Sector Review:

China Credit Spotlight: The Top Construction Machinery Makers Have Deep Enough Pockets For A Lengthy Downturn
Primary Credit Analyst: Huma Shi, Hong Kong 852-2533-3527; huma.shi@standardandpoors.com Secondary Contact: Christopher Lee, Hong Kong (852) 2533-3562; christopher.k.lee@standardandpoors.com

Table Of Contents
Slight Recovery But No Massive Economic Stimuli Overseas Growth Could Spur Recovery Global Ambitions Will Be Constrained Related Criteria And Research

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Sector Review:

China Credit Spotlight: The Top Construction Machinery Makers Have Deep Enough Pockets For A Lengthy Downturn
(Editor's Note: This article is part of our "China Credit Spotlight" series, which discusses the credit conditions for China's sovereign, key sectors, top 150 corporates, and top 50 banks.) Lenders and debt investors in China's construction machinery sector are becoming increasingly unsettled. Sales have slowed for 18 consecutive months and inventory is piling up, given sluggish domestic demand. The credit quality of customers is also deteriorating. Sales could rise slightly this year, as investment in infrastructure picks up. But many makers are still focusing on managing through a downturn that could last another two years, at least. Given the tough conditions, Standard & Poor's Ratings Services believes credit profiles could be at risk. Even the biggest players are feeling the strain. Zoomlion Heavy Industry Science and Technology Co. Ltd., for example, recently reported its lowest quarterly sales for two years. Its two nearest competitors, Sany Heavy Equipment International Holdings Co. Ltd. and XCMG Construction Machinery Co. Ltd., faced a similar squeeze. The combined sales of the three companies dropped 2% to Chinese renminbi (RMB) 125.22 billion (about US$20 billion) in 2012 from RMB128.36 billion a year earlier. That compares with 46% annual growth on average from 2009-2011. Each of these players has experienced weakened cash flow and a spike in working capital since the downturn began in 2011. And credit risks are rising as profitability drops. Overview Slumping sales, subdued demand, and overcapacity could prolong an industry downturn for at least two years at the same time that customers' credit quality is deteriorating. Major industry players are maintaining defensive measures, such as tightening credit policies, and their refinancing risks are likely to be limited. Some companies are eyeing emerging markets to restore sales growth and profitability; but that's a long-term strategy. Given the tough operating conditions, we expect credit profiles to deteriorate; but the top three companies should still be able to weather the downturn.

Across the industry, struggling customers started to slow down payments or stop them altogether. Account receivable days (or the period companies have extended credit to customers) increased on average 1.8x to 145 days--a high but manageable level so far. The top three players responded by tightening underwriting policies and demanding bigger down payments from customers. In addition, they are keeping a tighter grip on internal costs and cash flow. Another positive: The risk of refinancing appears limited in the next 12 months. Therefore, the sales slump hasn't damaged financial risk profiles.

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Sector Review: China Credit Spotlight: The Top Construction Machinery Makers Have Deep Enough Pockets For A Lengthy Downturn

We believe the three makers should have sufficient financial strength to withstand the difficulties that may emerge from a protracted downturn. Nevertheless, if the creditworthiness of customers sharply declines, the credit quality of the sector as a whole will deteriorate. In particular, credit risks could escalate if accounts receivables rise from their already-steep levels, and more and more customers return machinery they have bought because they can't pay for them.

Slight Recovery But No Massive Economic Stimuli

We believe the construction machinery industry can start to modestly recover over the next two years, with about 5% growth in sales from 2012 levels. Support for this should come from continued investment in infrastructure projects, as suggested in the urbanization development plans of China's National Development and Reform Commission. But the helping hand will be limited. The country's new leadership is unlikely to pump massive funds into infrastructure projects in response to a likely slowdown in economic growth (see chart). That wasn't the case in 2009, when the central government channeled much of the RMB4 trillion funds in its stimulus package into roads, sewage works, and other massive projects--fueling sales for machinery makers. The government will continue to invest in infrastructure in order to help GDP to grow, just not on the same scale. That's because the new leadership seems to be more committed to steering China's economy towards becoming consumption-led rather than investment-driven.

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Sector Review: China Credit Spotlight: The Top Construction Machinery Makers Have Deep Enough Pockets For A Lengthy Downturn

Overseas Growth Could Spur Recovery

We expect major companies to continue to look to emerging markets to restore sales growth and profitability. In the past few years, the top three players have established footholds with companies in Europe through either mergers or acquisitions. Their aim was to diversify products, enhance their technology and research and development capabilities, and gain access to new distribution channels. Now they are building up their shareholdings. For example, this June, Zoomlion bought the outstanding shares it did not already own in Italian concrete-pump maker Compagnia Italiana Forme Acciaio SpA (CIFA). Zoomlion's share of the market for concrete-pump trucks rose to 43% in 2013, compared with 22% in 2008 when it bought its first stake in CIFA. The company's overseas distribution channels grew 20% over the same period. In January 2013, Sany completed its US$475 million acquisition to wholly own Germany-based Putzmeister Holding GmbH, a major concrete-pump maker. In July 2012, XCMG snapped up a 52% stake in Schwing GmbH, another major German concrete-machine maker. We believe it's too early to tell whether any of these acquisitions will succeed in the long run. Not all acquisitions deliver anticipated benefits, largely because of the slow integration of entities. In addition, cross-border mergers can be risky, given different legal and political frameworks, labor relations, brand image, and culture. In time, however, overseas expansion can add value to machinery makers by diversifying their presence, enhancing their market position, and offering growth opportunities.

Pricing strategy could pay off

Aggressive marketing of products overseas should help China's machinery makers to gain market share. Their core focus is emerging markets, such as Brazil, Russia, India, and Africa, which are particularly price sensitive. Chinese companies tend to price their products 15%-20% lower than those of their foreign competitors to aid penetration. In the short term, we don't believe the low pricing strategy will restore growth and profitability to 2010 levels. The strategy will compress margins unless the makers can slash costs, too, and we've seen no sign of that. Notably, Zoomlion's overseas gross profit margin for the past two years has ranged from 16% to 19%, more than 50% lower than its margins from domestic sales.

Global Ambitions Will Be Constrained

China's biggest machinery makers are aiming to dig their way out of the downturn with the help of their overseas acquisitions. But they are unlikely to gain much of the overseas market share over the next two to three years, at least, given the high fragmentation in the global industry. The world's two biggest makers have a firm grip on the leader board. Last year, U.S.-based Caterpillar Inc. had a market share of 22% and Japan-based Komatsu Ltd. 11%--levels they have maintained for decades. Japan-based Hitachi Ltd. was a distant third, with just 5.5%. Zoomlion, Sany, and XCMG have a combined market share of about 10%. They have secured this modest level largely through an aggressive pricing strategy, which may not be sustainable. We expect the three top companies to continue to focus on the domestic market for the majority of their

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Sector Review: China Credit Spotlight: The Top Construction Machinery Makers Have Deep Enough Pockets For A Lengthy Downturn

sales growth. We don't anticipate that they will grow significantly beyond China's borders, but successful integration of their acquisitions will become increasingly important to shoring up profitability. For now, the Chinese companies will maintain their defensive measures by improving their working capital management and enhancing their internal cost controls to position themselves for the next growth phase. A projected pickup in sales from 2014-2015 suggests light may be at the end of the tunnel at last.

Related Criteria And Research

Key Credit Factors: Criteria For Rating The Global Capital Goods Industry, April 28, 2011 2008 Corporate Criteria: Analytical Methodology, April 15, 2008

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