEs, but is also relatively common among the country’s booming private sector. Such creative bookkeeping has created a huge opportunity for western short sellers, who have made millions of dollars over the last 2 years by questioning the financial statements of many Chinese firms listed in New York and Hong Kong. By shining a spotlight on the problem, these short sellers sparked a major confidence crisis against all Chinese firms, which may well be justified.
So, what advice would I give investors based on all of this? My biggest advice would be to generally avoid big Chinese SOEs, whose shares are often also available to foreign buyers via concurrent listings in Hong Kong, New York and on other western stock exchanges. If someone really wants to buy shares of SOEs, I would general advise to look for high growth areas like banking and telecoms, though even in these cases one should still treat financial reports with a certain skepticism.
Among China’s private sector, the case is a bit better, which is why I mostly look at companies in this space. But as the short seller attacks and ensuing confidence crisis show, even these companies are prone to the same creative accounting as their SOE cousins. The big difference is that at the end of the day, these private companies can’t count on government bailouts if they run into trouble. That means the downside risk could be large for investors who don’t understand these companies well enough.
Bottom line: An ongoing major asset sale by major Chinese state-owned companies to hide their losses reflects China’s broader corporate culture of using accounting tricks to mislead investors.
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