Published April 22, 2009

S-chips: cheap may not be good as earnings concerns persist

Analysts say S-chips painted with broad brush over credibility issues

By LYNETTE KHOO

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THE extremely low valuations of S-chips or Chinese listings here have left investors grappling with the question of whether it is time to plough their money back into these stocks.

While the debate over whether the actual strength of the Chinese economy continues, earnings visibility remains poor for many Chinese listings here, analysts say.

'It has become increasingly difficult to pick investable S-chips with conviction as even the many supposedly financially strong S-chips have turned up negative surprises,' said CIMB-GK analyst Ho Choon Seng.

'Moreover, earnings visibility for many for FY09-10 remains poor,' he added.

SIAS Research vice-president Roger Tan said he expects some negative surprises coming from S-chips in the first-quarter earnings reporting season, where a 15-20 per cent drop in revenue is not beyond imagination.

'Export-orientated manufacturing companies could show losses for the quarter and even for the year. Infrastructure companies, on the other hand, may benefit from the stimulus package introduced in November 2008,' he added.

For export-oriented manufacturing companies, Mr Tan is expecting revenue to fall by between 15 and 20 per cent, while businesses focused on providing products and services to the Chinese government could experience some modest revenue growth of about 5-8 per cent for the year.

So far, S-chips had failed to catch the coat-tails of the market rally in March and earlier this month before it ran out of steam. Analysts have attributed this underperformance to credibility issues surrounding the sector.

'S-chips have been painted with a broad brush due to the many fraud cases, refinancing problems and forced selling of pledged shares,' CIMB- GK's Mr Ho said. 'Problems have been compounded by a number of net-cash companies which have refused to pay any cash dividends.'

Jittery investors have shunned the sector since late last year as a fresh spate of bad news surrounding S-chips has followed since Ferrochina became insolvent, ranging from accounting irregularities to their controlling shareholders running into debt issues.

Now, external auditors of some S-chips are also taking a longer time to verify the trade receivables and cash balances for the financial accounts for the year ended Dec 31, 2008, resulting in a delay in holding annual general meetings (AGMs). Just this week alone, Reyphon Agriceutical and its parent firm Sinomen Technologies, as well as China Lifestyle, announced such a delay.

Pure quantitative analysis on net cash, price- to-earnings and price-to- book value has not worked well as most of the blow- ups have involved S-chips supposedly with net cash positions and undemanding valuations, Mr Ho noted.

Based on qualitative factors such as key shareholders, counterparties, business niche/reputation and steps taken to enhance shareholders' value such as cash dividends and bond buybacks, Mr Ho arrived at three top picks - China Fishery, Pacific Andes and Midas.

'While these companies may not appear the cheapest, we believe their risk-reward is more compelling,' Mr Ho said. 'Moreover, a recovery in confidence and greater earnings visibility should lead to a reversion in valuation multiples, providing further upside.'

'Other S-chips which we believe have strong qualitative qualities but with valuation concerns are China XLX, Cosco and Yanlord,' he added.

Mr Tan of SIAS Research noted that one way to invest in S-chips is to look for those that have minimum 'financial slack', or excess funds (after deducting working capital needs) accumulated by companies by not paying dividends.

While management prefers such a buffer to raising new capital, Mr Tan reads it differently. 'Releasing financial slack signals management's willingness to go through investors' scrutiny and enhance corporate governance,' he said.