Sunday, May 2, 2010

>EUROPEAN CHAMBER: Overcapacity in China

SUMMARY: Overcapacity is a blight on China’s industrial landscape, affecting dozens of industries and wreaking far-reaching damage on the global economy in general, and China’s economic growth in particular. Yet it is a strangely under-studied and seldom-examined phenomenon.

In the Summer and Autumn of 2009, the European Chamber and Roland Berger Strategy Consultants set out to examine to what extent overcapacity harms China’s economic development and contributes to rising trade tensions, and to provide suggestions on how this increasingly urgent problem could be addressed.

As will be outlined below, the overcapacity problem in China is by no means a new one. But its pervasive influence has become ever more prominent – and its effects on both the Chinese and international economies have become ever more destructive – in light of the global economic crisis that still grips world markets.

The crisis has throttled demand for exports from China at a time when even more investment, in the form of the Chinese government’s massive stimulus package, is being pumped into building new plants and adding unnecessary capacity. As a result, the problem is actually getting worse in many industries.

This in turn is having a severe effect on the Chinese economy. The extremely low utilisation rates in industries producing at overcapacity go hand-in-glove with resource waste. Companies are cutting corners, often disregarding environmental as well as health and safety standards and circumventing labour and social laws. Companies in overcapacity industries suffer from low profits and lack sufficient cash for R&D projects, leading to less innovation. Meanwhile, as banks bankroll the addition of unnecessary capacity in certain industries, the threat from non-performing loans (NPLs) is growing. At the same time, the global impact already can be felt in the form of growing trade tensions. Since trade frictions hamper supply chains, this is a major threat to globalisation’s positive effects.

The economic crisis has, then, given added impetus to the drive to find solutions to this key issue. It is precisely for this reason that the European Chamber, along with Roland Berger Strategy Consultants, produced this report.

The goal of the study is to discover why and how overcapacity has come to affect some of China’s key industries and, armed with this knowledge, to provide recommendations and suggestions on how the problem can be brought under control.

The study is divided into four sections. The first examines the emergence of China’s current overcapacity problem, the policies and politics that underpin it, and the reasons why the problem has worsened as a result of China’s stimulus package.

In the second section, the study will look at how this problem is affecting several key industries, and ask what are the specific drivers of overcapacity in these sectors. The industries examined in detail are:
• Steel
• Aluminium
• Cement
• Chemicals
• Refining
• Wind Power Equipment

Study findings show that overcapacity is driven by a small number of key recurring factors, among them:
1. High savings particularly driven by retained earnings from state-owned enterprises (SOEs)
2. Collapse of demand in export markets, primarily in the United States
3. Low domestic consumption
4. Weak enforcement of regulations
5. Low input prices due to government policies
6. Too low cost of capital in China
7. Fiscal system encourages local government to attract excessive investment
8. Local protectionism
9. Inexpensive and widespread availability of technology
10. Regionalism driving industrial fragmentation
11. Environmental, Health and Safety standards and laws not fully implemented
12. Philosophy of market share vs. profitability

The third section of the study then turns to the broader impact of China’s overcapacity – how it negatively affects the growth of China’s economy and how it also contributes directly to rising global trade frictions.

Finally, based on the findings of the first three sections the study offers a number of
recommendations on how overcapacity can be reduced by shifting policy priorities away
from investment- and export-oriented growth and focusing on more balanced patterns of
growth, driven by domestic consumption and a vibrant service sector. This policy shift is
the key to curbing industrial overcapacity.


It is normal for developing economies to go through a period of rapid industrialisation. China’s economy today follows a pattern already traced by the economies of Japan, Korea and Taiwan in the late 20th century. China’s concentrated focus on developing its heavy industry has led to overcapacity in this sector. This overcapacity can mainly be attributed to three factors:

Rapid urbanisation: 1% of China’s population moves each year from rural areas into urban ones. The major housing development that results from this migration creates massive domestic demand for construction machinery, building materials, steel, cement, and chemical products.

High savings: The Chinese have a high savings rate, partly because of the lack of social security, but also because of the limited investment choices available to households, stringent capital controls, and policies that systematically transfer income from the household sector to producers, thus exacerbating the gap between production and consumption. This abundance of capital has led to abundant domestic funding and low interest rates.

Low input prices: Input prices are low mostly because government policies stimulate the secondary sector, especially heavy industry.



HDFC Bank reported earnings at Rs. 8.4 bn for F4Q10: This was marginally lower than our estimate of Rs. 8.6 bn – driven by a small treasury loss. The core earnings progression was very strong (pickup in loan growth, CASA, NIMs with reduction in credit costs). In fact, if we look at (PBT-capital gains) per share, the core earnings almost doubled YoY in F4Q10.

