The Deloitte Research Monthly Report
18 September 2016
Anxiety ahead of next FOMC Meeting
All eyes are on the US Federal Reserve right now. Although the global financial markets have pretty much discounted higher interest rates in the US in the medium term, they could still be rattled by the pace of the Fed’s future tightening. If the Federal Reserve does not raise interest rates in a measured fashion, there will be disruptions or volatilities such as a drastic change in sentiment in emerging markets (It is worth remembering the massive sell-offs in the wake of the Fed’s tapering in 2014). In many countries (South Africa and Brazil for example) the real economy has suffered on account of capital outflows. The wave of sell-offs that we have seen in the US market of late is a perfect example of such jitters. Indeed, in light of the lofty valuations of so-called risky assets (mainly stocks and bonds) in the developed world, the market has adopted a sceptical view of central banks.
Meanwhile, the message from the G20 meet (held in Hangzhou in early September 2016) is that fiscal policy must play a greater role in rebalancing the economy, implicitly rejecting the effectiveness of monetary policy as a tool. At this juncture, our baseline scenario is that the Fed will hike rates at least once before 2017 (most likely in December 2016). According to the Federal Reserve, Fed Fund Rates are expected to hit 3% by 2019, suggesting that short term interest rates will be raised at least 10 times. The risk lies in the divergence of major central banks. Other than the Fed, other central banks are clearly in easing mode (e.g., European Central Bank, Bank of England and Bank of Japan). Even the People’s Bank of China seems to be stepping up its easing, but without proclaiming it.
A study on Beijing’s overheated property market suggests that such a rapid increase in prices within a matter of months was largely caused by monetary manipulation. In other words, the PBOC injected massive liquidity into the economy through various channels such as policy banks etc. and because the investment outlook has been weak in China due to over-capacity concerns, the bulk of such newly created credit was redirected into the housing market. Responding to signs of speculation in the property market, Ma Jun, chief economist of the PBOC, voiced his concern. He warned that excess liquidity could cause severe dislocations, and that the government should only intervene in order to prevent property bubbles from becoming bigger and to avoid excessive credit in the housing sector (at the expense of the real economy). Unlike the stock market where there are about 100 million retail investors, intervening in the property market would have far greater impact on the economy and consumer psyche. As such, we very much doubt that policymakers would prick “bubbles” in a pre-emptive fashion. In fact, if the GDP growth target stays around 6.5%, consumers will be expected to take on more debt if firms and local governments are to reduce their leverage. That is why the housing markets in the so-called big four first tier cities of China (Beijing, Shanghai, Guangzhou and Shenzhen) were able stay buoyant for such a long time despite the very high property prices.
So what are the risks? In our view, markets could be rattled if the Fed raises its rates more than once this year (next FOMC meeting will be on Sept 20 and 21). Risk aversion is likely to bolster the dollar’s strength, which will in turn put a certain downward pressure upon the RMB. If China wants to deplete its reserves (still at a very high level of about $3.2trn) in order to defend the RMB exchange rate, it could tighten liquidity conditions domestically, which will weigh heavily on asset markets and the housing market (the latter is clearly being supported by the flood of liquidity). The best policy is to accept a further slide of the RMB (we forecast USD/CNY close at 7.0 in 2016) and at the same time to bring down the GDP growth rate.
Consumption stays buoyant amid lackluster retail subsectors
According to the Chinese National Bureau of Statistics, total retail sales of consumer goods reached RMB21,050.5 billion in the first 8 months of 2016, a year-on-year increase of 10.3 percent. However, the national online retail sales of goods and services skyrocketed 26.7 percent from January to June to top RMB3,021 billion, accounting for 11.6 percent of total retail sales of consumer goods. Another positive sign was that China's consumer confidence index jumped to 106.8 in July for the second time in two months, showing further proof of the relative resilience of China's consumer market.
- Growth at traditional retail enterprises continues to slide.
Deloitte Research selected 56 A-share listed companies as their research targets and looked at their sales revenues and net profit growth in the first half of the year for the last three years. Our findings showed that between 2014 and 2016, more than half of these companies experienced negative revenue growth and the downward trend is intensifying this year. While the trend of net profit conformed broadly with the trend of revenue, our survey findings show that the situation is actually far worse than what the data reveal. More than 70% of these companies experienced negative profit growth and more than half of them saw their profits fall more than 18%. After accounting for the effects of revenue growth, Deloitte Research found that although COGS stayed relative stable, the relatively rapid increase of sales expenses, general and administrative expenses coupled with the decline of revenues were what caused the fall in net profit.
- Performance of retail subsectors continued to differ.
Department stores are still struggling. Negative revenue growth was recorded at 31 out of 38 department store enterprises and 26 experienced negative net profit growth. Famous enterprises like Dashang group and Nanjing Xinjiekou department store experienced both revenue and net profit negative growth. High COGS, sales expenses and general and administrative expenses were the culprits for the net operating loss at Nanjing Xinjiekou department store which resulted in negative net profit. Kunming Sinobright, on the other hand, registered high revenue growth, thanks in large part to the booming real estate business. Coupled with reduction of expenses and increase of investment income, the net income of Kunming Sinobright increased 10 times, reflecting the success of its business diversification and transformation efforts.
Negative revenue growth was registered at 7 out of 11 supermarket enterprises and 9 out 11 enterprises experienced negative profit growth. Again, falling revenue and rising expenses resulted in the decline of net profits. Yonghui supermarket, on the contrary, has managed to keep going strong over the past several years, enjoying double-digit revenue and net profit growth in 2016H1. In fact, their net profit growth in 2016H1 was 10% higher than their growth in 2015H1. Successful control of outgoing expenses and stable revenue growth is what has made Yonghui supermarket a shining star in this sector.
