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Carmakers Are A Step Behind In Industrial China's COVID Comeback

China's industrial sectors are staging a strong recovery from the COVID-19 outbreak, with production and public demand picking up sharply from their March lows. In 2020, government policies and infrastructure-focused stimulus will likely drive growth for many industries, including engineering and construction (E&C) and capital goods makers. S&P Global Ratings expects ratings in these sectors to be generally stable in COVID's aftermath, with most fundamentals in good shape. Carmakers are a weak spot, given the softness of consumer confidence.

While China's auto sales significantly beat our expectations in the second quarter, the sustainability of this recovery is uncertain. With the employment index under manufacturing and non-manufacturing purchasing managers' indexes (PMI) remaining below 50 in June, consumer confidence will likely stay weak, as will spending. This poses risks to our assumption of a 5%-6% year-on-year growth in China's auto sales in the second half of 2020, followed by 2%-4% growth in 2021. We believe most of our rated carmakers and suppliers will maintain low leverage, given low debt coming into this crisis. The bigger issue for these firms is their ability to ramp up sales and profit as the outbreak subsides.

China's rated E&C companies are in better shape. The entities have solid order backlogs. Accelerating project approvals amid a government push to build infrastructure propel orders. As the pandemic stabilized in China, construction returned to normal in April-May. These companies should continue to see solid revenue growth in 2020-2021 with largely stable margins. Their participation in investment-linked projects and management of working capital will drive their leverage position and, consequently, their credit profiles.

Similarly, the performance of our rated capital goods issuers has been generally resilient. Sales of excavators and heavy-duty trucks rebounded after March, growing more than 60% year on year in the second quarter. Healthy construction demand and replacement needs will likely support this demand through this year, before tapering off in 2021. We also anticipate wind power equipment demand will hit a new peak this year, given a rush to installation before subsidies are cut. For rated issuers, investment appetite will determine credit strength--the more they invest, the higher the leverage, all things being equal.

Autos: An Uneven Recovery

Chinese auto wholesale volumes recovered strongly from April, with auto dealerships resuming restocking after the pandemic receded. Such sales grew 10% year on year in the second quarter. Commercial vehicle sales recovered first. Strong logistics and construction demand fueled appetite for these vehicles, as did the need to replace old fleets, particularly those with substandard emissions. Passenger vehicle sales also started growing in May.

Chart 1


The sales recovery of our rated issuers generally outpaced the industry. The firms have kept the sales target set at the start of the year and are generally confident that auto sales will improve meaningfully in the second half, compared with the first.

Table 1

Rated Issuers' Sales Growth Surpasses Industry Average
1H 2020 ('000 units) 1H 2020 % change in sales (YoY) 2020 sales target ('000 units) 1H sales as % of 2020 sales target

Beijing Automotive Group Co. Ltd.

896 (16) 2,260 40

China FAW Group Co. Ltd.

1,631 2 3,810 43

Dongfeng Motor Group Co. Ltd.

1,144 (17) 3,158 36

Geely Automobile Holdings Ltd.

530 (19) 1,410 38
China auto sales 10,257 (17) N.A. N.A.
1H--First half. YoY--Year on year. N.A.--Not available. Sources: Company reports, WIND.

We, however, are somewhat skeptical about the sustainability of the sales recovery in the rest of the year. While retail sales for passenger vehicle improved meaningfully in the second quarter, we attribute this mainly to pent-up demand. Sub-50 PMI employment readings reflect continued strains on labor markets and income. This will weigh on consumer spending. Auto supply chains may be disrupted again if we see another wave of lockdowns triggered by a fresh virus outbreak.

Meanwhile, given intense industry competition, rated carmakers may be compelled to aggressively expand promotions to secure market share. EBITDA margins are unlikely to recover to pre-pandemic levels before 2022.

We expect BAIC Motor Corp. Ltd., China FAW Group Co. Ltd., Dongfeng Motor Corp., and Geely Automobile Holdings Ltd. to remain in a net cash position in 2020, as their operating cash flows will be more than sufficient to fund capital spending despite weaker profit. Beijing Automotive Group Co. Ltd. and Zhejiang Geely Holding Group Co. Ltd.'s leverage will continue to deteriorate in 2020. Declining revenue and shrinking margins will likely lead to free operating cash outflow for the entities, driving up debt.

Chart 2


We have taken a sector-wide rating actions in March-April, when we lowered the outlook on China FAW Group and Dongfeng Motor Group to negative and placed the ratings on the other carmakers on CreditWatch with negative implications.

