GLOBAL CORPORATE FINANCE
JULY 11, 2011
Red Flags for Emerging-Market Companies:
A Focus on China
SPECIAL COMMENT
Overview
Table of Contents:
OVERVIEW
RED FLAGS AN INTERESTING SCREEN
FRAMEWORK FOCUSES ON FIVE KEY
CATEGORIES
APPENDIX 1: FIVE CATEGORIES OF
WARNING SIGNS
APPENDIX 2: A FEW QUANTITATIVE
ADJUSTMENTS FOR PROPERTY
DEVELOPERS
APPENDIX 3: NUMBER OF RED FLAGS
TRIGGERED BY EACH CHINESE ISSUER
APPENDIX 4: CHINESE ISSUERS AND
RED FLAGS TRIPPED FOR EACH
MOODY’S RELATED RESEARCH
1
2
2
8
13
14
16
24
Analyst Contacts:
HONG KONG
852.3551.3077
Elizabeth Allen
852.3758.1353
Vice President – Senior Credit Officer
[email protected]
852.3758.1377
Gary Lau
Managing Director – Corporate Finance
[email protected]
852.3758.1333
Clara Lau
Senior Vice President
[email protected]
SYDNEY
612.9270.8100
Brian Cahill
612.9270.8105
Managing Director – Asia Pacific Corporate and
Finance Institute
[email protected]
Red flags as a screen. In rapidly developing emerging markets, the use of frameworks to
assess elements of credit risk provides consistency in identifying relative strengths and
weaknesses across a growing pool of rated issuers. In this report, we look at 20 red flags,
grouped into five categories, that highlight issues meriting scrutiny to identify possible
governance or accounting risks for non-financial corporate issuers in emerging markets.
These categories are as follows: (1) possible weaknesses in corporate governance, (2) riskier or
more opaque business models, (3) fast-growing-business strategies (4) poorer quality of
earnings or cash flow, and (5) concerns over auditors and quality of financial statements.
Application of screen to China. In this inaugural report, we apply the framework to
Chinese, non-financial rated companies that have recently received a great deal of attention
from regulators and investors. We use the screen on 61 rated Chinese entities and outline the
results by rating category, by industry segment, and by individual issuer.
Limited correlation in China between lower ratings and larger numbers of red flags. In
China, property companies with lower ratings do not tend to have a greater number of red
flags. However, a degree of correlation exists for non-property firms, where, on average,
investment-grade issuers of Baa and above trip 6 red flags, while high-yield Ba issuers trip 7,
B issuers trip 8, and Caa issuers 12. These findings show that screens for governance or
accounting risks can help identify areas to investigate but cannot serve as mechanisms to rank
order credit risk.
More red flags among Chinese non-property than property-related issuers. No property
developer triggered more than 7 flags; whereas five non-property firms set off from 9 to 12.
High-yield (HY) developers averaged 6 red flags versus 8 for HY non-property firms.
Framework an interesting screen. Our ratings already factor in the inherent challenges of
analyzing young, fast growing Chinese companies with few peers, concentrated family
ownership, and sometimes poor transparency. As an illustration, although we rate China’s
sovereign credit at Aa3 with a positive outlook, 80% of rated companies with predominantly
Chinese operations fall below investment grade. In fact, we rate 76% of non-financial HY
issuers at Ba3 and below. The red flags provide further clarity and detail, but do not
represent a change in our rating methodologies.
GLOBAL CORPORATE FINANCE
Focus on negative outliers. West China Cement (Ba3 stable) triggered 12 red flags, Winsway Coking
Coal (Ba3 stable) had 11, China Lumena New Materials (B2 negative) set off 10, and Hidili Industry
International (B1 stable) and LDK Solar (B1 stable) had 9 each. We examine the reasons for the relatively
high number of red flags for these issuers.
Approach appropriate across emerging markets . We initially look only at mainly high-yield and a few
investment-grade issuers in China, but the framework is also applicable to the rest of Asia and other
developing markets.
Red Flags An Interesting Screen
In recent weeks, a variety of participants in the market, including the U.S. Securities and Exchange
Commission (SEC), are looking into potential problems with the quality of financial reporting from
publicly listed Chinese companies. To address investors’ concerns and provide transparency on our
approach to ratings, this report identifies warning signs—so-called “red flags”—for our rated, highyield (HY), non-financial Chinese companies.
The identified issues that we flag do not represent a change to our analytical approach. Our ratings
already account for the inherent challenges in assessing these Chinese companies: their short history of
operations, their diverse industries with limited peers for comparison, their concentrated family
ownership structures, and their high-growth environments. As an illustration, although we rate
China’s sovereign credit at Aa3 with a positive outlook, 80% of rated companies with predominantly
Chinese operations fall below investment grade. In fact, we rate 76% of non-financial HY issuers at
Ba3 and below. We use these flags as an interesting screen to identify potential areas of concern for
follow up and closer scrutiny.
The methods we use and present here are applicable to all HY companies in developing markets , not
just China. Although we summarize our findings for China, we plan to follow up soon with a report
for other HY issuers in the Asian region. We will also include a sub-section on Chinese companies in
our monthly publication and commentary, “Asian Liquidity Stress Index”.
Framework Focuses on Five Key Categories
We use 20 red flags, grouped into the following five categories:
1. Weaknesses in corporate governance: short track record of operations and listing history, murky
shareholders’ background, large and frequent related-party transactions;
2. Riskier or more opaque business models: unusually high margins compared to peers,
concentration of customers, complicated business structures;
3. Fast-growing-business strategies: very rapid expansion, big capital investments resulting in large
negative free cash flow and intangible assets;
4. Poorer quality of earnings or cash flow: discrepancy between cash flows and accounting profits,
disjointed relationship between growth in assets and revenues, large swings in working capital,
insufficient tax paid compared to reported profits;
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SPECIAL COMMENT: RED FLAGS FOR EMERGING-MARKET COMPANIES: A FOCUS ON CHINA
GLOBAL CORPORATE FINANCE
5. Concerns over auditors and quality of financial statements: a switch in auditing firm or legal
jurisdiction of auditor’s office, delay in reporting, or adverse comment from auditors.
Appendix 1 discusses each of these five categories, provides details on the red flags used in each, and
shows the number of times by company type and rating category that Chinese non-financial issuers
triggered each flag. Because of rapid growth, nearly all Chinese HY issuers tripped certain red flags
related to aggressive business and financial strategies and quality of earnings. Moreover, because of the
prevalence of strong founding families in these companies, many of them tripped the red flag for
concentration of family ownership, a situation less common in developed markets. Other flags, which
we deem important, such as those pertaining to auditors, surfaced much more infrequently.
The number of flags triggered acts as a first screen, with each flag receiving equal weighting. As we
examine companies’ flags more closely, some may be of particular concern. For example a frequent
change in auditors appears more serious than having swings in working capital or material negative free
cash flow that the company’s stage of development can explain.
In addition to the five categories of red flags, we also monitor market indicators that may provide more
timely alerts to impending difficulties for an issuer. Such indicators include a sharp drop in an issuer’s
share price, the build-up of a large position of investors shorting the company’s stock, and an upward
spike in the cost of buying credit-default swaps to insure against the company’s default.
