By now it is common knowledge that China has a major debt problem at the macro level, one which may be even bigger than expected because according to at least one analysis by Rabobank, China's most recent debt has soared from the infamous McKinsey level of 282% as of mid 2014, to an unprecedented 346% currently.
Far less has been discussed about China's corporate debt at the micro level. Back in October we were shocked when we looked at the inverse of corporate leverage, namely interest coverage within the heavily indebted commodity sector where we found that as of the end of 2014, just one half of Chinese companies could cover their annual interest expense, implying that according to a Macquarie analysis, some CNY2 trillion in debt was in danger of default.
This was over a year ago: since then both industry pricing and cash flow dynamics have deteriorated substantially and some estimate that more than three-quarters of leveraged commodity companies are dead zombies walking, suggesting a massive default wave is about to be unleashed.
And while we are keeping a close eye on this very troublesome development, last week the FT revealed something even more disturbing: Chinese corporate leverage, represented by the traditional debt/EBITDA ratio is, in some cases, absolutely ludicrous, especially among companies which in recent weeks have tried to mask their balance sheet devastation through global M&A activity, such as ChemChina's recent record for a Chinese company $44 billion purchase of Syngenta, or Zoomlion's $3.3 bid for US rival Terex last month.
In fact, as the otherwise demure FT notes, "so high are the debt levels at ChemChina and several other companies behind some of the country’s biggest overseas investments that financing for the deals would have been difficult or prohibitively expensive were it not for the backing of the Chinese state, analysts said."
Looking specifically at ChemChina, FT writes that ChemChina, which bid $43.8bn for Syngenta, a Swiss company, is in poor financial shape. "It made a net loss of Rmb889m in the third quarter of last year and carried a total debt of Rmb156.5bn ($24bn). The debt load was equivalent to 9.5 times its earnings before interest, tax, depreciation and amortisation at the end of 2014, well above the international standard for excessive leverage of 8 times ebitda.
However, Kalai Pillay, a director at the Fitch credit-rating agency, said ChemChina’s status as an enterprise owned by Beijing’s State-owned Assets Supervision and Administration Commission (Sasac) ensures that it can get “unlimited access to funding from state banks”.
Nothing like the government indirectly buying offshore assets under the guise of corporate M&A.
"There is a danger for Syngenta and other acquisition targets. If Chinese state backing for an overseas deal starts to ebb, then a highly-indebted parent company could squeeze its new subsidiary for dividends to repair its balance sheet, Mr Pillay said."
But what is most disturbing is that ChemChina's 9.5x debt/EBITDA is downright conservative among Chinese corporations.
Take Zoomlion, a lossmaking Chinese machinery company that is partially state-owned: its total debt stands at 83 times its EBITDA. "Zoomlion’s bid is a desperate attempt to remain relevant,” said Mr Pillay.
Or how about Fosun, a serial Chinese acquirer that spent $6.5bn on stakes in 18 overseas companies during a six-month period last year, had a a 55.7x total debt/EBITDA in June 2015. "Fosun has bought brand names such as Club Med and Cirque du Soleil as well as a host of other assets including the German private bank Hauck & Aufhaeser."
Or maybe the highly publicized purchase of China Cosco Holdings of the Greek Piraeus Port Authority for €368.5m. Cosco has promised to invest €500m in the Greek port despite having total debt at 41.5x its EBITDA!
Or Cofco Corporation, which recently reached an agreement with Noble Group under which its subsidiary, Cofco International, would acquire a stake in Noble Agri for $750m (in the process preventing the insolvency of the biggest Asian commodities trader), has total debt equivalent to 52 times its EBITDA!
Or how about Bright Food, which bought the breakfast group Weetabix for $1.2bn last year, and has total debt at 24 times EBITDA!
The chart below summarizes these leverage horror stories:
Simply said, what is going on in China's massively overlevered corporate sector, is that virtually every company has become one massive "rollup" a la Valeant, hoping to deflect investors' and analysts attention from their deplorable credit metrics by engaging in a scramble of global M&A at any price, just to buy 1-2 more quarters of silence from skeptics, even as leverage continues to build at multiple turns of EBITDA every single quarter.
In any other case debt/EBITDA at or higher than 10x - certainly 15x - in a world in which cash flows are rapidly deteriorating, would be an excuse for bondholders to promptly take to the hills. But when you have such leverage ratios as 83x one can only quietly stand back, find a place behind which to hide, and hunker down ahead of the coming explosion.