In view of the recent market development, we have taken rating actions in June. We downgraded the long-term issuer credit ratings on Beijing Automotive Group and its core subsidiary, BAIC Motor, by one notch on June 23, given the former's elevated financial leverage. We removed all ratings from CreditWatch and assigned a negative outlook on the ratings on both companies to reflect the thin rating buffer on Beijing Automotive Group.

We kept the ratings on Zhejiang Geely and its core subsidiary, Geely Automobile, on CreditWatch with negative implications. Despite a sales recovery in recent months, Zhejiang Geely's credit metrics will likely worsen in 2020 amid profit erosion and elevated debt. The proposed secondary listing of Geely Auto on Shanghai's Star Market (a Nasdaq-style bourse for high-growth firms) may moderately alleviate its leverage squeeze, but the timing and amount of cash proceeds are uncertain. For China FAW Group and Dongfeng Motor, while their sales improved considerably in the second quarter, we need to monitor their sales momentum and their margins for a longer period before turning more positive on their ratings outlook.

Table 2

Chinese Carmakers' Rating Snapshot
Issuer credit rating Downgrade trigger

Beijing Automotive Group Co. Ltd.

BBB/Negative/-- FFO/debt <12%

BAIC Motor Corp. Ltd.

BBB/Negative/-- BAG's FFO/debt <12%

China FAW Group Co. Ltd.

A/Negative/-- EBITDA margin (excluding sales company of Toyota) <8%* or debt/EBITDA ~ 1x

Dongfeng Motor Group Co. Ltd.

A/Negative/-- Parent's proportionate EBITDA margin <8% or debt/EBITDA ~ 1x§

Zhejiang Geely Holding Group Co. Ltd.

BBB-/Watch Negative/-- EBITDA margin <6% or debt/EBITDA >=2x

Geely Automobile Holdings Ltd.

BBB-/Watch Negative/-- ZJ Geely's EBITDA margin <6% or parent's debt/EBITDA >=2x
Note: We only included financial triggers in the downgrade trigger. BAIC Motor Co. Ltd. is a core subsidiary of Beijing Automotive Group. Its rating is equalized to the parent company's rating. Geely Automobile Holdings Ltd. is a core subsidiary of Zhejiang Geely Holding Group. Its rating is equalized to the parent company's rating. *We forecast FAW's EBITDA margin (excluding the contribution of the sales company of Toyota) to be 8.0%-10.0% in 2020-2021. §We forecast DFM's EBITDA margin on a proportionate consolidation basis will contract to 7.0%-8.0% in 2020 and recover to 8.0%-8.5% in 2021, compared with 8.0% in 2019. It will remain in a net cash position. FFO--Funds from operations. Source: S&P Global Ratings.

Unlike rated carmakers, whose sales are concentrated in China, our rated auto suppliers generally have global exposure and are subject to the demand volatility in different regions. The U.S and Europe entered into lockdown during March-April 2020. Auto sales rebounded in May and June for those two markets, but were still sharply below levels seen the same period a year ago. We anticipate a 15%-25% drop in light-vehicle sales in 2020 in the U.S. and Europe, followed by a 10%-20% sales recovery in 2021.

Yanfeng Global Automotive Interior Systems Co. Ltd. generates about half its sales in Asia-Pacific (mainly China). As such, its operations have recovered faster than other rated peers more exposed to sales in the West. Nexteer Automotive Group Ltd. only resumed production gradually in North America and EMEA (which accounts for 80% of its total revenue) from mid-May after a nine-week suspension. Johnson Electric Holdings Ltd. is in the middle, with about one-third of its sales in China, the U.S., and Europe, respectively. We believe the company's selling rates in June have already reached the level in the same period last year.

We recently removed the ratings on Johnson Electric and Nexteer from CreditWatch. We affirmed our 'BBB-' rating on Nexteer with a negative outlook. While the company should maintain low financial leverage in 2020-2021, we believe it will be difficult for the company's margin to recover to pre-pandemic levels over 2020-2021. A slower rebound in demand than we anticipate may offset Nexteer's cost-cutting over the next 12-18 months.