We use the same set of qualitative red flags for property developers and for other corporate Chinese
issuers but have made adjustments to three quantitative measures under quality of earnings for
property developers to take account of their business model. Appendix 2 provides details on these
adjustments.
Chinese issuers’ mainly HY ratings already reflect many of the risks highlighted by the red flags
Of 61 Chinese non-financial issuers, we rate 49 as high yield, and 29, or nearly half of the total group,
are property developers. All of the developers, except three, have HY issuer ratings.
As shown below, we rate three quarters of the 49 high-yield Chinese issuers at Ba3 and below, a
percentage in line with the broader Asian (ex Japan) portfolio. Ratings for Chinese property developers
tend to rank lower than non-property firms in the country.
FIGURE 1
Breakdown of our rated HY non-financial corporate issuers by rating category
Rating category
JULY 11, 2011
Chinese Property
All Chinese HY
All HY in Emerging Market Asia
Ba
61%
42%
51%
50%
B
35%
58%
47%
44%
4%
0%
2%
6%
Total High Yield
100%
100%
100%
100%
Ba3 and below
65%
88%
78%
76%
Caa
3
Chinese Non-Property
SPECIAL COMMENT: RED FLAGS FOR EMERGING-MARKET COMPANIES: A FOCUS ON CHINA
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Findings: Limited Correlation Between Red Flags and Ratings
Across the portfolio, we found only limited correlation between lower ratings and larger numbers of red
flags. A lack of correlation characterized our 29 rated property developers – all except 1 tripped from 4 to
7 flags. However, a degree of correlation between number of red flags and rating category exists for the 23
non-property HY firms, where, on average, investment-grade issuers of Baa and above trip 6 red flags,
while high-yield Ba issuers trip 7, B issuers trip 8, and Caa issuers 12.
FIGURE 2
No. of red flags tripped by rating category
Non-property issuers
Rating Category
Property issuers
No. of Issuer
Average no. of red flags tripped
No. of Issuer
Average no. of red flags tripped
9
5.9
3
4.0
Ba
14
7.0
11
5.2
B
8
7.9
15
6.3
Caa
1
12.0
0
0.0
High Yield - Total
23
7.5
26
5.8
Total China
32
7.1
29
5.7
Investment Grade
As a group, the HY property firms had fewer red flags on average—at 5.8—versus 7.5 for the 23 HY
non-property issuers. The business model of property firms partly explains the lower number because
the broad, retail client base of developers ensures that almost all of these firms do not raise concerns
over undue concentration of customers. Only one developer tripped this red flag. Other possible
reasons for fewer red flags among developers include: (1) the high visibility of the industry in terms of
land costs, project values, and number of construction sites; (2) the large number of issuers make peer
comparisons easier for investors and lenders; and (3) rated firms tend to be the strongest among a huge
number of developers in the country and their activities thus attract a good deal of public attention
and scrutiny. Appendix 3 provides more detail on rated property and non-property Chinese companies
and numbers of red-flags tripped by each, while Appendix 4 names, in similar groupings, the
companies that set off each form of red flag.
Negative Outliers Attract Greater Scrutiny
The framework shows the following five companies as having the highest number of red flags in the
portfolio: West China Cement (Ba3 stable) with 12, Winsway Coking Coal (Ba3 stable) with 11,
China Lumena New Materials (B2 negative) with 10, and Hidili Industry International (B1 stable)
and LDK Solar (B1 stable) with 9 each. Three of these firms, Winsway, Lumena, and Hidili, mine
coal or other minerals, which tend to attract scrutiny because it is often hard to value these assets and
reserves in terms of size, value, or ownership rights. One property developer, Longfor Properties (Ba2
stable), had 7 red flags, the highest in the property group for the level of its rating.
An issuer’s tripping of many red flags does not represent an immediate rating concern because our
ratings already reflect many of the issues highlighted by the relevant red flags, and the ratings also
incorporate more than just the potential concerns that the flags capture. Moreover, as indicated, there
is only limited correlation between lower ratings and a higher number of red flags tripped.
Nevertheless, we provide some comments below on the red flags tripped by the negative outliers, and
what risks these flags are highlighting.
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West China Cement (Ba stable) – 12 red flags
As the second largest producer of cement in China’s province of Shaanxi, West China Cement (WCC)
has a risk profile that triggered the most red flags of our Chinese issuers. Two key individuals, WCC’s
chairman and his daughter, dominate the company with 44% of its stock; the firm’s auditors have
changed twice; and WCC has had inadequate compliance with International Financial Reporting
Standards (IFRS) and insufficient policies for internal control and procedures before its listing in
Hong Kong in August 2010.
In previous years, WCC’s accounting-control systems had struggled to keep up with growth in the
business. In response to this weaknesses, WCC implemented remedial actions and had two follow-up
and favorable reviews by an independent advisor on internal controls before listing on Hong Kong’s
stock exchange. WCC subsequently retained the independent advisor to review its internal controls for
the current year. A year before listing, WCC had changed from a small U.K.-based accountancy to
PwC, a big-four firm. It then changed to Deloitte, another big-four firm, after only two years, to take
advantage of lower fees.
In 2011, a change in chief executive officer (CEO) and chief financial officer (CFO) occurred, but we
view the CEO’s change as positive because it split the role of chairman and CEO, while the CFO
remains as an executive director of the company’s board.
WCC explains its high profitability, with EBITDA margins over 40%, as resulting from a favorable
geographic location that poses barriers to competitors’ entry in servicing nearby infrastructure projects
of China’s Western Development Plan. In general, the cement business is transparent in pricing and
market shares, which investors can verify at public domains such as Digital Cement
(http://www.dcement.com). WCC conducts a lot of business on a cash-upfront basis with its
customers and, thus, shows a low level of trade receivables.
Winsway Coking Coal (Ba3 stable) – 11 red flags
Our ratings for Winsway, a coking-coal logistics business, take into account the company’s short track
record and plan for rapid expansion. By quintupling its procurement of Mongolian coal from 1.3
million tons (MT) in 2008 to 6.5MT in 2010, the company triggered several red flags in its build-out
of needed infrastructure, which put pressure on working capital and resulted in negative free cash flow,
along with a fast rise in revenue.
The ratings also reflect a red flag for related-party transactions because the company’s chairman has
both majority ownership of Winsway and external, commodities-trading businesses, which facilitated
the debut and growth of Winsway’s operations. Nevertheless, reported related-party transactions have
been immaterial, and the chairman has a non-compete agreement with Winsway.
China Lumena New Materials (B2 negative) – 10 red flags
Lumena, a miner of thenardite, triggered red flags for its rapid growth, short listing history, high
concentration of customers and ownership, and poorer quality of earnings and cash flow. The firm
more than quintupled its revenue in three years and enjoyed strong operating profits, which we
attribute to Lumena’s high-grade thenardite reserves, the company’s status as the only commercialscale, specialty-thenardite producer, and its exclusive license in China to produce a valued commodity,
medical thenardite.
