China’s Corporate Earnings Smell Like Trouble

by Dan Burrows | August 17, 2012 12:53 pm

Will China come in for a hard landing or a soft one? It’s perhaps the burning question for investors the world over.

Unfortunately, the macroeconomic data are troubling but inconclusive — and so are earnings results from corporations in the world’s second-biggest national economy.

After the debt crisis in Europe[1], the greatest source of macroeconomic anxiety is China. Its economy is slowing rapidly, partly because Europe is China’s biggest trading partner and partly because the Chinese government is trying to cool an economy overheated by its own massive stimulus operations.

China emerged from the recession as the engine of the global economy. But now even the suspect official figures are painting a worrisome picture[2]. Second-quarter gross domestic product came in at just 7.6%, the weakest reading since the world went to hell in 2009, and a far cry from the double-digit rates of the preceding years.

Imports and exports have been declining, and industrial production stands at just 9.2% — an enviable figure for most economies but not nearly enough for China. Indeed, that’s the worst reading since May 2009.

Meanwhile, U.S. markets might be having a strong year, but the fact that Chinese equities aren’t participating in global market gains casts doubt on whether our own rally is sustainable. The S&P 500 is up 11% in 2012, but the Shanghai Composite is off more than 2%.

We know that from the top down, the data is troubling. But what about from the bottom up? Recent earnings reports from some key Chinese corporations confirm the deteriorating fundamentals.

China Construction Bank, which most U.S. investors hold through the popular iShares FTSE China 25 Index (NYSE:FXI[3]) exchange-traded fund, is flashing warnings signs with its quarterly results. The world’s No. 2 lender and second-largest bank by market capitalization is seeing a slowdown in loan growth and a deterioration in credit quality.

The manufacturing, retail and real estate sectors are borrowing less — and having a harder time making payments. That’s part and parcel of China trying to cool overheated growth and inflation, but the bank’s results show just how precarious that balance can be. As the economy slows, credit quality naturally follows. Provisions for loan losses then follow suit, and the balance sheet becomes less productive.

If Chinese stewards really can engineer a soft landing, you’ll see it in China Construction Bank’s balance sheet.

In other worrisome news, the highly sensitive travel and leisure sector is showing no signs of a rebound. Home Inns & Hotel Management (NASDAQ:HMIN[4]), China’s biggest budget hotel chain, posted second-quarter net income $5.7 million, well short of analysts’ estimate for $12.4 million. The second-biggest hotel-chain operator, 7 Days Group (NYSE:SVN[5]), also missed forecasts, posting profit of $8.7 million against Wall Street estimates for $10 million.

Meanwhile, in what has become all-too-common with U.S. corporate earnings, jobs recruiter 51Job (NASDAQ:JOBS[6]) beat quarterly income and revenue estimates, but only because expectations were so low the company could trip over them[7].

More telling was management commentary.

“Amid increased economic uncertainty in China, we observed softer market demand for our recruitment services in the second quarter,” CEO Rick Yan said in a media release.

Employers remain cautious about hiring, he added.

Sound familiar?

True, it hasn’t been all bad news on the Chinese corporate earnings front. Baidu (NASDAQ:BIDU[8]) — the Google (NASDAQ:GOOG[9]) of China — said second-quarter profit jumped 70% to beat Street estimates. It raised its third-quarter revenue estimate, too.

But Baidu is hardly a proxy for China’s real economy, which is largely in the hands of the state. And that’s where the earnings picture is particularly ugly.

Profits at state-owned companies declined 12% in the first half of 2012, according to official figures. A comparable decline among companies in the S&P 500 would be downright recessionary in the U.S.┬áIt’s only because China’s GDP still is running in the mid- to high-single digits that it can absorb such a slowdown.

If this is what a soft landing looks like, the world surely can’t stand to see a hard one.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

Endnotes:
  1. debt crisis in Europe: http://investorplace.com/hot-topics/europe-in-crisis/
  2. painting a worrisome picture: http://investorplace.com/2012/08/chinas-weak-data-could-still-capture-gold/
  3. FXI: http://studio-5.financialcontent.com/investplace/quote?Symbol=FXI
  4. HMIN: http://studio-5.financialcontent.com/investplace/quote?Symbol=HMIN
  5. SVN: http://studio-5.financialcontent.com/investplace/quote?Symbol=SVN
  6. JOBS: http://studio-5.financialcontent.com/investplace/quote?Symbol=JOBS
  7. expectations were so low the company could trip over them: http://investorplace.com/2012/05/why-earnings-beats-are-never-a-surprise/
  8. BIDU: http://studio-5.financialcontent.com/investplace/quote?Symbol=BIDU
  9. GOOG: http://studio-5.financialcontent.com/investplace/quote?Symbol=GOOG

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