China Inc.'s deleveraging is on pause. S&P Global Ratings' annual survey of the country's top corporates shows a modest erosion in debt-to-earnings levels in 2018. This trend will continue in 2019, in our view. Slowing economic growth and the absence of a significant credit stimulus will weaken cash flows and profit margins. However, more disciplined spending and borrowing should contain the deterioration.

After lowering leverage over 2015-2017, many companies had buffers to weather tougher operating conditions. Nevertheless, financial risk increased across most of the 21 sectors surveyed. And most of the deterioration occurred in the lower-rated sectors, including mining and retail.

We slightly enlarged our survey this year, to 257 companies in total, from 254 in 2018, by adding more sector-leading or high-growth companies into the mix, and also removing several names that no long meet our requirements to be among "China's top companies." In the process, private companies grabbed more share compared to last year, making up 40% of the portfolio.

Weakened Profitability Hurts Debt Serviceability

Earnings growth is waning as China's rate of economic expansion loses momentum. For our surveyed companies, median EBITDA rose 7% in 2018, a sharp fall from 34% growth in 2017. The median EBITDA margin shrank by 65 basis points to 15.6% in 2018. EBIT margin dropped a percentage point to 10.4%.

Narrowing margins are weighing on debt serviceability, which deteriorated in 2018 after improving consecutively over 2016 and 2017. The median debt-to-EBITDA ratio increased to 3.3x from a trough of 3.2x in 2017. Two key cash flow metrics also lost strength. These are interest coverage, which weakened to 6.8x from 7.4x, and funds from operations (FFO) to debt, at 20.8% from 22.7% (see chart 1).

Chart 1

The setbacks in credit metrics were larger for state-owned enterprises (SOEs) than private companies. In addition to the lower profitability, SOEs are less likely to derail production plans even as cash flows weaken, given the indispensable role they play in strategically important industries. We think SOEs are still of vital importance in upgrading the economic structure of China, and the government is promoting various reforms to improve SOE efficiency.

Privately owned enterprises (POEs) continue to demonstrate more capital efficiency, with median returns on capital nearly 2x that of the SOEs. However, POE profit margins tend to be more volatile, because they operate in more competitive industries, such as consumer and retail, and in downstream industries. As such, they have less room to protect themselves from rising raw material prices or lower selling prices (see charts 2 and 3).

Chart 2

Chart 3

Companies in some SOE-concentrated sectors managed to improve debt-servicing capability, including metals, railway/metro,and oil and gas. Many state-owned companies in these sectors are under mandate to reduce their total liabilities to assets. Even companies that benefited from commodity price gains over 2017 and 2018 have been more prudent about expanding.

On the whole, Chinese Inc. continued to be disciplined in capital spending in 2018. Of our 257 surveyed companies, median capital expenditure (capex) to revenue declined to 4.9%, from about 5.1% in 2017 and 5.3% in 2016. This offset weaker profitability and helped contain debt growth.

Sector Ranking Review: More Drift At The Bottom

The credit profiles of our lower-ranked sectors are displaying more volatility, while sectors in the front remain generally stable. Of the 21 sectors we rank in this study, 12 shifted in the rankings: seven moved up and five down; and of these, eight are in the lower-ranked half. While rankings have shuffled, the financial and business risk profiles of the sectors have not changed materially. Two of our scores for business risk profiles were raised. Six financial risk profiles were revised, in which the positive and negative changes were equally split.

Table 1

Mining dropped the most in the overall sector rankings, to 20 from 17, mainly due to slower demand and the effect of tightened environmental rules. Railway and mass-transit (metro) climbed to 13 from 15, given the sector's relative defensiveness in a downcycle. Auto, capital goods, and package express are now facing more difficult market dynamics and macro headwinds.

Stability in the top-half rankings suggests more resilience for sectors with strategic importance, or promising business potential as China transitions to a more consumer-driven economic structure. We note that companies in the top-five sectors are mostly SOEs, which benefit from high entry barriers. In the meantime, "new economy" companies, such as technology services and pharmaceuticals, are also better able to manage through the downturn due to their low leverage and strong financial position.

Our rankings might not be able to capture all nuanced dynamics in certain sectors. For example, technology hardware is increasingly exposed to U.S.-China trade disputes, yet market leaders such as Huawei Investment & Holding Co. Ltd. and Foxconn Industrial Internet Co. Ltd. have maintained their decent business positions. We expect continued divergence as winners emerge in a maturing market.