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However, in the last four years, Lumena has incurred much larger capital expenditure than operating
cash flow, and in the past year, growth in cash flows has lagged earnings due to a material worsening in
collections of trade receivables. In particular, Lumena has granted longer credit terms to its customers
of specialty thenardite and medical thenardite. So far, the company has not considered provisioning
for accounts receivable aged under one year based on its previous experience with these customers.
Nevertheless, we are monitoring the quality of Lumena’s cash flow, which we view as one of the major
drivers for the firm’s rating. Moreover, Lumena’s chairman has a 40% stake in the company, and our
rating also accounts for a need for greater transparency and consistency in the firm’s long-term
strategy.
Hidili Industry International (B1 stable) - 9 red flags
Our assessment of Hidili already factors in the company’s appetite for expansion, concentration of
customers, and slow accounts-receivable cycle and inventory turnover—all of which pop up as red
flags. Hidili has grown into its current size by aggressively acquiring small coal mines and then
consolidating them. Most of the acquired mines are still under applications for legal title from Chinese
local governments. This lack of governmental approval creates a degree of legal uncertainty over the
value of such assets. In addition, only slightly more than half of the coal reserves were assessed
according to the international standards code set by the Australasian Joint Ore Reserves Committee,
with the rest assessed by Chinese standards.
The following factors mitigate other potential concerns: (1) the company’s revenues involve few
related-party transactions, (2) market information for coking-coal prices is transparent, (3) Hidili’s
customers are less concentrated than a year ago, and (4) Hidili’s major clients are mainly large steel
plants in China.
LDK Solar (B1 stable) – 9 red flags
The high number of red flags for solar-panel-wafer manufacturer, LDK Solar, reflects the past few
years’ volatility in the solar-power industry’s prices for polysilicon raw materials and profitability.
Polysilicon prices dropped nearly 90%, from more than US$450 per ton in 2Q08 to about US$50 per
ton in 2009 during the global financial crisis but rebounded in 2010. This whipsaw in a key input’s
cost affected LDK’s revenue growth, inventory days, and bargaining power with customers which in
turn affected profitability, cash flow, and days for accounts receivable.
In 2010, LDK’s rapid growth in revenues and assets stemmed from fast expansion in capacity to
capitalize on improved market conditions. In addition, LDK’s short history mirrors the solar industry’s
robust growth over the last few years from a low base. We consider LDK’s volatility as being in line
with the industry’s recent trends and, thus, not a cause for concern. Although a single individual has a
nearly 50% stake in the company, the level of related-party transactions between LDK and the
shareholder’s other firms have remained limited.
Longfor (Ba2 stable) – 7 red flags
Longfor has the highest rating at Ba2 among property developers with the most red flags—7, slightly
above the property group’s Ba-average of 5. The red flags hit are: 1) aggressive growth, 2) short listing
history, 3) ownership concentration, 4) change in CFO, 5) Large negative free cash flow, 6) sales
generation on capital employed, and 7) low tax payment. Longfor’s fast growth is in line with the
overall sector and similar to that of peers such as Agile, Country Garden, and Shimao. Like other
developers, Longfor has a short listing history and concentrated ownership. Longfor’s large negative
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free cash flow is also a common characteristic of rapidly growing Chinese developers trying to gain
market share in a fragmented industry. In the past year, Longfor changed its CFO once in what we
view as a normal reshuffle of personnel. The company’s chairman and CEO is the largest shareholder
within the group.
Longfor’s ability to generate sales is low compared to peers due to its having a larger-than-average share
of its portfolio in investment properties, which lock up more capital than properties for development
and sale. Longfor’s tax paid was also low relative to its accounting profit and taxes paid by many of its
peers. This characteristic reflects Longfor’s relatively low cost for land and larger portfolio of
investment properties. Low land cost led to higher profitability, but such profit was subject to China’s
land appreciation tax, part of which is deferrable. At the same time, Longfor’s investment properties
have reported revaluation gains, which are taxable but non-payable.
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Appendix 1: Five Categories of Warning Signs
1. Weaknesses in Corporate Governance
Issue: Weak corporate governance may lead to decision-making processes that favor the interests of
some or all shareholders at the expense of bondholders and other creditors. It is difficult to determine
the effectiveness of a company’s corporate governance when the firm has a limited operating record
and short listing history as a public company. The predominantly family-controlled nature of Chinese
HY companies makes a clear view of its governance practices even more problematic. Such firms may
not yet have established a track record for investors to make informed judgments about managerial
behavior.
The existence and extent of related businesses are also hard to ascertain, and if they exist, raise concerns
over potential diversion of funds. Moreover, the companies’ management may report related-party
transactions as arms-length, which obscures their transparency when the related party’s identity
remains undisclosed.
The table below shows the red flags that fall into this category and the number of times, by company
type and rating category, that Chinese non-financial issuers triggered the flags:
FIGURE 3
Number of Red Flags Tripped – Corporate Governance
Non-Property HY Issuers
Rating Category / (No. of Issuers)
Property HY Issuers
Ba (14)
B (8)
Caa (1)
Total
Ba (11)
B (15)
Total
1
Short track record: Under 7 years of operating history
1
1
1
3
0
0
0
2
Short listing history: Under 3 years or private
3
4
1
8
3
7
10
3
Concentration of family ownership:
Major shareholding family control >30% stake
10
7
1
18
11
14
25
4
Change of senior management: Change of CEO/CFO
2
0
1
3
3
7
10
5
Significant related-party transactions
1
1
0
2
0
1
1
a) >10% of sales or 10% of cost of goods sold, or
1
1
0
2
0
1
1
b) Receivables due > 10% of total assets
0
0
0
0
0
0
0
Major shareholder's private business: Existence of
material business outside of issuer
4
3
0
7
3
3
6
6
Note: Tests applied to last 3 years, unless specified
Our Approach: We factor an issuer’s corporate governance into both our initially assigned ratings and
our ongoing monitoring process. In addition to the points noted above, we use a qualitative approach
based on discussions with the company’s management as well as an understanding of internal
corporate controls and risk appetite. We also look at the degree of ongoing disclosure that the
company provides—both to the public and to us.
We note that listing requirements mean most, if not all, listed companies, meet certain international
standards of best practice such as having a board with at least some independent directors who
comprise and chair an audit committee. It is difficult to determine the true independence of board
members and their influence over the company but more straightforward to evaluate the directors’
credentials to ensure that they are financially literate and versed in the business.
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2. Riskier or More Opaque Business Model
Issue: We look for business models that have unusual or possibly risky characteristics. Certain
industries are harder to analyze or value due to a low level of market transparency or a lack of
standardized valuation techniques.
Relative to its peers, a company may have abnormally high margins that the structure of its industry
may not adequately explain. The company’s revenue may also come from only a few customers,
making it prone to sudden shortfalls if it loses an account or leaving it susceptible to undue influence
from its key clients. Moreover, the information about these major customers could be limited and raise
concerns about hidden arrangements. The company may also have a complicated business structure –
particularly if involving non-consolidated joint ventures - that makes difficult the verification of
sources and uses of its funds, as well as valuation of assets on its balance sheet.
