China's cyclical capital goods makers are facing a downturn. Key types of construction machinery and heavy-duty trucks have posted monthly sales growth of 50%-plus year on year since March. S&P Global Ratings anticipates that, from this very high base, conditions are ripe for a moderate correction in 2021, particularly as stricter emission standards and fleet-replacement cycles work against producers. We expect improved risk management and ample financial headroom will allow our rated entities to come through the down-cycle with little effect on ratings.

Sales of key types of cyclical capital goods sales will likely drop 5%-15% per year in 2021-2022 from record highs in 2020. Replacement buying--a key dynamic of the current upcycle--will largely play out by end-2020. Moreover, new emission standards are set to kick in during the next six to nine months, which will discourage sales.

Rated cyclical capital goods producers have benefited from robust domestic demand. Zoomlion Heavy Industry Science and Technology Co. Ltd. (B+/Positive/--) and Weichai Power Co. Ltd. (BBB/Positive/--) are the only issuers with positive rating outlooks among our Chinese industrial names. Their strengthened balance sheet should help them cope with a likely industry downturn in the coming years. Having said that, Zoomlion's credit profile hinges greatly on its credit policy.

Upcycle Has Been Stronger, And Lasted Longer, Than We Expected

The roots of China's capital goods boom goes back to 2008-2011, when the government unleashed huge economic stimulus following the global financial crisis. The equipment sold during that period entered a replacement upcycle starting late 2016.

Rounds of government stimulus launched since the second half of 2015 further supported this boom. Chinese entities raised more than Chinese renminbi (RMB) 2 trillion through issuance of special purpose bonds over 24 months from the second half of 2015, helping construction equipment makers (see chart 1).

Chart 1

The market had expected sales momentum to gradually lose steam in 2020, following a robust four-year up-cycle. But sales of construction machinery and heavy-duty trucks continued to climb to new highs in the year.

This is likewise due to government stimulus, which has accelerated infrastructure spending, to bolster China's pandemic-struck economy after a dire first quarter. This includes a target of Chinese renmnibi (RMB) 3.75 trillion of local government special-purpose bond issuance in 2020, established at this year's National People's Congress (see " Carmakers Are A Step Behind In Industrial China's COVID Comeback ," published July 17, 2020, on RatingsDirect). The bonds are used to fund infrastructure.

Other policies have also supported the sales boom. For example, Beijing has tightened in recent years its controls on rampant truck overloading. The central government released new national standards in 2016 that cut heavy-duty truck loads by 15%-20%, on average. This has prompted people to buy more trucks, leading to annual heavy-duty truck sales of over 1.1 million units starting in 2017.

The government in 2019 tackled a common practice of lowballing truck loads. Operators would misrepresent the size of their load on toll roads, which reduced their toll charges. The crackdown forced operators to use more trucks to carry smaller loads, prompting fleet expansions over 2019-2020.

Meanwhile, China has been rolling out tighter emission standards that aim to reduce pollution. National emission standard stage IV, which targets diesel off-highway construction machinery, will likely take effect from December 2020. National emission standard VI, which targets diesel heavy-duty trucks, will likely take effect from July 2021. The new models are much more expensive than current ones. This has prompted operators to buy existing models ahead of the implementation of the emission standards, further fueling strong sales.

The government has also committed to decommissioning older-generation vehicles, typically by offering subsidies. We estimate over 1 million heavy-duty trucks are only compliant with national emission standard III. These may be phased out and replaced over the next 12-24 months.

With all these supporting factors, excavator sales reached 236,000 units in 2019, about one-third higher than the previous peak in 2011. January-August 2020 sales grew another 29%, year on year. Excavator sales will likely reach around 300,000 units for the full year, a 25% rise over 2019.

Chart 2

For similar reasons, annual sales of heavy-duty trucks passed 1.1 million units over 2017-2019. We anticipate annual sales to approach 1.5 million units this year, extrapolating from the 37% growth over January-September (see chart 3).

Chart 3

Rated Producers Are Well Prepared For Likely Downturn In 2021

We expect construction machinery and heavy-duty truck sales to gradually decline from 2021, off a record base in 2020. In our view, most of the replacement needs for equipment sold in the past cycle were already met in 2017-2020 (year to date). The implementation of newer emission standards also discourages sales, given the much higher cost to buy next-generation equipment. We also believe notable fleet expansion will be less likely in the next few years, as an already enlarged fleet can meet any incremental demand stemming from moderate growth in construction.

We estimate that China construction machinery sales may decline 5%-15% annually over 2021-2022. We also estimate that China's annual heavy-duty truck sales may drop to 1.1 million-1.3 million units in 2021 from close to 1.5 million units in 2020, before normalizing to annual sales of 900,000-1 million units in 2022 and beyond.

While sales performance may turn out to be much more volatile than our base case assumes, the strengthened balance sheets and risk management of rated producers in recent years will help them weather the impending downcycle, in our view.

Issuers Learned Lessons On Sales Discipline During Last Downturn

During 2009-2012, while downstream demand was favorable, industry dynamics became increasingly unhealthy. Producers competed ferociously for market share and aggressively undercut each other on prices and terms. For an industry heavily reliant on credit-backed sales given high sticker prices, much equipment were sold to customers with tight liquidity. Down payments were small--sometimes zero--and payback terms loose.

