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Credit FAQ: China's Infrastructure Push Plucks E&C Firms From COVID Lows

Engineering and construction (E&C) companies should remain the most resilient of all China's industrial sub-sectors this year and next. The entities are direct beneficiaries of the government's accelerated infrastructure spending, done to lift the nation from the first-quarter economic downturn. S&P Global Ratings expects healthy revenue growth for the sector in China, and that most rated names will maintain a stable credit profile over the next one to two years.

China's infrastructure investment (excluding utilities) has picked up since March, when the pandemic was largely contained in the country. Investment in the first eight months of 2020 was essentially flat with the previous year. Given that spending fell 19.7% in the first quarter, year on year, investment increased sharply in the second quarter.

The revenue and new orders of our rated construction companies correspondingly recovered rapidly in the quarter. The gradual resumption of existing projects, accelerated project approvals, and favorable funding conditions have all supported this recovery.

All our rated Chinese E&C entities are state-owned. Their businesses seem homogeneous and all are pursuing continuous expansion. While they are all under a central government directive to deleverage, a few have seen rising leverage in the past one to two years, and greater ratings pressure.

We note that investors tend to ask similar questions about China's E&C firms. We think the answers are key to understanding the credit quality of the companies and the reasons for their recent resilience.

Frequently Asked Questions

Does the second-quarter revenue recovery mean rated E&C companies are on track to meet our full-year sales expectations?

In line with our expectations, revenue grew for all but one rated E&C companies in the first half of 2020; China Aluminum International Engineering Corp. Ltd. (Chalieco) was the exception. China Railway Group Ltd. saw the highest growth (15%), with rising revenue from highway and municipal projects offsetting a slowing property development business. Metallurgical Corp. of China Ltd. also disclosed 14% growth following a swift resumption of nationwide projects after the pandemic.

Chalieco's revenue shrank 26% in the first six months, year on year, following delays to restarting several large projects. Unlike peers such as China Railway Group and China Railway Construction Corp. Ltd., which have significant order backlogs comprising hundreds or thousands of projects, Chalieco's order backlog is more concentrated on a few large projects.

In our base case, the rated E&C names will achieve 8%-10% revenue growth in 2020, on average. We see upside potential to our forecasts on a few names, including China Railway Group, Metallurgical Corp., and Power Construction Corp. of China. This accounts for the firms' strong performance in the first half and the fact that E&C companies' revenue booking tends to be back-loaded in the second half.

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How do the rated E&C companies differ in terms of revenue mix? How might this affect their intake of new orders?

While E&C companies' businesses seem homogeneous, our rated issuers each have a specialty.

China State Construction Engineering Corp. Ltd. has large exposure to the housing E&C market, and has dominance in super-high-rise buildings. It also has strong market position in property development via its subsidiary China Overseas Land & Investment Ltd.Shanghai Construction Group Co. Ltd. mainly operates in housing construction and is dominant in Shanghai and adjacent areas.

China Railway Construction and China Railway Group form a duopoly in China's railway construction market. Power Construction Corp. is the top player in the global power-related (especially hydropower) E&C industry.

Metallurgical Corp. is one of the largest players by revenue in the Chinese metallurgical E&C market. Chalieco is one of China's top firms by revenue in the nonferrous metals E&C market.

All have been ramping up their general infrastructure construction business to capture the increase in infrastructure investment.

Chart 3


The E&C industry's new orders grew 4.7% in the first half, year on year, according to China's National Bureau of Statistics. Among rated issuers, China Railway Group, China Railway Construction, and Metallurgical Corp. saw the greatest growth in orders due to their large exposure to general infrastructure E&C business.

By contrast, issuers with a higher focus on housing E&C--such as China State Construction International Holdings Ltd. and Shanghai Construction--experienced slower or negative new-order growth. Housing E&C orders may rebound in the second half following a recovery in property sales in the past few months.

Chart 4


What's the margin trend for E&C companies?