Specialty stores like Suning and Hongtu high technology both experienced a substantial decline of net profits. It is worth noting that Suning experienced a net loss in 2016H1 because of its relatively high COGS, sales expenses and general and administrative expenses. Adjustment in the business model of these specialty stores may be needed in order to adapt to the changing market conditions.
Data traffic propels future revenues for telecom operators
The Ministry of Industry and Information Technology reported that revenues from telecom-related services reached RMB611.28 billion in the first half of 2016, registering a year-on-year growth rate of 5.6 percent. The total number of mobile phone subscribers topped 1.3 billion, covering 94.6% of China's population; 2G and 3G users have been migrating to 4G at an accelerated speed with the number of 4G users surging explosively to 613 million. With the on-going construction of 4G networks and the fall in mobile fees, 4G users will keep on growing until they dominate the market.
In contrast, mobile call minutes and SMS messaging has been in decline. At 1.4 trillion minutes nationally, total minutes on mobile calls declined by 1 percent year on year. A total of 329.27 billion SMS messages were sent across the networks, a whopping 8.8 percent decline from a year ago, while total revenue from the SMS business plunged 9.4 percent to RMB 19.17 billion.
In the first half of 2016, three major telecom operators realized a combined revenue of RMB687.4 billion, a 6% increase from last year. China Mobile ranked first with an annual revenue of RMB370.4 billion, higher than the combined revenues of China Telecom and China Unicom. As data traffic revenue becomes the primary driver for revenue growth for telecom operators, surpassing the traditional services of voice calls and text messaging, competition in the data traffic operation sector will become ever fiercer.
It is estimated that China's data traffic will increase at a compounded annual growth rate of 70% in the next five years. By 2020, the average monthly overall data traffic will exceed 5.2 EB. The data traffic revenue of the three big telecom operators is expected to increase significantly thanks to the expansion of the 4G network and strategic development of 5G technology, along with the rapid rise of online streaming, mobile gaming and HD video content. As a result, managing their data traffic operations will become vital for telecom operators over the next few years.
The follow-up strategies of the three major operators indicate that China's telecom industry has already entered an era of data traffic operation. However, problems such as lack of innovation and data traffic fee structure mismanagement persist among the three operators. These problems, however, are not difficult to fix. They could be tackled in the following three ways.
First, telecom operators should establish an ecosystem for data traffic. As "traffic tunnels" themselves, telecom operators have access to an enormous amount of data resources. Using big data to build up a data traffic operating platform will help operators to provide services which can meet the needs of users, improving efficiency as well as identifying new avenues for growth.
Second, new business models should be explored. The operation of data traffic requires service providers to take customers' needs, and demands, into full consideration, especially in data traffic supply, fee structure design and service platform promotion - all of which are very different from traditional telecom services. With regard to fee structure design, for example, operators still charge the data traffic service on a monthly or quarterly basis while subscribers' data traffic usage is actually quite unevenly distributed within the monthly or quarterly billing cycles. This kind of mismatch between the supply and demand has created many problems and requires a more flexible approach where operators design fee structures in which users can have access to unlimited data traffic usage during a certain period of time by paying a flat fee.
Last but not least, operators should coordinate more intensely with their local branches in all cities, and integrate the feedback they receive into their management structure and services. Finally, the building of a data traffic operating platform requires executive-level decision making and support for setting up a unified across-the-board standard in the intensive management of services across different cities. Because the changes to the existing structures that this move necessitates are so widespread, it is perhaps worth implementing as a special project.
Life Science & Healthcare
Overseas M&A gathers steam
Express delivery industry ushered into a tidal wave of backdoor listings. As of July 2016, companies which went public by way of backdoor listing included SF, Shentong, Yuantong and Yunda. In the meantime, their major competitors (such as Zhongtong, Quanfeng, Deppon Logistics) all have plans to complete public listing either in 2016 or 2017. The strict listing standards will force the transformation of family business, enhance service quality, open up new markets and integrate industry as a whole.
There has been a rash of overseas M&As by Chinese pharmaceutical companies this year. The reasons for this are threefold: expectation of RMB depreciation, quality consistency evaluation for generic drugs in the domestic market and downward pressure on prices, domestic pharmaceutical companies with abundant capital are going overseas to look for companies with advanced technologies and mature business models. According to Thomson Reuters and Mergermarket, by August 2016, there had already been 12 M&A transactions by Chinese Pharmaceutical companies of which the deal value reached US$5.12 billion. This was more than triple the total amount spent on M&As of US$1.45 billion in 2015. The US and Australia are especially popular hunting grounds for Chinese companies, and medical service and pharmaceutical enterprises are hot targets.
Since there still remains a huge gap between supply and demand of medical services in the domestic market, domestic capital gravitates towards foreign medical enterprises with good profitability. In April, Luye Pharma completed the acquisition of Health Care, an Australian private hospital group (this transaction was announced in Dec. 2015), for US$688 million. In July, China Resources declared a partial acquisition of Genesis Care, an Australian company providing cancer treatment, with a valuation of US$ 1.25 billion.
In addition, pharmaceutical companies are also popular targets for Chinese acquirers as they can help domestic players acquire new drugs quickly and improve innovation capacity. On July 28th, Fosun Pharma announced their plan to acquire Gland Pharma, an Indian manufacturer of small volume parenteral injection for US$1.26 billion, setting a new record for cross-border M&As in the domestic pharmaceutical industry. This acquisition will help Fosun accelerate its internationalization progress and enhance its performance in global registration and certification.
However, it will remain a challenge for these companies to complete the post-acquisition integration, establish new management systems and produce synergy effects. Transactions in the medical service sector in particular will face additional difficulties as provision of medical services tends to be quite localized.