The table below shows the red flags that fall into this category and the number of times, by company
type and rating category, that Chinese non-financial issuers triggered the flags:
FIGURE 4
Number of Red Flags Tripped – Business Model
Non Property HY Issuers
Rating Category / (No. of Issuers)
Ba (14)
B (8) Caa (1)
Property HY Issuers
Total
Ba (11)
B (15)
Total
7
Extraordinary high profit margin: Reported EBITDA
margin >40%
4
3
1
8
4
7
11
8
High customer concentration: Top 5 customers >
30% of revenue
4
5
1
10
1
0
1
9
Complicated group structure :
2
2
0
4
1
2
3
a) Investment in JV/Associate to Total Assets,
0
0
0
0
0
0
0
b) Dividends from JV/Associate/
(FFO + dividends from JV/Associate) , or
2
0
0
2
1
0
1
c) Share of profit from JV/Asso to net profit > 30%
1
2
0
3
1
2
3
Note: Tests applied to last 3 years, unless specified
Our Approach: As a screen, we look at companies with an EBITDA margin greater than 40%. Since a
company’s business model and competitive positioning may justify such high margins, we then assess
the margins’ veracity and sustainability by looking at rated or unrated peers. We also evaluate the
relationship with, and performance of, group companies such as joint ventures and associated
companies whose financial results the firm does not consolidate due to a lack of controlling stakes.
3. Fast-Growing-Business Strategies
Issue: Companies in rapidly growing emerging markets like China often have ambitious plans for
expansion, which result in aggressive financial and operational strategies. A fast-growing company faces
challenges such as stretched managerial attention and over-extended infrastructure, systems, and
financial resources.
Moreover, such firms make big capital investments unsupported by cash flows from operations, which
result in large, negative free cash flow (FCF), funded by debt or equity. These companies may face
funding challenges if market participants suddenly lose confidence in them. Such a crisis of confidence
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can lead to shortfalls in balance-sheet liquidity, to a longer-term inability to execute the company’s
business strategy, or to both.
If the firms also make large acquisitions, the purchases result in a high percentage of intangible assets
from acquired goodwill—the difference between purchase price and book value. Companies might also
adjust their financial results via such accounting because they can assign values to purchased assets and
liabilities. The value of intangibles for a company that has grown quickly via acquisitions or mergers
may also no longer be accurate over time and could result in an over-statement of the company’s true
worth and profitability.
The table below shows the red flags that fall into this category and the number of times, by company
type and rating category, that Chinese non-financial issuers triggered the flags:
FIGURE 5
Number of Red Flags Tripped – Growth Strategy
Non Property HY Issuers
Rating Category / (No. of Issuers)
10
Ba (14)
B (8)
Total
Ba (11)
1
17
1
15
1
6
0
Aggressive growth
9
7
a) Total assets double over 3 years
7
7
b) Revenue double over 3 years
9
6
11
0
11
Large negative FCF: Negative FCF > 50% of OCF
12
Large proportion of intangible assets:
Intangibles/total assets > 25%
Caa (1)
Property HY Issuers
B (15)
Total
11
13
24
9
10
19
16
9
7
16
0
17
11
15
26
0
0
0
0
0
Note: Tests applied to last 3 years, unless specified
Our Approach: We classify a company as having a fast-growing-business strategy when it doubles its
revenue or asset base in three years. A pattern of past growth offers insight into management’s future
risk appetite. As a company expands via acquisition, it incurs large expenses. We also look at
companies with negative free cash flow greater than 50% of operating cash flow as well as serial
acquirers of subsidiaries and flag firms when the stated value of intangibles represent more than 25%
of total assets. These factors are common among Chinese corporate issuers, and have historically been
a key reason for our assignment of high-yield rather than investment-grade ratings.
4. Poorer Quality of Earnings or Cash Flow
Issue: In assessing a company’s strategy for growth, it is useful to look at relevant financial statements
to determine whether the generation of cash flow matches reported profits. The generation of cash
flow, not accounting profit, is crucial for repaying debt and funding future growth. Moreover, as large
sums frequently go into capital expenditure (capex) and investment, these are other areas to look at to
see whether such investments are generating cash flows. Although generation of cash flows may lag
investments and result in a prolonged period of imbalance, such a situation may also suggest a
deterioration of asset quality, a weakened ability to generate cash flow, or diversion of funds from
revenue-generating assets.
The two tables below show the red flags that fall into this category and the number of times, by
company type and rating category, that Chinese non-financial issuers triggered the flags:
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FIGURE 6
Number of Red Flags Tripped - Quality of Earnings & Cashflows
Non Property HY Issuers
Rating Category / (No. of Issuers)
13
14
Ba (14)
B (8)
Caa (1)
Total
1
21
Quality of cash flow generation
13
7
a) OCF/ net income <1
12
6
1
19
b) OCF before interest & tax / EBITDA <1
10
6
0
16
Deviation in working capital
13
8
0
21
a) Change in accounts receivable days > 20%
10
8
0
18
9
7
0
16
b) Change in accounts payable days > 20%
c) Change in inventory days >20%
11
8
0
19
15
Low tax paid relative to accounting profit: Tax paid in cash/profit before
tax <10%
9
2
1
12
16
Inadequate revenue generation from assets:
Change of PPE/Revenue ratio > 20% from prior year
9
6
1
16
Note: Tests applied to last 3 years, unless specified
FIGURE 7
Number Of Red Flags Tripped - Quality Of Earnings & Cashflows
Chinese HY Property Issuers
Rating Category / (No. of Issuers)
Ba (11)
B (15)
Total (26)
13
Quality of cash flow generation: (Cash + Restricted cash + Land – Increase in total
debt) / [(Advance from customers Yr2 - Yr1) + Sales Yr2] < 25%
2
5
7
14
Sales generation on capital employed: Sales / Total assets < 15%
4
8
12
15
Sales completion ability: Book sales Yr2 / Contracted sales Yr1 < 70%
0
6
6
16
Low tax paid relative to accounting profit: Tax paid in cash/profit before tax
<10%
2
4
6
Note: Tests applied to last 3 years, unless specified
Our Approach: We look at the relationship between operating cash flow (OCF) and accounting
profits, with OCF measured after deducting requirements for working capital, the fluctuation of which
could affect generation of OCF. The discrepancy between cash flows and accounting profits may
warrant further scrutiny. Generally, OCF should be much higher than net income, which includes
depreciation and amortization; whereas OCF does not. Moreover, a firm’s OCF before interest and tax
as a percentage of EBITDA should be fairly consistent, unless a business is growing rapidly, as are most
issuers in China.
A growing company also needs to fund its rising need for working capital, which weakens OCF. Since
a few Chinese issuers reported negative OCF, we look at individual deviations in working-capital
cycles, including accounts receivable, accounts payable, and inventory days. Sometimes, the evolution
of the company’s business model explains the deviation, but we still need to understand the factors
behind it.
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GLOBAL CORPORATE FINANCE
We also look at tax paid in cash to see if accounting profits match those reported for tax purposes. For
example, we investigate if a company reports large accounting profits but does not pay tax. Sometimes,
however, material tax holidays or other waivers explain the discrepancy.
