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May 2010 Newsletter: 2010 first quarter earnings season is on. Investor, how are you doing?

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question_2 April of 2010 proved to be more difficult for China stocks investors than originally thought. Investors took very seriously the austerity measures the Chinese government put in place, selling-off financials and real estate related stocks the heaviest. The month of April was a highly unusual one: Chinese stocks fell while U.S. equities continued to recover. These two markets have developed a close correlation in the past, a trend that was absent in April.

Statistically speaking, the DJIA (INDEXDJX:.DJI) advanced +1.4% while the Hang Seng Index (INDEXHANGSENG:.HSI) shed –0.6% and the Shanghai Composite Index (SHA:000001) dove –7.7% well under the psychologically important 3,000 level. Chinese stocks listed in the U.S. suffered as well, the China ADR Index tumbled –6.8% for the month. The steep fall in Chinese stock prices was particularly painful at a time when the most important indicators suggested that the global economy is back on track to leave the recession behind. The housing and jobs market improved, manufacturing activity along with improved productivity contributed to a strong first quarter GDP growth, helping U.S. indices to continue to rally. Yet Chinese stocks fell to 2010 record lows. What’s wrong with China, one may ask.

Newsletter_may2010_1

Stocks mentioned in this report: China Eastern Air (NYSE:CEA), China South Air (NYSE:ZNH), China Mobile (NYSE:CHL), China Unicom (NYSE:CHU), China Telecom (NYSE:CHA), Yanzhou Coal (NYSE:YZC), Petrochina (NYSE:PTR), CNOOC Ltd. (NYSE:CEO), Sinopec (NYSE:SNP), Sinopec Shanghai Petchem (NYSE:SHI), Huaneng Power (NYSE:HNP), China Life Insurance (NYSE:LFC), Fushi Copper (NASDAQ:FSIN), UTStarcom (NASDAQ:UTSI).

It all comes down to the break neck growth of the past year when banks pumped liquidity into the system to avoid a significant slowdown. Part of this excess funds went to the housing market accelerating property prices to a dangerous level. According to vital statistics, first quarter fixed asset urban investment rose 26.4% in China while property prices jumped to a record 11.7% in March.

Policy makers reacted swiftly in an effort to avoid property price bubbles: bank reserve ratios were lifted for the third time in 2010, banks were told not to lend for multiple home owners, applications for home loans were made more difficult. The result was a sell-off of property developers first, then banks and finally it became a broad sell-off.

And it wasn’t just the property market that became instable. China’s first quarter GDP growth exceeded the forecasted 11.7% rate by 0.2%, suggesting the economy might overheat as well.

But administrative measures had a cooling effect not limited to the equity markets alone; the April Purchasing managers’ index fell to a six months low of 55.4 from 57 a month before. Any reading above 50 means expansion.

With all that said, investors shouldn’t lose sight of the long term opportunity China represents. While this short term noise is certainly troublesome, investors will have to look though it and focus on what’s driving stock prices: earnings.

From this respect China looks attractive with corporate profits soaring not just in 2010 Q1 but beyond.

Earnings: there has been a handful of Chinese companies delivering earnings in April 2010. Most NYSE listed, large cap companies delivered 2009 full year and or 2010 first quarter earnings. Let’s take a look at them.

Chinese airliners: China Eastern Airlines (NYSE:CEA) and China Southern Airlines (NYSE:ZNH) returned to profitability in 2009 from losses a year before, thanks to lower oil and a high utilization rate. Both companies reported high passenger traffic growth and this trend is here to accelerate for CEA thanks to the Shanghai Expo 2010. China Eastern Airlines (NYSE:CEA) acquired smaller Shanghai Airlines at the end of 2009 and now controls over 50% of the skies over China’s financial center. Both airliners remain highly leveraged, CEA more heavily in debt, while ZNH is going to lose customers to the high speed rail linking Guangzhou to Wuhan and soon Beijing. Nevertheless the economic environment remains favorable for both airliners in the first six months of 2010.

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Chinese telcos reported 2009 full year and 2010 first quarter numbers as well, initiating a rotation within the sector. China Telecom (NYSE:CHA), the best performing Chinese carrier in 2010 up until earnings, fell out of favor giving up the leading position back to China Mobile (NYSE:CHL). Investors continue to shun China Unicom (NYSE:CHU), the second largest mobile carrier after China Mobile (NYSE:CHL).

Based on the latest reports, China Mobile (NYSE:CHL) was able to keep its leading position in both 2G and 3G markets, adding more subscribers in 2009 than the rest of the market combined, while its 2009 and 2010 Q1 financial position improved year-over-year (YoY). This is in sharp contrast to China Unicom (NYSE:CHU), whose 2010 Q1 net income fell –68% on high 3G network development and marketing expenses.

