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China Commodities Mega-Mergers: Increased Leverage Today, Efficiency Gains Tomorrow

As the saying goes, quantity has a quality all its own. Beijing appears to believe commodities mergers are the most direct path to creating world-beating entities of mass scale. This, it seems to assume, is the surest way to maximize efficiency, boost technology, address overcapacity, and raise profits. S&P Global Ratings expects such transactions to raise the efficiency and lower the costs of our rated issuers, bolstering their credit standing.

The launch of China's 14th five-year plan in coming months should firm up the country's plans for more giant commodities mergers. While we cannot preempt our views on ratings, which will be decided by committees as events unfold, it's instructive to outline the issues we would need to consider should another giant merger drop.

Case studies involving China Baowu Steel Group Corp. Ltd., and the much anticipated merger of Sinochem Group and China National Chemical Corp. Ltd. (ChemChina) give us clues on what's ahead.

The Costs And Benefits Of China's Commodities Mega-Mergers

The most direct benefit of merging two companies is larger scale. Efficiency gains can come from sharing facilities, optimizing value chains, cross-selling, and cutting administrative costs.

Such benefits need time to materialize, and depend on a well executed merger. Baowu's integration into Wuhan Iron & Steel Corp. (WISCO) was successful. The benefits of China Metallurgical Group Corp.'s integration into China Minmetals Corp. were less obvious.

Mergers between state-owned enterprises (SOEs) generally do not involve financing. The government is the ultimate owner of these entities, and it typically just transfers its ownership in one SOE to another. Yet the acquiror will usually be negatively affected by the acquiree, as the acquiror usually has the better business and financial profile. Materiality matters. A big firm will be little affected by the acquisition of a small enterprise.

Financial policy plays an important role in our ratings because it guides corporate actions. In recent years, Chinese SOEs have been shifting their focus from maximizing scale to boosting returns, and have therefore become more prudent in their capital spending.

Deleveraging is another key theme. Given the sheer size of SOEs, especially central SOEs, it takes time to meaningfully reduce debt ratios. And while the shuttering of zombie subsidiaries and the disposal of noncore assets have been underway for years, the pandemic has largely paused such initiatives.

Many SOEs have issued perpetual securities to give the appearance of deleveraging. Chinese accounting rules allow firms to book these instruments as equity, but many of these securities do not satisfy our requirements for equity content. We typically view the instruments as pure debt that do nothing to cut leverage.

The level of government support colors our ratings on SOEs. Commodities firms operate in competitive industries and are commercially driven. Generally, then, the level of state support for such enterprises is lower than that for SOEs undertaking economically vital infrastructure building, or projects with high social payoff (if little profit).

The one exception is oil and gas. China imports more than 70% (and rising) of its oil consumption. The national oil companies are operating with a near monopolistic position. The entities in this sector are commercially driven, and also have strong state backing due to their strategic role to ensure energy supply.

Merging two SOEs would eliminate one SOE peer, arguably raising the importance of the acquiror to the government. However this would not necessarily translate into a category increase in the level of extraordinary government support (see the Appendix for a detailed list of GREs and our assessment of their state backing).

The Legend Of Baowu, China's Steel Industry Consolidator-In-Chief

Baowu was among the first of eight pilot SOEs that were designated as state-owned capital investment companies under reforms implemented in 2018. The central government has given the company the policy role of consolidating China's fragmented steel industry. Its goals include increasing industry concentration, reducing overcapacity, and improving competitiveness through the consolidation and restructuring of state-owned steel mills.

Baowu's merger with WISCO in 2017 was a landmark event, as it formed the largest steel mill in China. Baowu has since moved for two other provincial SOEs. It bought Magang (Group) Holding Co. Ltd. in 2019, and announced in 2020 that it would acquire Taiyuan Iron & Steel (Group) Co. Ltd. (TISCO). The events capped a string of Baowu deals over the past decade (see chart 1).

Chart 1


Baowu became the largest steel mill in the world in 2019. Its crude steel capacity will reach 100 million-110 million tons per annum (mtpa) by the end of 2020, doubling from the around 50 mtpa production level prior to its merger with WISCO.

Baowu now produces in eight provinces, covering major markets in China. It obtained dominant market share in auto plates and silicon steel market post-merger with WISCO. The acquisition of Magang in 2019 strengthened its position in railway steel, and it will become the second-biggest stainless steel producer in China after acquiring TISCO.

We believe the acquisitions have strengthened Baowu's business position, and we continue to view its business risk as satisfactory. The entity does have concentration risk, given its dependence on a single market (China), and a single commodity.

WISCO's high leverage strained Baowu at the time of the merger. Baowu's debt-to-EBITDA was 9.1x as of end-2016 on a pro-forma basis, compared with 4.6x as of end 2015. This leverage jump, coming just as the steel market hit a trough in 2015 and 2016, prompted us to lower the rating on Baowu in early 2016.

However, Baowu significantly improved the efficiency of WISCO through cost cutting, benchmarking WISCO to Baowu's standards, and selling lossmaking entities. As the steel market began recovering (starting end 2016), we upgraded the rating on Baowu in 2018.

Chart 2


Baowu has maintained disciplined financial policies to support its credit profile. First, Baowu is selective about its acquisitions. Masteel's and TISCO's leverage ratios were low, and the acquisitions did not blow out Baowu's leverage levels. The acquisitions also did not involve any cash. They were a form of government support for Baowu, in our view.

Baowu participated in the restructuring of Chongqing Iron & Steel Group Co. Ltd. while holding just a minority stake. The aim was to improve the company's operations, and not to inject funds. In its recent integration with Sinosteel Group Corp. Ltd., Baowu has also only acted in a custodial capacity (that is, it took control of its Sinosteel's operations without consolidating its financials). The arrangement has had no financial effect on Baowu.