In addition we look at the relationship between the company’s revenue and the value of its plant,
property and machinery (PPE). As a company spends to expand, we want to be sure that amounts
reported as capex go into productive assets and that capex is, indeed, capex and not operating
expenditure (opex). As shown ten years ago by fraud uncovered at Worldcom, the reporting of opex as
capex is one of the most difficult sleights of hand to spot, yet one of the easiest ways for dishonest
managers to fraudulently dress up reported financial numbers.
Please refer to Appendix 2 for a discussion on adjustments that we make in the quantitative metrics for
property developers.
5. Concerns over Auditors
Issue: A company’s change of auditor is often an important red flag as it may indicate concerns with
the accuracy of the company’s accounts or other possible problems. A firm that relies on an auditor
lacking a physical presence in China or Hong Kong raises concern as to whether the auditor has
sufficient understanding of local market practices and has sufficient resources to do an effective audit.
More obvious potential shortcomings include delays in financial reporting and accounts qualified by
auditors.
The table below shows the red flags that fall into this category and the number of times, by company
type and rating category, that Chinese non-financial issuers triggered the flags:
FIGURE 8
Number Of Red Flags Tripped – Concerns Over Auditors/Financial Statements
Non Property HY Issuers
Rating Category / (No. of Issuers)
Ba (14)
B (8) Caa (1)
Property HY Issuers
Total
Ba (11)
B (15)
Total
17
Change in auditors
1
0
0
1
0
3
3
18
Signing auditor located in a different country to
key business operations
2
1
0
3
1
0
1
19
Delay in result announcement or filing audited
statements in past 3 years
0
0
1
1
0
0
0
20
Qualified accounts
(incl. internal control weakness)
0
0
1
1
0
0
0
Note: Tests applied to last 3 years, unless specified
Our Approach: During the past three financial years, we note any changes in auditors and the location
of the auditor’s offices. We also examine any delays in reporting of results or filing of audited
statements, and any adverse opinions from the auditors. However, by the time such delays or opinions
surface, as in the case of China Forestry (Caa2 negative), problems at the company may have already
escalated to a serious stage.
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GLOBAL CORPORATE FINANCE
Appendix 2: A Few Quantitative Adjustments for Property Developers
Although we use the same qualitative red flags for property developers and for other corporate Chinese
issuers, we have adjusted three quantitative measures, grouped under quality of earnings for developers,
to take account of their business model.
China’s property developers may sell their product before completion of construction, which results in
a material time gap between their recognition of revenues upon the properties’ delivery and cash
generation from pre-sales that constitute developers’ main cash inflow. We look at developers’ ability
to collect cash from pre-sales and deliver the pre-sold properties within a reasonable timeframe.
Moreover, developers’ use of working-capital and operating activities for certain long-term investments
such as payments for land for later development makes operating cash flow from accounting
statements an unreliable measure of cash-flow generation. Thus, we use these three factors to measure
quality of earnings:
1. [Cash holding + land payments – increase/(decrease) in borrowings]/[Change in advance from
customers between Y2 and Y1 + sales revenues for Y2]. Since pre-sales are neither audited nor
reported in the financial statements, we use the denominator as a proxy for cash or contracted
property sales for year two (Y2). This ratio tests developers’ abilities to collect cash by measuring
whether the cash holding (after stripping out investment activities such as payment for land and
cash flow from financing activities) is consistent with the companies’ cash-based or contracted
sales figures.
2. Sales/Total assets: This ratio compares developers’ ability to generate sales versus their assets. Any
material difference from the industry norm would merit more scrutiny.
3. Accounting revenues for Y2/Contract sales for Y1: This ratio compares developers’ ability in
turning contracted sales into accounting revenues within a certain timeframe. Any material
difference from the industry norm would call for further examination.
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GLOBAL CORPORATE FINANCE
Appendix 3: Number of Red Flags Triggered by Each Chinese Issuer
The following tables arrange by descending rating the number of flags triggered by each Chinese
issuer, grouped according to non-property and property firms. The yellow highlights point to the
companies with the most red flags in each of the two groups.
FIGURE 9
List of Chinese HY Non-Property Issuers - By Rating
Corporate Family
Rating/Bond Rating/
Outlook
Issuer Name
1
China Oriental Group Company Ltd
2
Red
Flags
Tripped
Industry
Ba1/Negative
7
Steel
Parkson Retail Group Limited
Ba1/Stable
3
Retail
3
Citic Pacific Limited
Ba1/Stable*
7
Conglomerate
4
Chaoda Modern Agriculture (Holdings) Ltd
Ba2/Stable
6
Natural product
5
Fosun International
Ba2/Stable
7
Conglomerate
6
Texhong Textile Group Limited
Ba2/Stable
4
Manufacturing
7
Sino-Forest Corporation
Ba2/RFPD
7
Paper & Forest Product
8
China Liansu Group Holdings Ltd
Ba2/Stable
6
Building Materials
9
E-Land Fashion China Holdings Ltd
Ba2/Stable
8
Retail
10
Winsway Coking Coal Holdings Ltd
Ba3/B1/Stable
11
Transportation
11
China Fishery Group Limited
Ba3/Stable
8
Natural product
12
China Automation Group Limited
Ba3/Stable
6
Manufacturing
13
West China Cement Limited
Ba3/Stabe
12
14
Lonking Holdings Ltd
(P)Ba3/Stable
6
Manufacturing
Building Materials
15
LDK Solar Co. Ltd
B1/B2/Stable
9
Manufacturing
16
China Qinfa Group Limited
B1/B2/Stable
8
Metals and Mining
17
China Glass Holdings Limited
B1/B2/Stable
5
Building Materials
18
Hidili Industry International Development Ltd
Metals and Mining
19
China Lumena New Materials Corp
20
Global Dairy Holdings Limited
21
CITIC Resources Holdings Limited
22
23
B1/Stable
9
B2/Negative
10
B2/Stable
6
Natural product
Ba3/Stable**
7
Oil & Gas
Giti Tire Pte. Ltd
B3/Caa1/Stable
9
Autoparts
China Forestry Holdings Co Ltd
Caa2/Negative
12
Chemicals
Paper & Forest Product
* Standalone credit profile of CITIC Pacific is Ba3
** Standalone credit profile of CITIC Resources is B2
Note: Negative outliers are shaded
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FIGURE 10
List of Chinese HY Property Issuers - By Rating
Corporate Family Rating/
Bond Rating/ Outlook
Issuer Name
1
Longfor Properties Co. Ltd.
