China's Earnings Season: What to Expect in April

We are bullish on Chinese stocks. It seems to us, however, that average American investors got a distaste of China after the 9 percent plunge in Shanghai on February 26 that sent global equity markets south. As a result, March was a very quiet month for us stock researchers, while this was the time stock research would have been needed the most. We will get back to this later.

As the following chart reveals, despite the 9 percent one day plunge, the Shanghai Composite index in green has recovered while the Dow (red) and the Hang Seng (blue) are still below the late February levels.

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Bright corporate earnings prospects and huge amounts of money rushing into the Chinese stock exchanges, Shanghai and Shenzhen, are providing sustained growth momentum to the equities. The China Securities Regulatory Commission [CSRC] said earlier last month that investors have opened 4.69 million new accounts with the country’s two stock exchanges in the first two months this year, in a dash to cash in on the bull equity markets.

Another evidence of such a rush is the surging prices of bank papers. As a result, Industrial and Commercial Bank of China [ICBC], China’s largest bank, overtook Bank of America Corp. (BAC) as the world’s second-largest bank by market value on March 29. This may come as a shocker to many; however, our readers can recall that we have been arguing about the emergence of Chinese global behemoth companies in the past. We predicted previously that some Chinese companies will become global leaders, and market size and demand within China will be the key drivers to help them get there. This was the case with PetroChina Co. (PTR), when it overtook Royal Dutch Shell (RDS.A) to become the world’s second largest oil company by market value in December 2006.

Another indication of the exuberant investor confidence and liquidity is the record funds raised by IPOs in China in 2006. First time in history, Chinese companies raised 74.5 billion dollars through IPOs, surpassing the U.S. during the same period. This number is somewhat misleading though. Both of the two largest Chinese banks, ICBC and Bank of China, went public via mega IPOs in 2006, an event that will not reoccur. Still, the numbers speak volumes. Going back to the value of stock market research in volatile markets, let’s take a look at how our last recommendations from the previous Newsletter worked out. As the below chart shows, most of the stocks we covered moved only +/- 5 percent in the last month with two exceptions: TOM Online (TOMO) is up almost 20 percent while eLong Inc. (LONG) is down exactly by 20 percent just from a month ago.

In TOMO’s case, we argued that the stock is undervalued and is a buy at $11 or lower. The stock was just coming down from $13 to the low $12 range the time those lines were written. The stock price continued to fall until $11.62 when news broke out regarding a possible proposal to privatize the Internet portal and wireless services subsidiary. Before investors knew it, the stock has been trading 20 percent higher.

In eLong’s case, we reiterated our SELL rating on the stock before the upcoming earnings announcement. Sure enough, the Company reported disappointing earnings and lowered guidance, sending its shares down 20 percent. The rest of the recommendations worked out just fine, moving up or down within a 5 percent band.

We have to admit our disappointment at the China Mobile (CHL) price chart however. While CHL reported very strong results not just for the last quarter but for the year 2006 as a whole, investors got cold feet from future subscriber acquisition costs. Markets in the richer east coast are getting saturated and mobile companies have to turn to the less urbanized western regions to look for growth. While this phenomena was not new to us when we made up our buy recommendation, we did not anticipate a negative momentum with such a big magnitude emerging from this issue.

Regarding the oil sector, the current standoff between Great Britain and Iran lifted oil prices above $60 a barrel, mixing up fine tuned stock predictions. The general argument goes that China’s growing thirst for fuel will keep lifting profits at its three oil giants; PetroChina Co. (PTR), CNOOC Ltd. (CEO) and Sinopec (SNP). However, there are important differences among them. CEO is strictly an oil producer while Sinopec boosts Asia’s largest refining capacity besides oil production of its own. Plus, Siopec has the most extensive gasoline station network in China. In contrast, PetroChina is more exposed to oil and gas production than Sinopec plus has the number one pipeline network in the country.

So the argument continues that PTR and CEO are likely to post slower earnings growth due to the windfall tax imposed on oil producers while Sinopec’s extensive station network is giving it an edge. However we tend to agree with Goldman Sachs Group Inc. analyst Kelvin Koh saying that “With uncertainty lingering over domestic pricing system coupled with the recent oil price rebound, we believe investors at tent ion will soon turn to a potential margin squeeze in the first half of 2007 ”. With this in mind, we keep our longterm buy recommendation for PetroChcina Co. Sinopec will report in April 2.

Another set of recommendations we provide to our readers come in five to ten pager stock analysis reports. We posted three of them in March. We gave Shanda Interactive Entrainment (SNDA) a BUY recommendation on March 6 and the stock has been trading up by 15 percent since then. We strongly recommend using stop-loss orders to protect further gains. For Sina Corp. (SINA), we extended our SELL recommendation, while for Baidu.com (BIDU), the Chinese language search engine company, our recommendation is HOLD.

Regarding the upcoming events, five major companies have not announced earnings yet. They are Huaneng Power (HNP), China Southern Airlines (ZNH), China Life Insurance (LFC), China Eastern Airlines (CEA) and Brilliance Auto of China (CBA). Interestingly enough, all of them but CBA are listed in the three important markets: the NYSE, Hong Kong and Shanghai.

As we argued in the first part of this article, Chinese investors have poured tremendous liquidity into the domestic exchanges sending the Shanghai Composite to record highs. As a result, any positive earnings announcement is expected to propel the stock to seemingly unreasonable heights. Still, this is an opportunity U.S. investors should take advantage of, since we don’t see signs of slowing down in the near future. We think that liquidity in Shanghai will drive stock prices in the future, taking the lead away from Hong Kong. As we have seen in the past, NYSE prices mirrored Hong Kong actions often resulting an a sizeable gap at the open and flat trading throughout the day. This is about to change

As the increasing number of Chinese investors rush into equity markets, a seemingly endless liquidity is about to keep stock prices high. Companies with triple listings, NYSE-HKEXShanghai, will experience benefits on the first hand. As the table above shows, there are seven Shanghai-NYSE crosslisted equities as we speak. However we expect China Mobile (CHL) and Aluminum Corp. of China (ACH) to list in the Shanghai Stock Exchange within a foreseeable future. This will mean increased liquidity and possible stock price appreciation.

Going back to the stocks that will report in April, we reiterate our anticipation that Yanzhou Coal will cheer investors on April 23 by delivering strong results. The Company is successfully shrugging-off mines in problematic areas while it is backedup by strong coal prices. In addition, a current trade standoff between China and Japan over coal supply cold bring stronger coal prices for the foreseeable future. For these reasons we keep our BUY rating on the Company.

Huaneng Power (HNP) will see a marked slowdown in capacity growth this year as an industry supply surplus looms after a plant construction binge. The Company plans to rise its generating capacity by 17.5%, or 10 GW, this year to 67.2GW. Still, 2006 results are expected to be very strong as the Company increased power generation by 6.24% with improved generating efficiency. Another set of companies to keep a close eye on are from the airline industry: CEA and ZNH. Both Companies reported preliminary results on their websites, showing increased passenger and cargo traffic in the second half of 2006. With moderate fuel prices in the same period, both of them are expected to return to profitability. Liquidity remains an issue but it should not deter long-term investors from taking positions in these companies.