Moody's yesterday released special reports on the credit analysis of leading un-rated Chinese companies in the airline, oil and gas and power industries.

The reports look at the fundamentals driving each of the three industries, which are growing users of foreign capital, and also compare the credit profiles of the Chinese companies to leading firms in the same industries in other parts of the Asia-Pacific region and the US.

The three sectors share strong growth prospects, evolving regulatory regimes but a lack of transparency in government policy, corporate structures and practices, Moody's illustrates in the reports as follows.

Outlook for China's airline industry: Strong growth prospects but challenges remain

The growth prospects for China's airline industry is generally strong as domestic and international passenger traffic will continue to expand and even more so with the World Trade Organization (WTO) entry.

Ultimately, the strength of China's airlines rests on the immense scale and potential of the Chinese market, where travel for business and leisure is expanding fast, says the Moody's report on China's airline industry.

The only major disruption to date has been the SARS (severe acute respiratory syndrome) outbreak in early 2003, but that has ultimately proved to be just a temporary setback.

The report also analyzes the financial profiles of the three major carriers "China Southern Airlines, China Eastern Airlines and Air China "and then compares them with their regional and global peers. None of the three are currently rated by Moody's.

The largest advantage for Chinese airlines is the sheer size of their market and the growth of the Chinese economy, says Mable Chan, a Moody's vice-president and senior analyst, and also an author of the report.

Total passengers carried by the big three Chinese airlines have grown continuously over the past five years. It is expected that the passenger expansion would continue for domestic and international traffic "both in and out of China.

The consolidation of China's carriers into three major groups is reducing some of the excess capacity and improving the sector's overall competitiveness, given the smaller number of players, the report says.

However, at the same time, challenges are apparent as the airline groups face integration risk, due to the sheer breadth of the consolidation which is now unfolding.

Key areas of concern also include the lack of clarity over the timing of integration, the extent to which the airlines can achieve the anticipated synergies and savings, and the degree to which management may become excessively distracted from normal business.

"The other concern is that the three major groups, as the sector's financially stronger entities, may have to absorb the relatively weaker carriers as part of the consolidation process,"Chan says.

Furthermore, regulatory behaviour generally lacks transparency and is hard to predict.

Other considerations include the state of financial profiles, levels of exposure to foreign exchange risk, cost control efforts and passengers"perceptions of products on offer.

The Chinese airlines also face the possibility of added competition, not so much on domestic flights, but on the Hong Kong-mainland and international routes.

To facilitate the growth of Chinese airlines on international routes, the Chinese Government ultimately cannot avoid opening up more of the domestic market, though the process is expected to be gradual, the report says.

"Compared with other regional and overseas airlines, China's carriers have yet to fully prove their competitiveness,"says Chan.

"Their revenue sources and route networks are not as diverse as those of some of their overseas counterparts, while issues such as cost control and the strengthening of brand equity require close attention."

Going forward, Chinese airlines need to strengthen brand equity and change customer perceptions of their product offerings, the report says.

To achieve this, they must establish a stronger safety record and raise service quality, factors which are crucial to successful competition on regional and international routes.

Stronger branding often translates into higher margins and greater market share.

China's power generation sector: Strong demand growth and sound financial profiles mitigate uncertainties of reform

Moody's believes that the financial profiles of China's major independent power producers (IPPs) will remain sound as the companies continue to benefit from the strong growth in electricity demand, partly mitigating the uncertainties associated with ongoing sector reform and downward pressure on generation tariffs.

China's three major H-share listed IPPs "Huaneng Power International, Beijing Datang Power and Huadian Power International (formerly known as Shandong International Power) "in particular exhibit relatively efficient operational abilities and maintain strategic positions within their parent groups and the industry overall.

"This situation means they are well-positioned to compete when the generation market is further liberalized as well as preserve financial profiles supportive of investment grade ratings,"says Gary Lau, a Moody's vice-president and senior credit officer, and an author of the report on the power sector.

In China, growth in power consumption closely tracks real gross domestic product (GDP) expansion.

Over the last five years, demand has climbed robustly at a compound annual growth rate (CAGR) of 7.5 per cent, driven by rapid economic development, and then accelerated to 15 per cent in the first 10 months of 2003.

Electricity consumption is projected to grow annually at over 10 per cent for the next three years, according to the State Grid Corporation of China, one of two power grid companies. The industrial sector, which accounts for over 70 per cent of this consumption, will be the key driver.

The credit profiles of China's IPPs, which have stronger profit margins and more conservative capital structures, compare favourably with those for their peers in the region and globally, the report says.

But at the same time, the preservation of sound operating performances, against the backdrop of greater competition and downward pressure on tariffs, will largely hinge on the abilities of the IPPs to control costs and improve operating efficiencies.

In addition, they need to maintain sufficient international or back-up liquidity to mitigate short-term market volatility, the report says.

The key drivers behind the reform are the need for investment to meet the robust growth in consumption as well as maintain stable and reliable power supply and the push for improved operating efficiency.

Major investments are also required to strengthen network connectivity and other infrastructure must be constructed to rectify the supply/demand imbalance between regions.

