China's industrial landscape remains marked by macro headwinds and overcapacity. Most companies are adjusting to these conditions by various means such as cutting costs, selecting projects more stringently, switching up their product mixes, or growing export sales.

Policy is another key factor shaping the sector's outlook. The central government's tighter control on public-private-partnership (PPP) projects is positive for engineering and construction (E&C) players, given likely lower capital spending and faster working capital turnover over the next three to five years. Equipment makers supplying the coal-fired power sector, on the other hand, will see further momentum on continued policy support.

The key industrial sectors we cover in China are auto and auto parts, E&C, and capital goods. S&P Global Ratings believes most of the rated industrials should be able to absorb industry volatility even as external conditions change, though some could see thinning financial buffers.

Auto: Price War To Persist Amid Moderating Sales Growth

The rated auto OEMs are industry leaders and should be able to steer past the wreckage of price wars and oversupply in domestic light vehicle market. We expect financial metrics to be largely steady or modestly improve despite the industry headwinds.

Our estimates put this year's expansion of domestic light vehicle sales in China at 0%-2%. This follows a stronger-than-expected increase of 5.6% last year, in part due to major discounts and promotions. We view price wars as the new norm, with carmakers eager to expand volume and take share amid overcapacity. A few auto OEMs have already slashed prices in January 2024 to stimulate sales ahead of the Chinese New Year in early February.

Domestic auto OEMs are more optimistic than us, targeting ambitious growth (see table 1). Also embedded in their targets is the expectation for higher exports, which offer additional growth opportunities and higher margin.

Table 1

We think China's export of passenger vehicles could hit a speed bump in 2024, following an increase of 66% to 4.4 million units last year. Growth in key export destinations such as Russia is set to slow, after Chinese carmakers swiftly occupied the market post the pull-out of international players.

Chinese auto makers including BYD (nonrated) and SAIC Motor (nonrated) are speeding up the establishment of production facilities overseas. This is necessary to avoid rising trade hurdles. Nonetheless, the process will take time and hence their overseas exposure will be small at this stage.

Meanwhile, domestic sales of electric vehicles (EV) look set to grow by 15%-20% in 2024-2025, lifting EV penetration to 35%-40%. With the launch of new and upgraded models at short intervals and the entrance of new players, the competitive landscape is ever-shifting in China's EV market. BYD and Tesla are the best EV sellers in the country but will have to stay vigilant to safeguard their market share.

Chart 1

Our quick credit take on rated automakers and suppliers: 

Our negative rating outlook on Geely Auto and Zhejiang Geely reflects uncertainty that they can restore margins over the next 12-24 months.  As the two most aggressive players in electrification in the rated universe, their margins eroded the most relative to peers in 2022-2023. Our base case factors in a slight improvement in their EBITDA margins over 2024 (see chart 2). This is despite rising EV sales and takes into consideration of higher operating efficiency, lower battery cost, and continuous improvement in product portfolio. That said, risk is tilted toward the downside given the demand uncertainty and price pressure.

Chart 2

We see reasonable rating headroom for China FAW and Beijing Auto.  The two companies have been slower in electrification and their profitability has been steadier. We expect margins to slightly contract in 2024 on modestly higher EV sales. Yet, mild volume growth and stable capital spending will support positive free operating cash flows and steady leverage during the period. Their EV progress will have growing importance on their market position and business strength over the next three to five years.

Table 2

Auto suppliers: 

Contemporary Amperex Technology will further strengthen its credit profile in 2024.  Growing battery demand and better economies of scale will underpin a moderate improvement in the company's profitability, despite intensifying market competition in China. Increasing operating cash flow and steady capital expenditure should deepen the company's net cash position.

Johnson Electric will stay in good financial shape.  Competitive products, continued efficiency gain, and disciplined capital spending will buttress sustained positive free operating cash flow and low leverage for Johnson Electric.

Yanfeng International's tactical structure changes will help it manage tough industry conditions.  The company's consolidation of the seating and safety business from its direct parent has boosted the rating buffer. This is thanks to improved product offerings, enlarged operating scale and stronger balance sheet of the combined business, leaving the company sufficient financial room to absorb adversities as needed.

Table 3

Engineering And Construction: Slower Top Line But Margins Will Hold

A number of factors will weigh on topline growth in 2024 for rated E&C firms.

China's infrastructure investment is likely to moderate this year, after rising 8.2% in 2023, in view of more disciplined local government spending. Investment in PPP projects will become more measured because Beijing has tightened supervision to rein in high leverage at local governments. The State Council will review PPP projects on an individual basis and only user-paid projects with investment returns will be approved. This will lead to shrinking new contracts from PPP projects, which rated issuers in general have 10%-20% revenue exposure to.

