China’s SOEs: Expect More Focus on Profitability

China’s State-Owned Assets Supervision and Administration Commission (“SASAC”) will now begin focusing more on profitability, not sales, in evaluating the performance of the state-owned enterprises (“SOEs”) that it supervises. This shift will have many implications for SOEs as well as their international counterparts in both China and the global marketplace.

Despite the fact that China’s SOEs have virtual monopolies in many of the industries in which they operate, the profitability of SOEs as a whole lags behind that of private companies. For the first nine months of 2013, profits of all large industrial firms in China rose 13.5 percent year-on-year, compared to a decline of 1.8 percent during the same period last year. For the first three quarters, SOE profits were up 9.4 percent, compared to a decline of 11.8 percent for the first nine months of 2012. Meanwhile, the profit growth of private companies has been consistently strong. Large Chinese private companies registered a 17 percent increase through September, compared to a 15.6 percent increase for the first nine months of last year.

China’s private firms, not their SOE brethren, are now driving China’s economy, and their influence is growing. According to Andy Rothman, China Macro Strategist for CLSA, private companies account for about 80 percent of China’s urban employment and 90 percent of net new job creation. Private firms account for two-thirds of total fixed-asset investment, up from 55 percent in 2009 and 42 percent in 2004. Private firms, excluding the profits from the tens of thousands of private companies that are too numerous for even China’s National Bureau of Statistics (“NBS”) to include, now account for a larger share of total, larger industrial firm profits than do SOEs. Bottom line: entrepreneurialism is alive and well in China, and the outperformance of the private sector has not gone unnoticed by the government and party leaders.

Zhu Rongji, former premier and economic czar of China, was the first to tackle the SOE issue. In 1997 and 1998, Zhu led a large-scale privatization in which all state enterprises, except a few large monopolies, were liquidated and their assets sold to private investors. Between 2001 and 2004, the number of SOEs decreased by 48 percent. As part of economic reform, SASAC was formed in 2003, and the remaining SOEs were put under its supervision. SASAC’s powers include appointing top executives and approving any mergers or sales of stock or assets, as well as drafting laws related to SOEs.

In an effort to encourage SOE managements to grow larger and become Chinese champions that could stand “toe to toe” with the largest global companies, SASAC has had “sales” as one of its Key Performance Indicators (KPIs). This has encouraged SOEs to merge with other Chinese companies, without regard for profitability, and has also made it difficult for them to gain approval for taking minority ownership positions in domestic joint ventures and minority positions in overseas companies. According to both international and Chinese accounting standards, companies cannot consolidate sales and earnings of subsidiaries unless they have majority ownership and/or management control.

With SASAC’s shift to a focus on profitability, there are already signs that SOE practices are changing. SOEs are showing more of a willingness to accept minority positions in domestic joint ventures where international companies can bring technology that is critically needed in China. In these cases, the Chinese SOE can record on its books its share of joint venture profits, even though the sales of the joint venture will be consolidated on the books of the majority owner.

Attitudes towards overseas investments/acquisitions may also be similarly affected, which may lead to more overseas investment by Chinese companies. In many cases, owners of overseas companies may be willing to take on a minority investment by a Chinese company, but may not be ready to sell the entire company. In other cases, an overseas acquisition may be too large for many Chinese companies to consider acquiring outright. With a need to have majority ownership and management control so that sales can be consolidated, the burden — and risks — of taking on the management of an overseas acquisition falls completely on the Chinese acquirer, and this has been a big deterrent for many cross border deals. The ability to take minority positions, however, opens the door to taking on financial, management and other partners, making such deals more manageable.

Due to the existence of well-developed debt markets in mature economies like the U.S. and Europe, investment bankers tend to focus on a company’s cash flow available to service high levels of debt. Therefore, “Earnings Before Interest, Taxes, Depreciation and Amortization” (“EBITDA”) has become a substitute for “Net Income” when evaluating acquisition candidates. Western bankers and owners may find Chinese buyers to be more interested in “Net Income” than in “EBITDA” as a result of the new KPIs.

SASAC’s focus on profitability could have a significant impact on everything from overseas investment in China to cross border mergers and acquisitions in 2014 and beyond. The Year of the Horse could be a very interesting year as a result.

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