The median business risk profile for our 21 sectors is fair, and median financial risk profile is significant (see table 3 in the appendix). This financial risk profile is one category lower in 2018, and echoes more challenging credit conditions and economic prospects. These metrics map the entire sampled portfolio to an anchor of 'bb', lower than 'bb+' last year, and 'bbb/bbb-' in 2016.

In an exact comparison against last year's portfolio, 84% of the business profiles and 78% of the financial risk profiles remain unchanged. We revised around 22% of the profiles, less than that of 25% in 2017.

Among the newly added companies, 64% have a financial risk profiles of minimal or modest, while 86% have business risk profile of fair or higher. This is because we incorporate firms that represent "top players" in each sector.

Chart 4

Table 2

Structural Reform Needed To Restore Deleveraging

We expect corporate leverage to continue to creep higher. The issue is not simply a matter of slowing growth, which is inevitable as the economy matures. Rather, it reflects stagnant profitability and especially low efficiency of some SOEs. In our view, an improvement can only be brought about through structural reform. This includes more substantive "mixed-ownership" reform of state-controlled entities, and more market-oriented exits of inefficient or unprofitable ("zombie") companies.

Who's Who In The Top Corporates?

In total, 257 entities from 21 industry sectors are included in our 2019 China's top corporates study, up from 254 entities included in last year's survey. The 14 newly included companies include three in consumers, two in metals, and two in technology hardware. The changes reflect our expectation that "new economy" areas such as services, consumers, and technology are China's growth engine.

The portfolio is comprised of more unrated names than rated ones. About 63% of the sampled companies are not rated by S&P Global Ratings, similar to last year.

A good representation of China Inc.

In general, we believe the selected constituents meaningfully represent the financial status of China's top companies. The top 257 constituents together make up 18.4% of the total debt of nonfinancial enterprises as of year-end 2018.

We also seek a balance across sectors. Almost all represented sectors have at least five companies. The only exception is oil and gas, in which four entities are included in the sample.

Consumers remain the largest industry sector in our survey in terms of number of entities, followed by capital goods, and utilities. Each of these sectors makes up more than or very close to 10% of the sample size (see charts 5 and 6).

The top five sectors--railway and metro, utilities, real estate, oil and gas, and engineering and construction--account for about 57% of total assets. Regarding gross debt, railway and metro, utilities, and real estate are leading the sampled sections.

Chart 5

Chart 6

China State Railway Group (China Railway), which changed its name from China Railway Corp. (CRC) and restructured as an SOE in June 2019, remains the largest borrower in our study this year--accounting for 18% of the sample's gross debt.

As we did in our previous study, we look at the median rather than average metrics to remove the impact of company size and outliers.

SOEs' dominance has dropped moderately

Over the years, the portfolio's SOE representation has been declining. In 2018 it further decreased to about 60%, from 63%. Only four of the 14 new joiners are SOEs.

Meanwhile, SOEs will continue to dominate sectors crucial to China's national interests, which include infrastructure (telecommunication, transport, railway and metro), energy (oil and gas, utilities, mining), and engineering and construction. SOEs in these sectors play a role in supporting the government's economic policies and fulfilling social responsibilities. At the same time, their financial positions are fairly stable due to low funding cost from preferential lending, and policy initiatives such as debt-to-equity swaps and mixed-ownership reforms to reduce heavy reliance on debt funded expansions. Package express is the only sector in our portfolio that has no SOE constituents.

Appendix

Table 3

How We Assess Business And Financial Risk Profiles

We analyze the credit profiles of China's top corporates by assessing their business risk and financial risk profiles (see table 3).

These factors are two key components in determining the anchor rating (see chart 7). In our analysis, we do not consider the rating modifiers (including liquidity, capital structure, among other factors) and group or government support. For some companies, extraordinary support from government or the parent group often provides a meaningful uplift to the rating.

Chart 7

In calculating the total debt for the sample, we typically have assumed a "haircut" of 25% for accessible cash unless there is specific information to use a different amount. The residual cash is used to offset gross debt. This treatment can have a meaningful impact on the financial risks assessment as our portfolio's accessible cash is nearly 22.7% of total reported gross debt in 2018.

Chart 8

Chart 9

Chart 10