2
Agile Property Holdings Limited
3
Yanlord Land Group Limited
4
Powerlong Real Estate Holdings Limited
5
Red Flags Tripped
Ba2/Ba3/Stable
7
Ba2/Stable
6
Ba2/Stable
5
Ba3/B1/Negative
6
KWG Property Holding Ltd
Ba3/B1/Stable
4
6
SPG Land (Holdings) Ltd
Ba3/B1/Stable
5
7
Central China Properties
Ba3/B1/Stable
4
8
Renhe Commercial Holdings Ltd
Ba3/Stable
7
9
Country Garden Holdings Company Limited
Ba3/Stable
4
10
Road King Infrastructure Limited
Ba3/Stable
4
11
Shimao Property Holdings Limited
Ba3/Stable
5
12
Fantasia Holdings Group Ltd
B1/B2/Stable
4
13
Evergrande Real Estate Group Ltd
B1/B2/Negative
7
14
Kaisa Group Holdings Ltd
B1/B2/Negative
7
15
Zhong An Real Estate Limited
B1/Stable
6
16
Hopson Development Holdings Limited
B1/B2/Stable
7
17
Yuzhou Properties Company Limited
B1/B2/Stable
7
18
China South City Holdings Limited
19
China SCE Property Holdings Ltd
20
Lai Fung Holdings Limited
21
Glorious Property Holdings Ltd
22
Shanghai Industrial Urban Development Group Limited
23
Greentown China Holdings Limited
24
Shanghai Zendai Property Limited
25
SRE Group Limited
26
Coastal Greenland Limited
B3/Caa1/Stable
3
B1/B2/RFD
7
B1/B2/Positive
7
B1/Stable
5
B2/B3/Stable
7
B2/RFU
7
B3/Caa1/Negative
7
B3/Caa1/RFD
7
B3/Caa1/Stable
7
Note: Negative outliers are shaded
15
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GLOBAL CORPORATE FINANCE
Appendix 4: Chinese Issuers and Red Flags Tripped for Each
The following two sets of tables summarize the extent to which HY non-property and property issuers in China triggered particular
red-flag categories. The first set covers our 23 HY non-property firms; the second does the same for our 26 HY property developers.
FIGURE 11
Red Flags for Chinese HY Non-Property Issuers (1)
Rating
Outlook
Number of Red Flags Tripped
China
Oriental
Parkson
Retail
CITIC
Pacific
Chaoda
Fosun
Texhong
Textile
SinoForest
Ba1
Ba1
Ba1
Ba2
Ba2
Ba2
Ba2
Negative
Stable
Stable
Stable
Stable
Stable
RFPD
7
3
7
6
7
4
7
x
x
x
x
Corporate Governance
1
Short track record: Under 7 years of operating history
2
Short listing history: Under 3 years or private
3
Concentration of family ownership: Major shareholding family
control >30% stake
4
Change of senior management: Change of CEO/CFO
5
Significant related party transactions: > 10% of sales, cost of goods
sold; or receivables > 10% of total assets
x
6
Major shareholder's private business: Existence of material business
outside of issuer
x
x
Business Model
7
Extraordinary high profit margin: Reported EBITDA margin >40%
8
High customer concentration: Top 5 customers > 30% of revenue
9
Complicated group structure : Investment in JV/asso to total assets
> 30%, Dividends from JV/asso/(FFO + dividends from JV/Asso), or
Share of profit from JV/asso to net profit > 30%
x
x
x
x
x
x
Growth Strategy
10
Aggressive growth: Total asset or revenue doubled over 3 years
x
11
Large negative Free Cash Flow: Negative FCF > 50% of OCF
x
x
x
12
Large proportion of intangible assets: Intangibles/total assets > 25%
13
Quality of cash flow generation: OCF/net income or OCF before
interest & tax/EBITDA < 1
x
x
x
x
x
x
14
Deviation in working capital: Year-on-year change in accounts
receivable days, accounts payable days , or inventory days > 20%
x
x
x
x
x
x
15
Low tax paid relative to accounting profit: Tax paid in cash/profit
before tax <10%
x
x
x
x
x
x
16
Inadequate revenue generation from assets: Change of PPE/Revenue
ratio > 20% from prior year
x
x
Quality of Earnings & Cashflows
x
x
x
Concerns over Auditors/Financial Statements
17
Change in auditors
18
Signing auditor located in a different country to key business
operations
19
Delay in result announcement or filing audited statements in past 3
years
20
Qualified accounts (incl. internal control weakness)
x
Note: Tests generally applied to last 3 years
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FIGURE 12
Red Flags for Chinese HY Non-Property Issuers (2)
Rating
Outlook
Number of Red Flags Tripped
Winsway
China
Fishery
China
Automatio
n
West
China
Cement
Lonking
Ba3
Ba3
Ba3
Ba3
(P)Ba3
Stable
Stable
Stable
Stable
Stable
Stable
8
11
8
6
12
6
x
x
China
Liansu
E-Land
Fashion
Ba2
Ba2
Stable
6
Corporate Governance
1
Short track record: Under 7 years of operating history
x
2
Short listing history: Under 3 years or private
x
x
x
3
Concentration of family ownership: Major shareholding family
control >30% stake
x
x
x
4
Change of senior management: Change of CEO/CFO
5
Significant related party transactions: > 10% of sales, cost of
goods sold; or receivables > 10% of total assets
6
Major shareholder's private business: Existence of material
business outside of issuer
x
x
x
x
x
Business Model
7
Extraordinary high profit margin: Reported EBITDA margin
>40%
x
8
High customer concentration: Top 5 customers > 30% of
revenue
9
Complicated group structure: Investment in JV/asso to total
assets > 30%, Dividends from JV/asso/(FFO + dividends from
JV/Asso), or Share of profit from JV/asso to net profit > 30%
10
Aggressive growth: Total asset or revenue doubled over 3 years
x
11
Large negative Free Cash Flow: Negative FCF > 50% of OCF
12
Large proportion of intangible assets: Intangibles/total assets >
25%
13
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
Quality of cash flow generation: OCF/net income or OCF before
interest & tax/EBITDA < 1
x
x
x
x
x
x
x
14
Deviation in working capital: Year-on-year change in accounts
receivable days, accounts payable days , or inventory days >
20%
x
x
x
x
x
x
x
15
Low tax paid relative to accounting profit: Tax paid in
cash/profit before tax <10%
x
x
16
Inadequate revenue generation from assets: Change of
PPE/Revenue ratio > 20% from prior year
x
x
Growth Strategy
Quality of Earnings & Cashflows
x
x
x
x
Concerns over Auditors/Financial Statements
17
Change in auditors
x
18
Signing auditor located in a different country to key business
operations
x
19
Delay in result announcement or filing audited statements in
past 3 years
20
Qualified accounts (incl. internal control weakness)
Note: Tests generally applied to last 3 years
17
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FIGURE 13
Red Flags for Chinese HY Non-Property Issuers (3)
Rating
Outlook
Number of Red Flags Tripped
LDK
Solar
China
Qinfa
China
Glass
Hidili
China
Lumena
Global
Dairy
CITIC
Resources
B1
B1
B1
B1
B2
B2
Ba3
Stable
Stable
Stable
Stable
Negative
Stable
Stable
9
8
5
9
10
6
7
x
x
x
x
Corporate Governance
1
Short track record: Under 7 years of operating history
2
Short listing history: Under 3 years or private
3
Concentration of family ownership: Major shareholding family control
>30% stake
4
Change of senior management: Change of CEO/CFO
5
Significant related party transactions: > 10% of sales, cost of goods sold;
or receivables > 10% of total assets
6