China Telecom (NYSE:CHA) reported a 9% drop in net income for the first quarter of 2010 as high 3G related costs dented into profits. Investors were reminded again that China Telecom (NYSE:CHA) is essentially the largest fixed-line carrier of the country despite a fact that its mobile arm has been growing rapidly.

Energy: Chinese oil companies reported strong 2009 financials with Sinopec (NYSE:SNP) surprising to the upside. Lower oil prices throughout 2009 helped Asia’s largest refiner to enjoy hefty margins and as a result, strong profits.

Chinese oil producers, Petrochina Co. Ltd. (NYSE:PTR) and CNOOC Ltd. (NYSE:CEO), reported net income declines of –10.6% and –33.4% as price of the crude fell sharply from 2008 levels. Chinese oil producers recorded a sales price of $61.6/barrel on average, down –38.2% from 2008. But on the operational level both CNOOC LTd. (NYSE:CEO) and Petrochina (NYSE:PTR) were able to increase production, a trend that stretched over to the first three months of 2010 as well.

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Profitability of Chinese oil producers boils down to this: the higher the crude the more the bottom line. So it’s really the crude production growth that keeps CEO and PTR apart. China’s offshore oil specialist, CNOOC Ltd. (NYSE:CEO), reported +31.9% oil production growth in 2010 Q1 vs. Petrochina’s 2.1% growth rate. As long as price of oil stays over $60/barrel CNOOC Ltd. (NYSE:CEO) looks to be a better bet.

Besides oil companies, Yanzhou Coal (NYSE:YZC) reported an extremely strong 2010 first quarter. The third largest Chinese coal miner reported a +190.8% jump in net income for the first three months of 2010 thanks to higher coal prices and increased production. Yanzhou acquired Australian Felix Resources, increasing production by over 15% for the group. Coal production increased in its domestic mines but the big increase in production came from Australia. Despite strong first quarter operational and financial results, the stock came under pressure lately as Australia is formulating the toughest tax regime for resource players, denting directly into the bottom line of the company.

The largest listed Chinese power producer, Huaneng Power (NYSE:HNP), reported outstanding 2010 Q1 operational and financial report. Total revenues increased 38.7% to $3.58 billion and net income rose 40.9% to $167.8 million. Despite strong results the stock price of the company has been virtually unchanged since January 2010. Part of the problem is lack of confidence that the company will be able to repeat such a strong financial performance. Rapid power generating capacity growth puts pressure on utilization and margins, putting investors on hold for now. On the same time, I personally think HNP is an outstanding investment opportunity for the mi-term given China’s 10% plus GDP growth and a flat stock price in the last five years.

Sinopec Shanghai Petrochemical (NYSE:SHI), the largest Chinese ethylene and propylene maker, swung back to profits in 2009 thanks to lower oil price. Total revenues fell almost 20% but the company reported a 2009 net profit of $234 million vs. a huge net loss of $917.4 million a year before. Going forward the oil price is going to determine the bottom line of the company. When oil is above $60/barrel, Chinese refiners and oil byproduct makers make less than they did a year before.

China Life Insurance (NYSE:LFC), the largest Chinese life insurer, reported a strong 68% income growth for 2009—yet the stock price remained virtually unchanged. Most of the gains are attributed to investment income, an income reliant on the performance of the Shanghai Composite Index. With Chinese indices under pressure in 2010, shares of China Life Insurance (NYSE:LFC) came under pressure.

Nevertheless it is safe to say that most NYSE listed Chinese stocks are sound investments for the mid– to long-term. To play these large cap stocks for the short term one has to time stocks right, depending on the price of oil, performance of the Shanghai Composite Index (SHA:000001) or simply just stay on the sidelines.

NASDAQ listed China plays are different. Some offer higher return with a low level of risk, but some don’t even meet basic investment criteria. Take a look at the two following stories: Fushi Copperweld (NASDAQ:FSIN) and UTStartcom (NYASDAQ:UTSI). Both companies reported 2010 first quarter financials on April 4, Tuesday with remarkably different characteristics. Fushi Copperweld (NASDAQ:FSIN) reported strong revenue and profit growth YoY though profits fell from previous quarter. Nevertheless the company issued a bullish profit outlook for the upcoming quarter. Note that FSIN has been profitable for the past three years despite the economic slowdown in 2009. The company accumulated $82 million in net profits over the last three years. This is in sharp contrast to UTStarcom (NASDAQ:UTSI), a company that was profitable for one out of the last thirteen quarters and accumulated a total loss of approximately $600 million since March 2007.

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My point is that investors have to be extremely cautious when it comes to NASDAQ listed China stocks.

For upcoming earnings releases for May, see table on bottom of page.

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Wish you successful investing,

Blaze Fabry

 

 



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