Meanwhile, the report also suggests that China's regulatory regime have greater transparency.

The establishment of a consistent and transparent regulatory regime, a market-oriented industry structure and fair competition are essential if China wants to achieve a reliable power supply and greater operating efficiency as well as attract the investments needed to build infrastructure.

It is expected that regulators should issue more details regarding its implementation of tariff reform and the establishment of a nation-wide power trading market.

The wide geography of the country with its different local vested interests and the low level of transparency and predictability regarding regulatory philosophy place China's industry in the medium-to-high-risk category when compared to regional markets such as Australia and South Korea, the report says.

However, at the same time, it also says that the three major H-share listed IPPs possess the financial flexibility needed to cushion themselves from the impact of any short-term business downturns arising from potentially adverse regulatory moves.

Their strategic positions within the power sector and close relationships with the regulator will, to some extent, mitigate the risk of any drastic regulatory measures.

Overall, China's power generation sector remains fragmented. Consolidation, in the form of the acquisition of State-owned generation assets by the IPPs, will continue.

Furthermore, the five major nation-wide IPP groups, which have strong access to the capital markets and potential acquisition targets, will be the most active participants in this process. Depending on their funding strategies, aggressive acquisition initiatives may pressure credit profiles.

China's power matrix is characterized by an imbalance between supply and demand.

For example, energy sources, such as coal and hydroelectric resources, are principally located in China's inland provinces in the north, centre and southwest, whereas the high levels of consumption are occurring in the coastal areas in east and south. The imbalance has pushed the authorities to restructure the industry and initiate a power transmission programme.

Those IPPs operating in regions with high demand growth and tight reserve margins, such as the Beijing Datang Group in the Beijing-Tianjin-Tangshan region and the Huaneng Group in the Eastern coastal regions, will continue to benefit from the current matrix, the report says.

However, even though the authorities"restructuring plan for the industry continues to unfold, uncertainties persist as to how tariffs and the planned power pool system will eventually evolve. Such uncertainties will have negative implications for the operation performances and financial profiles of China's IPPs.

Chinese oil & gas companies: Well positioned to withstand key challenges ahead

China's three major oil & gas companies exhibit strong credit characteristics, reflecting their large and long life reserves, dominant market positions, improving to strong operating fundamentals, and high degree of financial flexibility, according to Moody's report on Chinese oil & gas companies.

PetroChina and Sinopec, for example, are well positioned for solid investment grade ratings. CNOOC, which is the only one of the three currently rated by Moody's, carries an A2 rating, the highest globally for any E&P company.

With strong access to the capital market and bank support, the three Chinese companies maintain solid liquidity and financial flexibility, reflecting their substantial operating cash flow generating capacity, large cash reserves, manageable short-term debt maturity and staggered maturity of long-term debt.

The three companies also benefit from a supportive regulatory regime, given the strategic importance of the oil sector.

"Furthermore, we believe that the current regime will persist in its current form over the intermediate term, and the government is unlikely to introduce arbitrary changes that would materially affect the industry's progress,"says Terry Fanous, a Moody's vice-president and senior credit officer and author of the report.

The industry's strategic importance will remain high and the fundamentals of the Chinese oil and gas companies will remain sound.

However, the companies do face a number of key challenges, Fanous says.

These include the expected increase in competition in the downstream sector, the need to continue improving refining and marketing efficiency, and the large capital expenditure programs needed to develop undeveloped reserves, as in the case of CNOOC, and replenish large mature onshore oil basins and upgrade downstream infrastructure, as in the case of PetroChina and Sinopec.

The companies"acquisitions of overseas reserves are raising additional challenges, as their ability to manage these investments continues to evolve.

But Moody's says the companies are well positioned to respond to these challenges, though they do require continued skillful management and prudence in executing their growth strategies.

The Chinese oil and gas companies should focus on delivering results that reflect sustained improvement in operating fundamentals and financial management, rather than merely higher oil prices and downstream margins, Fanous says.

As part of its WTO entry promises, China agreed to provide foreign companies with greater access to its domestic market. Accordingly, the downstream operations of Sinopec and PetroChina will face substantial competitive pressures, as multi-national companies can start petroleum retail operations from January 2005 and wholesale activities from January 2007.

China, currently the world's second-largest oil consuming country, undoubtedly offers attractive opportunities for international oil companies, the report says. This expected rise in downstream competition raises additional operating challenges for PetroChina and Sinopec over the medium and long term.

However, the Chinese companies still maintain formidable distribution systems, which provide them with natural competitive advantages. They also have pursued strategies to solidify their positions, including optimization of refining capacity, enhancement of product quality and the expansion of their petroleum retail and petro-chemical networks.

Finally, both PetroChina and Sinopec have established significant joint ventures and strategic alliances with their potential competitors "Shell, ExxonMobil and BP "in petrol retailing and various petrochemical projects.

Moody's expects these initiatives to continue over the next few years and to some extend limit the competitive pressures in the downstream market.

(China Daily 01/16/2004 page11)