The bank is in an extremely sweet spot: It is entering a new credit cycle with significant competitive advantages. New NPL formation has decreased to the lowest level in years and it has no legacy NPL book – implying it can potentially run with lower than normalized credit costs. Moreover, its competitors are still trying to work out legacy issues – implying less competition and hence better returns. Moreover, with a Tier 1 ratio of 13.3%, the bank is extremely well capitalized to grow rapidly.

We are building in 30% CAGR in EPS over the next two years: We have not changed our headline earnings much, but we have improved the quality of earnings in our estimates (took down capital gains to zero).

Potential upside to earnings could come from better
asset growth (we are building in 26% loan growth for the next two years) and lower credit costs (we are at 125 bps but could be lower if last quarter’s NPL formation trend continues).

At 22x F2011e earnings, multiples are not cheap but given the outlook, we think they can be
sustained: On PEG, the stock is trading below its long-term average. Given the strong growth outlook, we can see the bank continuing to trade at current multiples. With earnings growing meaningfully, this could cause the stock to deliver good returns. Our new target price is
Rs. 2400 (implying 20.8x on F2012e earnings).

To read the full report: HDFC BANK

>Bharat Heavy Electricals Limited (ICICI DIRECT)

A dominant industry position, wide product portfolio and strong relationship with government agencies make Bharat Heavy Electricals (Bhel) the prime beneficiary of aggressive power capacity addition targets set for the XIth and XIIth plans (~178 GW). With Bhel enjoying 54% share in XIth Plan power orders and order book size of Rs 1,43,800 crore (FY10), the company enjoys strong sales visibility over the next three or four years. However, we expect new order flows to slow down over the next two or three years as 45% of XIIth plan orders have already been placed. We initiate coverage on the stock with ADD rating.

Strong sales visibility; robust private sector order inflows in FY10
With an order book size of Rs 1,43,800 crore in FY10 and enhanced execution capabilities (capacity increased by 50% in FY08-10 to 15 GW), we estimate robust growth of revenues at 22% CAGR in FY10-12E to Rs 49,873 crore. In FY10, Bhel secured orders worth 14.7 GW from the private sector (not a conventional stronghold for the company), contributing to the order book growth (+7.3%). In our view, the recent success in the private sector bodes well for Bhel as the sector will account for ~50% of XIIth Plan power orders (vs. 14% in the XIth Plan). Lastly,
Bhel is well positioned to capture supercritical orders (~60% in XII plan) due to its technological partnerships, JVs with state electricity boards and its first mover advantage in the supercritical segment.

Limited scope to grow power sector order book
Nevertheless, we estimate Bhel’s order book will peak in FY11E to Rs 155,339 crore as nearly 45% of the power equipment ordering for the XIIth Plan is already complete (54% share of Bhel). Assuming a nearly 55% share of Bhel in XIIth Plan orders, we estimate 29 GW order inflows in the power segment in FY11E-13E. In our view, Bhel will find it tough to significantly expand its margins in FY11E-12E due to the continued rise of commodity prices, execution of higher proportion of supercritical orders (higher import content) and competitive pressures.

At the CMP of Rs 2,500, the stock is trading at a P/E of 22.8x in FY11E and 19.6x in FY12E. We have valued Bhel using the DCF methodology due to the long execution period associated with its projects (~four years). Despite strong sales visibility over the next three or four years, new order growth and margins are likely to come under pressure. We are initiating coverage on the stock with an ADD rating.

To read the full report: BHEL


Company Background: Hyderabad Industries Limited (HIL) is a flagship company of the C.K.Birla group of companies, incorporated on 17 June 1946. HIL's key product range include Fibre Cement Roofing Sheets sold under the brand name CHARMINAR, Autoclaved Aerated Concrete Blocks
and Panels called AEROCON, and Calcium Silicate Insulation Product (thermal insulation) called HYSIL. The company is one of the leading manufacturers of Fibre Cement Sheets in India with a market share of about 20.5%. After starting out as a roofing manufacturing company, HIL has evolved into a multi product, green building products organization. HIL owns a 15% stake in a
property at New Delhi, which cost the company Rs. 8.46 cr and this property, is currently given on lease.

Building products division:

This segment consists of Fibre Cement Corrugated Sheets, Flat Products, Autoclaved Aerated Concrete Blocks (Light Weight Bricks)
and Aerocon Panels.