We have affirmed our 'BBB' rating on Johnson Electric, with a stable outlook. We anticipate the company's leverage to remain low in the fiscal years ending March 31, 2021, and 2022. We believe the company's competitive product offerings and diversified customer base will help it maintain an EBITDA margin of 12%-14%. The company's reduced debt level and prudent financial management also give it more financial headroom than peers (see "Nexteer Automotive Group Ltd. 'BBB-' Ratings Affirmed With Negative Outlook; Off CreditWatch," June 26, 2020, and "Johnson Electric Holdings Ltd. 'BBB' Ratings Affirmed With Stable Outlook; Off CreditWatch," June 30, 2020.

Table 3

Chinese Auto Suppliers' Rating Snapshot
Issuer credit rating Downgrade trigger

Nexteer Automotive Group Ltd.

BBB-/Negative/-- Debt/EBITDA>1.5x, or EBITDA margin has no signs of recovery toward 9%, or FOCF <0

Johnson Electric Holdings Ltd.

BBB/Stable/-- Debt/EBITDA >1.5x, or EBITDA margin materially deteriorates, or DCF<0

Yanfeng Global Automotive Interior Systems Co. Ltd.

BBB-/Negative/-- Debt/EBITDA >1.5x or parent's EBITDA margin< 6%*

Pearl Holding III Ltd.

CCC+/Watch Negative/-- No concrete refinancing plan, or likelihood of debt restructuring has increased
*We forecast the EBITDA margin of Yanfeng's parent to drop to 6.0%-7.0% in 2020 from 9.7% in 2019 before recovering to 7.0%-8.0% in 2021 and the company to be in net cash position. FOCF--Free operating cash flow. DCF--Discretionary cash flow. Source: S&P Global Ratings.

E&C: Robust Backlog And Stimulus Keep Sales Growth Healthy

China's infrastructure investment (excluding utilities) picked up in the past few months, with the year-on-year decline narrowing to 2.7% in the first half of 2020, from a 19.7% drop in the first quarter. A resumption of existing projects and faster approval of new projects since March--when the pandemic stabilized in China--explain the recovery.

We believe an easing in the funding environment will support the acceleration of construction. This should create growth (year on year) in infrastructure investment in the coming months. In late May, the National People's Congress approved Chinese renminbi (RMB) 3.75 trillion of new issuance quota of local government special purpose bonds of for 2020, (see "China Debt After COVID-19: Flattening The Other Curve," June 4, 2020.)

In the year to end-May, local governments' new issuance of special purpose bonds came to RMB2.15 trillion, exactly matching issuance for all of 2019. Unlike previous years, when 60%-70% of the special purpose bonds proceeds went to land reserves and shantytown renovation projects, we believe that most of the proceeds will be used to fund infrastructure projects.

We anticipate our rated E&C companies will continue to see healthy revenue growth in 2020. Most of these companies' revenue declined in first quarter due to construction halts. Construction activities gradually resumed in mid-February, starting with large-scale key infrastructure projects, followed by municipal and housing projects.

Companies with higher exposure to key railway, road and power station projects--including China Railway Group Ltd., China Railway Construction Corp. Ltd., and Power Construction Corp. of China--have experienced smaller revenue decline during the period. China Aluminum International Engineering Corp. Ltd. saw the largest revenue drop given its small operational scale and dependence on a few large projects. Metallurgical Corp. of China Ltd. is the only rated Chinese E&C entity registering growth in the first three months, as fewer of its projects were affected by the pandemic.

We believe most of our issuers can make up for the loss of construction days in the first quarter and achieve a mid- to high-single-digit revenue growth in 2020. The entities will likely record slightly higher revenue growth in 2021, in line with higher anticipated GDP growth.

Chart 3


E&C firms' new orders weakened in the first quarter but picked up after March. China Railway Construction, China Railway Group, and China State Construction Engineering Corp. Ltd. registered new order growth in the first quarter, and their order backlog will support revenue growth for at least the next two years. China State Construction International Holdings Ltd.'s new contracts grew 4% by value in the first five months of 2020, after a nearly 60% decline in the first quarter, thanks to the normalization in tendering for new projects. Metallurgical Corp.'s new contracts also increased 22% by value as of June 2020, year on year, despite a 4% drop in the first three months.

Chart 4


For our rated Chinese E&C companies, with demand not a problem, growth appetite and the ability to manage working capital turnover will drive the entities' leverage and credit strength. Most incurred large working capital outflow and capital spending in the past few years, on growing revenue and increasing participation in investment-linked projects. As such, most of them see increasing debt consecutively, with additional borrowings incurred to make up for the internal funding gap. We believe this will continue to be the case in 2020-2021, given the acceleration in construction projects and a shortened lead time for the implementation of new projects.