Producers recorded these credit sales either as trade receivables (for sales using installment payments) or finance leasing receivables (for sales via captive capital leasing units).

In the case of third-party financing, when the customer pledges purchased machines as collateral for financing, lenders do not have the expertise to repossess, evaluate, and resell the equipment if there is a default. Producers would generally provide guarantees for these types of sales. In the event of default, producers repossess the machines, sell them, and pay back an outstanding guaranteed amount.

When industry conditions soured in 2012-2016, a considerable portion of those credit sales became delinquent. Some producers collected less than half of the receivables due. The off-balance sheet guarantees of major players skyrocketed to close to their on-balance sheet debts in 2012-2014. Entities had to write off huge amounts of bad debt in 2015-2017, which meant many barely broke even in the period.

As producers struggled to clean up their balance sheets, they imposed stricter standards on credit sales. Down payments have increased to 20%-30% of the purchase amount, at a minimum, for most sales since 2014. Companies have adopted heavier checks on customer creditworthiness, squeezing out many prospective low-quality buyers.

Table 1

After this painful clean-up, major producers' outstanding guarantees are down to about one-third of the levels seen in 2012-2014. Strengthened risk controls have also helped producers significantly improve cash flows in recent years. Zoomlion's operating cash flow to revenue ratio reached 15%, on average, in 2016-2019, much higher than the around 5% recorded in 2011-2012. Other major producers recorded similar improvements.

Chart 4

The balance-sheet gains and greater discipline in credit sales have positioned rated construction machinery producers well for a potential downturn. While revenue may decline moderately in the next few years, we anticipate that profit and leverage will be much less volatile than in 2012-2016.

Zoomlion's adjusted debt-to-EBITDA ratio surged to over 20x in 2014 (from 3x in 2012). For this downturn, the company's leverage should stay comfortably below 5x, compared with 3.5x in 2019.

Chart 5

Credit Policy Key To Determining Leverage Trends

The heavy reliance on credit sales still exposes producers to considerable financial risks, compared with other rated capital goods names, given the much higher price tags. High-end construction machinery can cost RMB4 million or higher.

Many customers are small operators with weak balance sheets that rely on financing for purchases. As such, credit sales still make up most of equipment producers' revenue. During the most recent boom, issuers appear to be losing some sales discipline despite their recent hard-earned lessons.

For example, we estimate that Zoomlion financed almost three-quarters of its sales using installment and leasing plans in the first half of 2020. This compares with less than 40% of sales that used captive financing in 2016.

The collection ratio of receivables are heavily dependent on economic and market financing conditions, as well as producers' ability to screen out low-quality customers. If macro conditions deteriorate, the collection risk on producers' receivables and losses in relation to guarantees may rise significantly.

Zoomlion's off-balance-sheet guarantees rose to RMB7.8 billion as of end-June 2020, up from RMB3 billion in 2017 (see chart 5). Though the current level is still much lower than the record of RMB18 billion in 2013, a cautious attitude toward credit sales expansion could safeguard its balance sheet and credit quality, especially in light of a potential industry downturn next year.

Chart 6

Other variables will have less effect on the company's leverage. A five percentage point change in our revenue growth assumption or a one percentage change in the gross margin forecast will lead to only a slight change in the company's debt to EBITDA ratio in 2021 (see table 2).

Table 2

While sales of heavy-duty trucks share the cyclicality and much of the downstream construction exposure with that of construction machinery, investors appear less concerned about the credit quality of heavy-duty truck producers.

Most heavy-duty trucks sold in China are priced RMB200,000–RMB300,000, much lower than construction machinery. Heavy-duty truck sales are also less reliant on financing, and most financing is done by third parties without need for a guarantee from producers.

Engine producers' direct customers are truckmakers, not individual customers. As such, their receivables risks are even lower than heavy-duty truck producers. Weichai Power, the largest heavy-duty truck engine producer and fourth largest heavy-duty truck seller in China, has enjoyed strong operating cash flow over recent years. COVID-19 may lower its cash flow this year as the company takes measures to ease supply-chain strains, but its operating cash flow would still be sufficient to fund capital expenditure.

Chart 7

Weichai's leverage is likely to remain low in the next 12-24 months. The rating on the company will therefore depend more on its market share performance as well as how its overseas businesses may rebound from the pandemic.

Table 3

While Weichai's share of the key heavy-duty truck engine market softened somewhat in the year to date amid product and supply chain adjustments, its share will likely expand by two-three percentage points in 2021-2022 to well over 30%. This strengthening will come as the company bolsters its advantage in next-generation engines, and ramps up sales to new customer Sinotruk Group.

Weichai's overseas subsidiary, KION Group AG, has taken a hit from COVID-19 this year. However, surging global e-commerce and logistics demand should help Kion make a swift recovery. A rebound in overseas business and powertrain business expansion for non-truck segments could help the company cope with a potential downturn in heavy-duty truck sales from 2021.

Related Research

• China's infrastructure Push Plucks E&C Firms From COVID Lows, Sept. 30, 2020
• Bulletin: Record Truck Demand Keeps China's Weichai On Deleveraging Path, Sept. 1, 2020
• Bulletin: Zoomlion's Credit Strength Boosted By Strong Sales, Proposed Share Placement, July 7, 2020
• Research Update: China Construction Machinery Maker Zoomlion Upgraded To 'B+' On Resilient Performance And Deleveraging; Outlook Positive, May 15, 2020