Demand for housing construction is unlikely to meaningfully improve, given the weak sentiment in the property market. Our rated E&C companies also obtain 4%-14% of their revenue from property development and the segment may continue to downsize.

New orders have already slowed down over the past 12-18 months, which points to moderating expansions for rated E&C companies. Their order backlog remain healthy, however, normally at over 3x annual revenue, and this provides good visibility for their revenue growth in the next one to two years.

Chart 3

Chart 4

We expect stable or slightly improving EBITDA margins for rated E&C companies in 2024, with more stringent cost controls. Debt growth is likely to decelerate in the next few years, partly because exposure will gradually decline to investment-linked projects which require heavy upfront spending. Overall, we expect healthy earnings growth to support stable credit profiles for most of these firms.

One vulnerability is cash collection, which is clouded by worsening funding conditions at some of the project owners, including the local governments. Downside risk will heighten if receivables turnover days materially lengthen without signs of improvement.

Chart 5

Most rated E&C companies have sufficient financial headroom and will maintain stable leverage ratios in 2024. We typically use the EBITDA interest coverage ratio to assess the financial risk of these E&C companies. This considers their refinancing record and wide funding channels thanks to their state-owned enterprise status.

Chart 6

Our quick credit take on selected rated E&C entities: 

Power Construction Corp. of China and Beijing Construction Engineering Group have tight rating headroom.  Our scenario analysis indicates that they will likely breach the downgrade triggers if EBITDA margins underperform our base case by 0.5-1.0 percentage points in 2023-2024. Such downside pressure will also heighten if their working capital turnover is materially slower than our expectation, due to prolonged cash collection cycle.

China State Construction International has been solidifying its balance sheet and cash flows.  Its continuous shift to government targeted repurchase projects with much shorter receivable cycles in mainland China should help the company further deleverage over the next 12 months.

Shanghai Construction Group is on track to restore its financial strength.  It has recovered notably from pandemic-related disruptions to operations, posting 21% year-on-year revenue growth in the first nine months in 2023. Profit growth and disciplined financial management will beef up its financial metrics in 2024.

Table 4

Capital Goods: Earnings Growth And Investment Appetite Drive Ratings

Following a reopening-led recovery last year, rated capital goods names are coming into the new year in better shape. Profit growth and investment discipline will drive ratings.

Coal-fired power equipment will see buoyant demand in 2024, thanks to government policy support. To strengthen the national power security and ensure adequate supply in peak seasons, the Chinese government accelerated project approvals since 2022 and guided to start construction of 165 gigawatts (GW) coal-fired power capacity in 2022-2023. This has led to surging new orders for coal-fired power equipment.

The government also aims to install at least 80 GW of coal-fired power capacity this year, compared with 45 GW in 2022 and 58 GW in 2023. This implies meaningful growth opportunities for equipment producers over the next 12 months.

As a leading thermal power equipment supplier, Shanghai Electric Holdings Group Co. Ltd. will benefit from the industry's tailwinds.  We anticipate its revenue will grow by mid-to-high single-digits over the next two years, riding on solid order backlogs for its key products. Its profitability should also gradually improve with the company continuing to optimize its business mix.

In our view, Shanghai Electric has been moving away from debt-funded expansion and reducing its investment appetite. More cautious capital spending, together with profit growth, should improve cash flows and lower leverage over the next 12-24 months. We expect the company's ratio of debt to EBITDA to trend down to 7.0x-8.0x in 2024 from our projected 8.0x-9.0x in 2023.

Demand for railway equipment should find support from passenger ridership, which should stay strong during the year, after more than doubled in 2023 year-on-year post the removal of pandemic-related travel restrictions.

Volatility would emerge, however, if China State Railway Group Co. Ltd. (CSRG), the national railway operator, doesn't make up for the under investment during the COVID period. This is especially the case after CSRG unveiled its 2024 priority, in which it only targets to launch over 1,000 kilometers of new railway lines, compared with the 3,637 kilometers in 2023.

That said, improving maintenance needs and gradual expansion of its new industry business should support CRRC Corp. Ltd. to deliver steady revenue in 2024.  Solid operating profit and prudent capital spending should help the company to continue to generate positive free operating cash flow and maintain a net cash position over the next one to two years.

Table 5

Related Research

• Economic Research: China Deflation Risks Hinge On Growth Mix, Jan. 29, 2024
• China Policy Shift May Saddle LGFVs With A Fresh Problem: Stranded Assets, Jan. 25, 2024
• SLIDES: China Engineering & Construction To Ride Through The Speed Bump, Jan. 25, 2024