Major shareholder's private business: Existence of material business
outside of issuer
x
x
x
x
x
x
x
x
x
Business Model
7
Extraordinary high profit margin: Reported EBITDA margin >40%
8
High customer concentration: Top 5 customers > 30% of revenue
9
Complicated group structure: Investment in JV/asso to total assets >
30%, Dividends from JV/asso/(FFO + dividends from JV/Asso), or Share
of profit from JV/asso to net profit > 30%
10
Aggressive growth: Total asset or revenue doubled over 3 years
11
Large negative Free Cash Flow: Negative FCF > 50% of OCF
12
Large proportion of intangible assets: Intangibles/total assets > 25%
x
x
x
x
x
x
x
x
x
Growth Strategy
x
x
x
x
x
x
x
x
x
x
x
x
x
Quality of Earnings & Cashflows
13
Quality of cash flow generation: OCF/net income or OCF before interest
& tax/EBITDA < 1
x
x
x
x
x
14
Deviation in working capital: Year-on-year change in accounts receivable
days, accounts payable days, or inventory days > 20%
x
x
x
x
x
x
15
Low tax paid relative to accounting profit: Tax paid in cash/profit before
tax <10%
x
16
Inadequate revenue generation from assets: Change of PPE/Revenue
ratio > 20% from prior year
x
x
x
x
x
x
x
Concerns over Auditors/Financial Statements
17
Change in auditors
18
Signing auditor located in a different country to key business operations
19
Delay in result announcement or filing audited statements in past 3
years
20
Qualified accounts (incl. internal control weakness)
Note: Tests generally applied to last 3 years
18
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FIGURE 14
Red Flags for Chinese HY Non-Property Issuers (4)
Giti Tire
Rating
Outlook
Number of Red Flags Tripped
China Forestry
B3
Caa2
Stable
Negative
9
12
Corporate Governance
1
Short track record: Under 7 years of operating history
x
2
Short listing history: Under 3 years or private
x
x
3
Concentration of family ownership: Major shareholding family control >30% stake
x
x
4
Change of senior management: Change of CEO/CFO
5
Significant related party transactions: > 10% of sales, cost of goods sold; or receivables > 10% of total assets
6
Major shareholder's private business: Existence of material business outside of issuer
x
x
Business Model
7
Extraordinary high profit margin: Reported EBITDA margin >40%
x
8
High customer concentration: Top 5 customers > 30% of revenue
x
9
Complicated group structure: Investment in JV/asso to total assets > 30%, Dividends from JV/asso/(FFO + dividends
from JV/Asso), or Share of profit from JV/asso to net profit > 30%
x
Growth Strategy
10
Aggressive growth: Total asset or revenue doubled over 3 years
11
Large negative Free Cash Flow: Negative FCF > 50% of OCF
12
Large proportion of intangible assets: Intangibles/total assets > 25%
x
x
Quality of Earnings & Cashflows
13
Quality of cash flow generation: OCF/net income or OCF before interest & tax/EBITDA < 1
x
14
Deviation in working capital: Year-on-year change in accounts receivable days, accounts payable days , or inventory
days > 20%
x
15
Low tax paid relative to accounting profit: Tax paid in cash/profit before tax <10%
16
Inadequate revenue generation from assets: Change of PPE/Revenue ratio > 20% from prior year
x
x
x
x
Concerns over Auditors/Financial Statements
17
Change in auditors
18
Signing auditor located in a different country to key business operations
19
Delay in result announcement or filing audited statements in past 3 years
x
20
Qualified accounts (incl. internal control weakness)
x
x
Note: Tests generally applied to last 3 years
19
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GLOBAL CORPORATE FINANCE
The next set of tables summarize the extent to which our 26 rated HY Chinese property developers triggered particular red-flag
categories:
FIGURE 15
Red Flags for Chinese HY Property Issuers (1)
Rating
Outlook
Number of Red Flags Triggered
Longfor
Agile
Yanlord
Powerlong
KWG
SPG Land
Central China
Ba2
Ba2
Ba2
Ba3
Ba3
Ba3
Ba3
Stable
Stable
Stable
Negative
Stable
Stable
Stable
7
6
5
6
4
5
4
x
x
x
x
x
x
x
Corporate Governance
1
Short track record: Under 7 years of operating history
2
Short listing history : Under 3 years or private
x
3
Concentration of family ownership: Major shareholder family control
>30% stake
x
4
Change of senior management: Change of CEO/CFO
x
5
Significant related party transactions: > 10% of sales, cost of goods sold;
or receivables > 10% of total assets
6
Major shareholder's private business:
Existence of material business outside of issuer
7
Extraordinary high profit margin: Reported EBITDA margin >40%
8
High customer concentration: Top 5 customers > 30% of revenue
9
Complicated group structure: Investment in JV/asso to total assets > 30%,
Dividends from JV/asso/(FFO + dividends from JV/Asso), or Share of profit
from JV/asso to net profit > 30%
x
x
x
Business Model
x
x
x
Growth Strategy
10
Aggressive growth: Total asset or revenue doubled over 3 years
x
x
x
x
x
x
x
11
Large negative Free Cash Flow: Negative FCF > 50% of OCF
x
x
x
x
x
x
x
12
Large proportion of intangible assets: Intangibles/total assets > 25%
13
Quality of cash flow generation: (Cash + Restricted cash + Land – Increase
in total debt) / [(Advance from customers Yr2 - Yr1) + Sales Yr2] < 25%
14
Sales generation on capital employed: Sales / Total assets < 15%
x
x
15
Sales completion ability: Book sales Yr2 / Contracted sales Yr1 < 70%
16
Low tax paid relative to accounting profit: Tax paid in cash/profit before
tax <10%
Quality of Earnings & Cashflows
x
x
x
x
Concerns over Auditors / Financial Statements
17
Change in auditors
18
Signing auditor located in a different country to key business operations
19
Delay in result announcement or filing audited statements in past 3 years
x
20 Qualified accounts (incl. internal control weakness)
Note: Tests generally applied to last 3 years
20
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FIGURE 16
Red Flags for Chinese HY Property Issuers (2)
Rating
Outlook
Number of Red Flags Triggered
Renhe
Country
Garden
Road
King
Shimao
Fantasia
Evergrande
Kaisa
Ba3
Ba3
Ba3
Ba3
B1
B1
B1
Stable
Stable
Stable
Stable
Stable
Negative
Negative
7
4
4
5
4
7
7
x
x
x
x
x
x
x
x
Corporate Governance
1
Short track record: Under 7 years of operating history
2
Short listing history : Under 3 years or private
x
3
Concentration of family ownership: Major shareholder
family control >30% stake
x
4
Change of senior management: Change of CEO/CFO
5
Significant related party transactions: > 10% of sales, cost
of goods sold; or receivables > 10% of total assets
6
Major shareholder's private business:
Existence of material business outside of issuer
x
x
x
x
x
x
Business Model
7
Extraordinary high profit margin: Reported EBITDA margin
>40%
x
8
High customer concentration: Top 5 customers > 30% of
revenue
x
9
Complicated group structure: Investment in JV/asso to