The EBITDA margin for our rated companies will likely stay stable in 2020 and 2021, supported by healthy demand and improving revenue mix. Most of the rated E&C companies achieved better EBITDA margins in the first half compared with 2019, on optimized revenue mix and stringent cost controls.

China Railway Group is an exception. Its EBITDA margin slipped to 5.0%-5.2% from 5.4% in 2019 amid a slight deterioration in the profitability of its property development business. China Railway Group's full-year EBITDA margin may fall short of our previous expectation of 5.4%-6.0%. Shanghai Construction's adjusted EBITDA margin also dipped slightly, to 3.6% in the first half. This was in line with our expectation as we saw intensified competition in the housing E&C sub-market.

Chalieco's EBITDA margin slid to 2.9% in the first half of 2020, versus 3.4% in 2019. This followed a significant revenue drop and a higher ratio of expenses (selling, general and administrative) to revenue.

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What is the leverage trend for rated issuers?

We believe most of our rated names will maintain largely stable leverage in 2020-2021. Healthy revenue growth and steady margins underpin growing profit, which may surpass or match the debt increase from working capital outflow and capital spending. In addition, we anticipate improving interest-servicing capability as borrowing costs drop. All issuers have swapped some higher interest rate borrowings with lower cost ones during the low interest rates window earlier this year.

Metallurgical Corp. will likely continue to generate positive free operating cash flow, facilitating deleveraging in 2020-2021. The company has exercised prudent working capital management and disciplined capital spending over the past seven years. In the first half of 2020, its EBITDA interest coverage ratio rose to 3.3x from 2.3x in 2019, on the back of robust revenue growth, improved EBITDA margin, and lowered borrowing costs.

We believe China Railway Construction will maintain adequate financial headroom over the next two years on healthy revenue growth and stable margins. The proposed IPO of its equipment manufacturing subsidiary should also help to improve its financial strength moderately.

Shanghai Construction's leverage will likely rise on wider working capital outflow in 2020. However, as construction activities and the cash collection cycle normalize, its leverage should improve in 2021.

The growth appetites of China State Construction Engineering and China Railway Group may increase working capital outflow and capital spending, reducing the ratings buffers. Both companies will likely take measures to contain debt and stabilize leverage ratios. For example, China Railway Group announced in April 2020 a plan to list its equipment manufacturing subsidiary.

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Power Construction Corp. and China State Construction International will continue to face leverage strains in relation to their participation in, and consolidation of, investment-linked projects. Although Power Construction Corp. has been strictly controlling its investment plans, and China State Construction International has started to replace public-private partnership projects with government-targeted repurchase projects, it will take time for their efforts to take effect.

Government-targeted repurchase projects also require upfront investment, with cash paid back over years. However, the payback period is much shorter than public-private partnership projects.

Chart 8


What's the effect of public-private partnership projects on rated E&C companies?

Generally, special purpose vehicles invest in and manage public-private partnership projects. E&C companies and other participants (often local government financing vehicles and private-sector investors) fund the seed capital of the special purpose vehicles, about one-quarter to one-third of the project's total investment. The rest of the project funding comes via debt, typically bank loans.

The special purpose vehicle generates no revenue or profit during the construction period. It only recognizes intangible assets--or long-term receivables or contract assets--on its balance sheet, while accumulating debt. The project constructor, normally an operating subsidiary of the E&C company, recognizes construction revenue throughout the construction period.

E&C companies consolidate public-private partnership projects when they have control of the special purpose vehicle. Such consolidation fully captures the financial and execution risk of these projects. It also elevates the company's leverage, as the public-private partnership project significantly increases debt, but only moderately increases profit during the construction phase.

When the projects are operational, the E&C firms will recognize operating revenue. Public-private partnership projects generally involve a construction period of several years, and a 20-30 year operating period.

If not consolidated, E&C contractors will recognize the construction revenue and profit during construction, and book the invested seed capital as long-term equity investment in the cash flow statement.