Baowu, acting as China's steel industry consolidator-in-chief, in accordance with government policy, has benefited from strong state support. Yet, the company's business remains highly competitive and commercially driven. We assess the company's likelihood of receiving extraordinary government support as high.

Sinochem, Meet ChemChina

There is a lot of investor interest in the much-anticipated merger between Sinochem and ChemChina. The vast size of the two groups and their volume of outstanding bonds throw up many ratings considerations.

The combination would create one of the largest chemical companies globally, by revenue. Combined sales would exceed Chinese renminbi (RMB) 1 trillion, based on 2019 numbers. However, the EBITDA margin would be lower than global peers', given the combined entity would have a large and lower-margin, trading business.

There would be little overlap in the merged group's operations. Indeed, they are complementary in some cases. For example Sinochem's rubber business fits well with ChemChina's tire operations. We see potential for cost savings and cross-selling, however it will likely take years for such benefits to materialize, especially given the complexity of the two groups.

ChemChina's credit metrics are weaker than Sinochem's. ChemChina's debt levels are hefty following a series of chunky acquisitions, particularly its US$43 billion acquisition of Swiss agribusiness giant Syngenta AG, in 2017.

The company's debt-to-EBITDA ratio in 2019 was 12.4x and we expect it to remain elevated in 2020-2021 due to high ongoing capital expenditure needs. We estimate Sinochem's debt-to-EBITDA ratio was 6.5x-7.0x in 2019. Assuming no equity injection or major assets sales, the debt-to-EBITDA ratio of the merged entity would have been 10.4x in 2019.

The level of government support will be based on our assessment of the merged entity's policy mandate, and its strategic importance to Beijing. The combined firm would become the only chemical SOE under the control of the central government.

We assess Sinochem to have a very high likelihood of receiving extraordinary government support in case of stress, which is one notch higher than that of ChemChina. Other than securing and advancing China's agriculture industry, the higher assessment of Sinochem reflects the company's role in holding national strategic reserves for important materials, such as rubber.

A merger would prompt a review of the strategic importance of the six rated subsidiaries under the new group (see table 1). The entity's chemical subsidiaries would get stronger group support, in our view, though the pecking order could change. Ultimately the group's strategic direction would have the biggest effect on subsidiaries' status within the group.

Table 1:

Rated Subsidiaries Of Sinochem Group And ChemChina
Parent Rated subsidiary Business description of subsidiary SACP on subsidiary Ratings/outlook on subisdiary Current group Status
Sinochem Group

Sinochem Hong Kong (Group) Co. Ltd.

Investment and offshore financing arm of Sinochem Group, real estate, chemical trading bb+ A-/Stable/-- Core
Sinochem Group

Sinochem International Corp.

Fine chemicals, natural rubber, agrochemicals bb- BBB+/Stable/-- Highly strategic
Sinochem Group

China Jinmao Holdings Group Ltd.

Real estate bb+ BBB-/Negative/-- Moderately strategic
Sinochem Group

Far East Horizon Ltd.

Finance bb+ BBB-/Stable/A-3 Moderately strategic

China National Bluestar (Group) Co. Ltd.

Silicon materials, animal nutrition b+ BBB/Negative/-- Core

Syngenta AG

Agrochemicals, commercial seeds bbb- BBB-/Stable/A-3 Strategically important
ChemChina--China National Chemical Corp. Ltd. SACP--Stand-alone credit profile. Source: S&P Global Ratings

We believe further mergers between SOEs will remain integral to China's aspiration to build world-leading enterprises that excel in scale, profits, and technology. Although this may increase the immediate leverage of the acquiror, it should enhance its credit quality in the three to five years after the deal is sealed. To achieve this goal, execution will be as important as the plan.


Table 2

Likelihood Of Extraordinary Government Support For China Commodities GREs
Extraordinary government support
SACP Government Link Role Likelihood Issuer credit rating

China National Petroleum Corp.

aa- Central Very strong Ctitical Extremely high A+/Stable/--

China Petrochemical Corp.

a Central Very strong Ctitical Extremely high A+/Stable/A-1

China Petroleum & Chemical Corp.

a+ Central Very strong Ctitical Extremely high A+/Stable/--

China National Offshore Oil Corp.

a Central Very strong Ctitical Extremely high A+/Stable/--


a Central Very strong Ctitical Extremely high A+/Stable/--

Yankuang Group Co. Ltd.

b Shandong Very strong Important High BB/Stable/--

China Baowu Steel Group Corp. Ltd.

bbb Central Very strong Important High A-/Stable/--

China National Gold Group Co. Ltd.

bb Central Very strong Important High BBB/Stable/--

Shandong Gold Group Co. Ltd.

bb Shandong Very strong Important High BBB-/Stable/--

China Minmetals Corp.

bb+ Central Very strong Important High BBB+/Stable/--

China National Chemical Corp. Ltd.

bb Central Very strong Important High BBB/Negative/--

Shanghai Huayi (Group) Co.

bb+ Shanghai Very strong Limited importance Moderately high BBB/Stable/--

Beijing Haidian State-Owned Asset Investment Group Co. Ltd.

b- Beijing Haidian Very strong Critical Extremely high BBB-/Negative/--
GRE--Government-related entities. SACP--Stand-alone credit profile. Source: S&P Global Ratings.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Danny Huang, Hong Kong (852) 2532-8078;
Christine Li, Hong Kong (852) 2532-8005;
Ronald Cheng, Hong Kong (852) 2532-8015;
Secondary Credit Analyst:Lawrence Lu, CFA, Hong Kong (852) 2533-3517;

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