(1) Fiber Cement Roofing Sheets
Fibre Cement Sheet is the main product accounting for about 85% of company's sales. In FY10, HIL set up a new production line at Vijayawada with a capacity of 90,000 MT per annum taking the total capacity to 8,54,500 MT per annum. This capacity came on stream in July 2009. HIL has a 20.5% market share in this segment, followed by players like Visaka Industries (15% market share), Ramco Industries (13%) and Everest Industries (13%). Other players also include Swastik (9%), Utkal (9%) and Sahyadri Industries (5%). Key raw material is Chrysotile (Asbestos Fibre), which constitutes 45% to 50% of the total raw material costs and is 100% imported, followed by OPC (Ordinary Portland Cement), flyash and wood pulp. Overall, to make 100 kgs of fiber cement roofing sheet, 80 kgs of input are required (43 kg of cement, 8 kg of asbestos fibre, 28 kg of flyash and the balance is dry waste, pulp etc). The remaining is water weight gained during the manufacturing process.

The roofing industry is largely a commoditized business. While this product started out as an industrial product, the rapid spread of players, increase in production and increase in the number of access points has made this into a retail product. There is limited brand value or premium in the roofing business. HIL is a leader in this segment and thus its brand Charminar commands a band premium of between 2-4%. 80% of the sales come from rural markets with the balance 20% coming from the industrial and other segments (warehouses, poultry, urban slums etc).

(2) Aerocon Panels (Green product)
HIL also manufactures various boards and panels that find application in housing, partitioning, interiors etc. HIL also supplies these panels to the army. HIL is one the largest players in this segment and has developed a patented process to manufacture the same. The boards and panels contribute about 3% to HIL’s topline. Any product that replaces wood (in this case plywood) or saves on the consumption of energy (energy efficient) is termed as a ‘Green product.’ Thus, Aerocon panels fall into this category. HIL has a capacity to produce 4,60,000 numbers of these panels. The company is currently running at about 70% capacity utilization. The plants are
located at Thimmapur (AP) and Faridabad (Haryana). The raw materials for this product includes flat cement sheets, fillers etc. In terms of competitors, Everest Industries Ltd is also present in the boards and panels segment. However, HIL is a market leader.

While panels contribute a negligible amount to topline, HIL is quite excited about the prospects of the use of panels in the low cost housing market. HIL is working on project with the AP Government to make a house out of these panels that could cost less than Rs. 1 lakh. HIL is currently working on a 40-house project and any breakthrough on this front could be beneficial for the company. Currently, HIL is running 2 shifts and thus can increase capacity from the current 4,60,000 numbers by 33% by running a third shift, if need be.

To read the full report: HIL

>3G Update: Pan-India 3G collections cross USD8.5bn (HSBC)

The DoT overall completed 104 rounds of 3G auctions at the end of Day 18. The price at the end of Day 18 increased c1.7% to USD8.6bn, compared to USD8.4bn on Day 17. The USD8.6bn price is c3.6% lower than the government’s new estimates of USD8.9bn from the 3G auctions alone and is c14.2% higher than our fair value estimates of USD7.5bn for 3G auctions.

We note that final 3G auction collections could be lower than USD8.6bn, as there is a possibility that the government might not find takers for all the slots available in some circles (particularly in few C category circles). As of now, we are calculating Pan-India collections assuming that all the slots are taken up. Given the limited details, we do not have complete clarity on demand in all circles.

We estimate fair value for pan-India 3G spectrum at cUSD7.5bn, using a bottom-up approach, and a hurdle rate of 11%. While the bids have crossed our fair value estimates, we highlight that our calculations are based on circle specific business case and the returns may differ depending on the operators’ current subscriber profile. Further, operators winning across key markets may stand with a relatively better business case. Our fair value calculation assumes a gradual adoption to 3G. However, availability of 3G handsets that allow voice/video features in the range of USD50-100 could be an upside to our business case. (Refer figure 1).

Mumbai and Delhi continue to see aggressive bidding, both closing over 4.5x the reserve price at the end of Day 18. Separately, fifteen circles including all B circles, Andhra Pradesh, Gujarat, Assam, Bihar, North East, Orissa, and Kolkata closed above our fair value estimates, whereas 14 circles ended with negative demand. We remain cautious on the sector, and we view consolidation as a positive catalyst, as 3G revenues appear unlikely to be material, at least in the next 12 months. However, we note that the format of consolidation will be important, and that if incremental policies allow new entrants to merge with each other, the competitive landscape may deteriorate further.

We remain cautious on the sector, and we view consolidation as a positive catalyst, as 3G revenues appear unlikely to be material, at least in the next 12 months. However, we note that the format of consolidation will be important, and that if incremental policies allow new entrants to merge with each other, the competitive landscape may deteriorate further.

To read the full report: 3G UPDATE