total assets > 30%, Dividends from JV/asso/(FFO +
dividends from JV/Asso), or Share of profit from JV/asso to
net profit > 30%
x
Growth Strategy
10
Aggressive growth: Total asset or revenue doubled over 3
years
x
x
x
x
x
x
x
11
Large negative Free Cash Flow: Negative FCF > 50% of OCF
x
x
x
x
x
x
x
12
Large proportion of intangible assets: Intangibles/total
assets > 25%
Quality of Earnings & Cashflows
13
Quality of cash flow generation: (Cash + Restricted cash +
Land – Increase in total debt) / [(Advance from customers
Yr2 - Yr1) + Sales Yr2] < 25%
14
Sales generation on capital employed: Sales / Total assets <
15%
15
Sales completion ability: Book sales Yr2 / Contracted sales
Yr1 < 70%
16
Low tax paid relative to accounting profit: Tax paid in
cash/profit before tax <10%
x
x
x
x
Concerns over Auditors / Financial Statements
17
Change in auditors
18
Signing auditor located in a different country to key
business operations
19
Delay in result announcement or filing audited statements
in past 3 years
20
Qualified accounts (incl. internal control weakness)
x
Note: Tests generally applied to last 3 years
21
JULY 11, 2011
SPECIAL COMMENT: RED FLAGS FOR EMERGING-MARKET COMPANIES: A FOCUS ON CHINA
GLOBAL CORPORATE FINANCE
FIGURE 17
Red Flags for Chinese HY Property Issuers (3)
Rating
Outlook
Number of Red Flags Triggered
Zhong
An
Hopson
Yuzhou
China South
City
China SCE
Lai Fung
B1
B1
B1
B1
B1
B1
Stable
Stable
Stable
Stable
Positive
Stable
6
7
7
7
7
5
x
x
x
x
x
x
x
x
x
x
x
x
x
Corporate Governance
1
Short track record: Under 7 years of operating history
2
Short listing history : Under 3 years or private
3
Concentration of family ownership: Major shareholder family control
>30% stake
4
Change of senior management: Change of CEO/CFO
x
5
Significant related party transactions: > 10% of sales, cost of goods
sold; or receivables > 10% of total assets
x
6
Major shareholder's private business:
Existence of material business outside of issuer
x
x
Business Model
7
Extraordinary high profit margin: Reported EBITDA margin >40%
x
8
High customer concentration: Top 5 customers > 30% of revenue
9
Complicated group structure: Investment in JV/asso to total assets >
30%, Dividends from JV/asso/(FFO + dividends from JV/Asso), or
Share of profit from JV/asso to net profit > 30%
10
Aggressive growth: Total asset or revenue doubled over 3 years
x
x
x
x
x
11
Large negative Free Cash Flow: Negative FCF > 50% of OCF
x
x
x
x
x
x
12
Large proportion of intangible assets: Intangibles/total assets > 25%
x
x
x
x
x
x
x
Growth Strategy
Quality of Earnings & Cashflows
13
Quality of cash flow generation: (Cash + Restricted cash + Land –
Increase in total debt) / [(Advance from customers Yr2 - Yr1) + Sales
Yr2] < 25%
14
Sales generation on capital employed: Sales / Total assets < 15%
x
15
Sales completion ability: Book sales Yr2 / Contracted sales Yr1 < 70%
x
16
Low tax paid relative to accounting profit: Tax paid in cash/profit
before tax <10%
Concerns over Auditors / Financial Statements
17
Change in auditors
18
Signing auditor located in a different country to key business
operations
19
Delay in result announcement or filing audited statements in past 3
years
20
Qualified accounts (incl. internal control weakness)
x
Note: Tests generally applied to last 3 years
22
JULY 11, 2011
SPECIAL COMMENT: RED FLAGS FOR EMERGING-MARKET COMPANIES: A FOCUS ON CHINA
GLOBAL CORPORATE FINANCE
FIGURE 18
Red Flags for Chinese HY Property Issuers (4)
Glorious
Rating
Outlook
Number of Red Flags Triggered
Shanghai
Ind.
Urban Devp
Greentown
Shanghai
Zendai
SRE
Group
Costal
Greeland
B2
B2
B3
B3
B3
B3
Stable
RFPU
Negative
RFPD
Stable
Stable
7
7
7
7
7
3
x
x
x
x
Corporate Governance
1
Short track record: Under 7 years of operating history
2
Short listing history : Under 3 years or private
x
3
Concentration of family ownership: Major shareholder family control >30%
stake
x
4
Change of senior management: Change of CEO/CFO
5
Significant related party transactions: > 10% of sales, cost of goods sold; or
receivables > 10% of total assets
6
Major shareholder's private business:
Existence of material business outside of issuer
x
x
x
x
x
Business Model
7
Extraordinary high profit margin: Reported EBITDA margin >40%
x
8
High customer concentration: Top 5 customers > 30% of revenue
9
Complicated group structure: Investment in JV/asso to total assets > 30%,
Dividends from JV/asso/(FFO + dividends from JV/Asso), or Share of profit
from JV/asso to net profit > 30%
10
Aggressive growth: Total asset or revenue doubled over 3 years
x
11
Large negative Free Cash Flow: Negative FCF > 50% of OCF
x
12
Large proportion of intangible assets: Intangibles/total assets > 25%
x
x
x
x
x
x
x
x
x
x
x
x
x
Growth Strategy
x
Quality of Earnings & Cashflows
13
Quality of cash flow generation: (Cash + Restricted cash + Land – Increase
in total debt) / [(Advance from customers Yr2 - Yr1) + Sales Yr2] < 25%
14
Sales generation on capital employed: Sales / Total assets < 15%
15
Sales completion ability: Book sales Yr2 / Contracted sales Yr1 < 70%
16
Low tax paid relative to accounting profit: Tax paid in cash/profit before tax
<10%
x
x
x
x
x
x
x
x
x
Concerns over Auditors / Financial Statements
17
Change in auditors
18
Signing auditor located in a different country to key business operations
19
Delay in result announcement or filing audited statements in past 3 years
20
Qualified accounts (incl. internal control weakness)
x
Note: Tests generally applied to last 3 years
23
JULY 11, 2011
SPECIAL COMMENT: RED FLAGS FOR EMERGING-MARKET COMPANIES: A FOCUS ON CHINA
GLOBAL CORPORATE FINANCE
Moody’s Related Research
Special Comments:
»
Corporate Governance in Latin America: Our Top Ten Considerations for Non-Financial
Family-Controlled Corporates, 29June 2011 (133487)
»
Small CIS Companies: Moody’s Explains Its Approach to Added Risks for Small Non-Financial
Companies in the CIS, June 2011 (133143)
»
Corporate Governance in the Credit Crisis: Key Considerations for Investors, November 2008
(112847)
»
Assessing Corporate Governance In Family-Controlled Companies From A Debt Holder
Perspective, January 2008 (106287)
»
Lessons Learned in Moody’s Experience in Evaluating Corporate Governance at Major North
American Issuers, April 2006 (97104)
To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of
this report and that more recent reports may be available. All research may not be available to all clients.
24
JULY 11, 2011
SPECIAL COMMENT: RED FLAGS FOR EMERGING-MARKET COMPANIES: A FOCUS ON CHINA
GLOBAL CORPORATE FINANCE
Report Number: 134306
Author
Elizabeth Allen
Financial Writer
Paul Ulrich
Senior Production Associates
Wing Chan
Sarah Warburton
Judy Torre
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JULY 11, 2011
SPECIAL COMMENT: RED FLAGS FOR EMERGING-MARKET COMPANIES: A FOCUS ON CHINA