Chart 5


We assume generally stable leverage for rated issuers in 2020 as steady expansion in EBITDA should largely offset mild increases in debt. We believe that most of the rated issuers, which are central or local state-owned enterprises, will continue to adopt other measures such as mixed-ownership reforms and debt-to-equity swaps, to meet their deleverage target. The launch of publicly listed infrastructure real estate investment trusts may offer additional liquidity to issuers (but note that few projects are eligible to be used as assets in infrastructure trusts at the moment given stringent requirements).

We anticipate lower leverage in 2021 for most of our rated Chinese E&C firms, with EBITDA expansion likely outpacing debt increases. Power Construction Corp. of China and China State Construction International Holdings Ltd. should see the most rating pressure among its peers, given their higher exposure to investment projects and lower financial buffers.

Chart 6a


Chart 6b


Table 4

Chinese E&C Companies' Rating Snapshot
Issuer credit rating Downgrade trigger

China State Construction Engineering Corp. Ltd.

A/Stable/-- Debt/EBITDA >= 3.5x OR EBITDA/interest <=4.5x

China Railway Construction Corp. Ltd.

A-/Stable/-- FFO/debt close to 20%

China Railway Group Ltd.

BBB+/Stable/-- Debt/EBITDA > 4x

China Metallurgical Group Corp.

BBB+/Stable/-- EBITDA/interest < 2x

Metallurgical Corp. of China Ltd.

BBB+/Stable/-- EBITDA/interest < 2x

Shanghai Construction Group Co. Ltd.

BBB/Stable/-- FFO/debt declines to 20%

Power Construction Corp. of China

BBB+/Negative/-- EBITDA/interest < 2x

China State Construction International Holdings Ltd.

BBB/Negative/-- EBITDA interest coverage < 3x

China Aluminum International Engineering Corp. Ltd.

BB/Stable/-- EBITDA interest coverage fails to imrove from 2019 level
E&C--Engineering and construction. FFO--Funds from operations. e--Estimate. Source: S&P Global Ratings.

Capital Goods: Investment Appetite Will Drive Ratings

China's capital goods names have been largely resilient to COVID-19 fallout. The rated names are industry leaders in each of their subsectors, with high exposure to infrastructure projects, which have been launching at a healthy pace. Our ratings on the entities will largely depend on the degree to which they expand into other business lines using acquisitions and capital expenditure.

In our view, sales of construction machinery in China will continue to grow steadily in the rest of the year. Demand has rebounded strongly starting from March, (see chart 7). With the current upcycle likely coming to an end in 2021--given the eight to 10-year life cycle of this equipment--we think industry sales may decline moderately next year.

Chart 7


As a leading construction machinery producer with high mid-to-late cycle product exposure, we expect Zoomlion Heavy Industry Science and Technology Co. Ltd. to continue to outperform the market. We anticipate the company will deliver close to 10% revenue growth in 2020 and record largely stable margins. If strong industry sales momentum continues in the second half, revenue may grow even faster.

Despite a likely higher working capital outflow this year (to ease supply chain pressures), the company's operating cash flow should be sufficient to fund a moderate increase in capex for capacity expansion. We estimate that its debt-to-EBITDA ratio may drop to under 3.5x in 2020, and stay under 4x in 2021, even after factoring in a 5%-10% sales decline in the period. A recently announced equity placement plan could help Zoomlion enhance its financial headroom and bring upside to our forecasts (see "Zoomlion's Credit Strength Boosted By Strong Sales, Proposed Share Placement ," July 7, 2020.)

Similar to the construction machinery sector, China's heavy-duty truck sales rebounded after COVID-19 was largely contained in the country, with year on year growth of about 60% in April-June (see chart 9). Year-to-date, heavy-duty truck sales have grown 24% year on year, from a record high base set in 2019. The strong demand is due to healthy logistics and strong demand from the construction sector, as well as a government push to upgrade national emission standards. Heavy-duty truck sales will Likely drop 10%-20% in 2021 as the higher emission standards kick in that year, with most of the fleet upgrades already completed.