Some investors are concerned that such treatment does not properly capture the E&C company's operational and financial risks carried on such projects.

However, we believe the public-private partnership projects that our rated issuers undertake are generally of good quality. Even if they do not consolidate such projects, the issuers are not materially understating the financial risk.

The participation in public-private partnership projects weighed significantly on Chalieco's leverage in 2019, when it started to consolidate a large-scale highway project. With revenue of only Chinese renminbi (RMB) 31 billion in 2019, the company needs to book the capex of this project, which requires investment of RMB23 billion over four years. We expect Chalieco's leverage ratios to improve in 2020-2021 on increasing profit from its higher-margin highway projects, but still remain high.

Power Construction Corp.'s leverage has risen since 2016 when it started to participate in such projects. The firm fully consolidates its public-private partnership projects. As of end 2019, about one-third of its RMB370 billion gross debt stemmed from investment in such projects. We think its leverage ratio will remain high in 2021.

China State Construction International's leverage has also been trending up in the past few years on increased involvement in public-private partnership projects. The company has been reducing its exposure to such projects since 2019 and has shifted focus to government-targeted repurchase projects to improve cash flows. Government-targeted repurchase projects have a cash collection period of four to six years, in comparison with the 20-30 years for public-private partnership projects. As such, the leverage ratios of the company will likely improve in the next two-three years.

Table 1

Consolidation of PPP Projects Could Significantly Elevate Leverage Of E&C Firms
PPP exposure (by revenue or order backlog) in 2019* Degree to which an issuer consolidates PPP projects*
High (> 30% ) CSCI Full PCCC, SCG
Moderate (10%-30%) CSCEC, CRG, CRCC, MCC, PCCC, Chalieco Significant majority CSCI, CSCEC, CRG
Low (<10%) SCG Moderate CRCC, Chalieco
*S&P Global Ratings estimates. PPP--Public-private partnership. CSCI--China State Construction International Holdings Ltd. PCCC--Power Construction Corp. of China SCG--Shanghai Construction Group Co. Ltd. CSCEC--China State Construction Engineering Corp. Ltd. CRG--China Railway Group Ltd. CRCC--China Railway Construction Corp. Ltd. MCC--Metallurgical Corp. of China Ltd. Chalieco--China Aluminum International Engineering Corp. Ltd. Sources: Company reports, S&P Global Ratings.
How significant is E&C companies' overseas exposure?

Most of our rated issuers generate less than 10% of revenue and profit from overseas markets. These companies will likely continue to expand overseas, but the exposure should remain small over the next two to three years.

Among the rated companies, Power Construction Corp. is the offshore leader. The company makes almost one-quarter of its revenue overseas, with a focus on the Middle East, South Asia, and Africa. Chalieco made just 1.4% of its revenue abroad in 2019, the lowest of our rated entities.

Overseas development brings many uncertainties, including political and social risks. E&C companies have adopted measures to mitigate such risks. These include hiring local project managers and subcontractors for construction work, buying raw materials locally, and also using U.S. dollars or euros as the contract currency in countries with volatile exchange rates.

The firms sometimes also buy insurances to hedge potential losses from project delays or execution issues caused by local counterparts. We generally see good risk management on overseas projects among our rated firms.

Although some large state-owned E&C companies, such as China Railway Construction and China Communications Construction Co. Ltd. (nonrated), are included in the U.S. government entity list and are subject to potential sanctions, we don't yet see a material hit on their operations or financial performances. These companies have almost no contracts in the U.S., and are in control of the technologies they need for project construction.

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Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Yolanda Tan, Hong Kong (852) 2912-3006;
Claire Yuan, Hong Kong (852) 2533-3542;
Secondary Contacts:Lawrence Lu, CFA, Hong Kong (852) 2533-3517;
Torisa Tan, Shanghai (86) 21-3183-0642;
Additional Contact:Sardonna Fong, Hong Kong + 852 2533 3586;

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