Weichai Power Co. Ltd. will likely benefit from the strong demand for heavy-duty trucks in 2020 given its commanding position in making engines for such vehicles. The strong performance in the domestic market may offset disruptions to its overseas operations stemming from COVID-19. We see sufficient rating buffer in Weichai. This accounts for a stress scenario for its overseas subsidiary, KION Group AG, in which revenue declines by a fifth together with 4-5 percentage point margin contraction. In such circumstances, Weichai's free cash flow would still be break even in 2020 and its leverage ratio will remain below 1.5x--without cutting capital expenditure. In 2021, a likely recovery in Kion's profit should largely counter a moderate drop in its domestic business, and improve the group's credit metrics, provided that global pandemic has largely subsided.

Chart 8


For wind power equipment, we see strong demand in 2020-2021 due to an expected installation rush. Wind farms would like to speed up construction and connect their onshore wind power plants to the grid before end-2020/end-2021 (depending on the new capacity approval date) and offshore wind generation plants before end-2021, so as to be eligible for central government subsidies. As such, wind turbine generator installation will likely rise to over 30 gigawatts in 2020 from 28 gigawatts in 2019 and stay high in 2021. Prices for wind turbine generators also started rising in 2019.

Xinjiang Goldwind Science & Technology Co. Ltd. will likely post strong revenue growth and margins in 2020. Profit expansion, moderate reduction of capex on new wind farms, and continued asset disposals will all likely lower Goldwind's leverage. The company's funds-from-operations-to-debt ratio may return to over 20% in 2020. However, uncertainty in the company's spending discipline may hinder its deleveraging.

Similarly, Shanghai Electric (Group) Corp.'s sales will likely rise over the next 12-24 months, backed by its expanding business portfolio and solid backlog. Growth in renewable power equipment and smart manufacturing equipment will likely more than offset the decline in demand of coal-fired power equipment and a slowdown in E&C revenue. Fierce competition and supply chain disruptions may strain margins.

We estimate that the company's leverage ratio (as measured by debt to EBITDA) will rise to 2.0x-2.5x in 2020-2021, from 1.9x in 2018-2019, mainly due to the consolidation of newly acquired companies. Its expansion appetite during business transition and industry headwinds such as intensified competition in multiple key markets as well as the structural decline in traditional thermal power equipment segment could weigh on the company's financial performance, driving up its leverage.

Railway equipment demand will remain largely resilient in 2020, in our view, despite some delays in the tendering of rolling stock. China's railway fixed-asset-investment target for 2020 is still set at RMB800 billion, the same annual target set over the past five years. There number may rise given the high volume of government stimulus that is rolling out now. While national railway passenger transport volumes have plunged due to COVID-19, freight transport volume have still grown year-over-year over the first six months. Additionally, demand of rapid transit vehicles for metropolitan railways remains robust.

As the dominant railway equipment producer in China, CRRC Corp. Ltd. should be able to weather operational challenges posed by the pandemic. We forecast the company will see revenue decline of single-digit percent with moderate margin erosion in 2020. Nevertheless, the company will likely generate positive free cash flow given its solid operating cash flow and limited spending needs.

Table 5

Chinese Capital Goods Companies' Rating Snapshot
Issuer credit rating Downgrade trigger Upgrade trigger

CRRC Corp. Ltd.

A+/Stable/-- Debt/EBITDA >1.5x Higher sovereign rating

Shanghai Electric (Group) Corp.

A/Negative/-- Debt/EBITDA ~3.0x Debt/EBITDA ~2.0x

Shanghai Electric Group Co. Ltd.

A/Negative/-- SEC's debt/EBITDA ~3.0x SEC's debt/EBITDA ~2.0x

Weichai Power Co. Ltd.

BBB/Positive/-- Market position weakens Debt/EBITDA <1.5x

Xinjiang Goldwind Science & Technology Co. Ltd.

BBB-/Negative/-- FFO/debt <20% FFO/debt >20%

Zoomlion Heavy Industry Science and Technology Co. Ltd.

B+/Positive/-- Debt/EBITDA ~4.0x Debt/EBITDA <4.0x
FFO--Funds from operations. Source: S&P Global Ratings.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Claire Yuan, Hong Kong (852) 2533-3542;
Stephen Chan, Hong Kong (852) 2532-8088;
Chloe Wang, Hong Kong + 852-25333548;
Yolanda Tan, Hong Kong (852) 2912-3006;
Secondary Contacts:Lawrence Lu, CFA, Hong Kong (852) 2533-3517;
Torisa Tan, Shanghai (86) 21-3183-0642;
Additional Contacts:Sardonna Fong, Hong Kong + 852 2533 3586;
Rhett Wang, Hong Kong + 852-2912-3070;

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