Arms race

Shares in shipbuilder surge as it gains access to major military contracts

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Fancy investing in a Chinese company building fleets of these?

Huangpu is a place where China’s economic and military histories converge.

John Couper from the Peninsular & Oriental Steam Navigation Company (now P&O) set up the first foreign-owned dockyard Couper Doch there in 1845 (the Guangzhou district was then known as Whampoa). Shipbuilding grew rapidly in scale, with Huangpu becoming a hub for some of China’s first workers in the heavy industry field. In 1861 the Couper Doch yard was acquired by a Hong Kong firm which eventually became Hutchison Whampao, today the crown jewel of Asia’s richest man, Li Ka-shing.

The Huangpu Military Academy was also China’s early answer to West Point. After its establishment in 1924, the school produced commanders who fought in all of China’s conflicts over the last century. And adjacent to the academy was Huangpu Shipyard, a shipbuilder started by the Qing government to produce the warships that later formed the core of republican China’s naval forces.

Today Huangpu Shipyard is run by Huangpu Wenchong, a state-owned producer of cruisers and frigates. And in another convergence of economic and military activity, the firm looks set to become part of Hong Kong-listed Guangzhou Shipyard International (GSI), a situation that will give investors a rare chance to gain ownership exposure to China’s fast growing military spending.

Shares of GSI, which are also listed in Shanghai, had been suspended from trading since early April pending an announcement on a major restructuring. Investors were wary, anticipating measures aimed at dealing with overcapacity in the shipbuilding sector. But when the announcement was finally made on October 31, they got more of a shake-up than many expected. GSI said it will pay Rmb4.5 billion ($741 million) for Huangpu Wenchong as part of a Rmb5.5 billion asset injection by state-owned parent China State Shipping Corp (CSSC), one of China’s top 10 military conglomerates.

The deal is positive for GSI on several counts. Because of the weak industry conditions in the commercial shipbuilding sector, GSI’s net profit had dwindled from over Rmb700 million in 2010 to a paltry Rmb13 million last year. In the first half of this year, GSI plunged into a Rmb270 million loss. The potential contribution from Huangpu Wenchong – which is expected to make Rmb275 million in 2014 – could return GSI to profit. But observers are also interested in GSI’s potential prospects on the defence front, after it revealed that its parent CSSC has been following “the market reform direction for the national defence science and technology industry”.

This restructuring is part of the effort to “deepen reform of military enterprises” while helping CSSC to carry out “asset securitisation for relevant military assets”.

On the day that trading in GSI stock resumed, its Hong Kong-listed H-shares charged up more than 70%. Its Shanghai-listed A-shares also surged to their daily limit.

As of this week, GSI’s A-shares are still 47% higher than their Hong Kong counterpart. With investors rekindling their interest in GSI, and with the start of the Shanghai-Hong Kong Stock Connect next week (a trading scheme that allows Hong Kong and mainland investors freer access to each other’s stock markets, see WiC252), the Hong Kong Economic Times expects this premium to narrow. “This is the first time that Hong Kong investors can buy into China’s defence industry. Defence is set to become one of the high-growth sectors. The next 10 years will be the industry’s golden decade,” the newspaper predicts.

The sheer size of CSSC also has analysts hoping that GSI will get access to more prized assets.

CSSC was formed in 1999 when the State Council split a shipbuilding monopoly into two halves to encourage greater competition. In the same year the China Shipping Industry Corp (CSIC) was also established. Both firms have engaged heavily in building military vessels. Akin to the state-backed trainmaking duopoly of CNR and CSR, the two shipping giants essentially divided their territories along the line of the Yangtze River (CSIC is dubbed “the North Ship” because of its dominant position in northern China, while CSSC is “the South Ship”.)

The operating revenues of both have topped Rmb100 billion since 2010. According to 21CN Business Herald, CSSC’s assets total Rmb210 billion, which is almost 10 times GSI’s, and the newspaper notes that a couple of CSIC units have already undergone similar restructurings in deals that involved missile-carrying destroyers and submarines.

There have been reports that a CSIC unit is poised to acquire the scientific research and development institutions from its parent company too.

“As a pair of archrivals, the South Ship and the North Ship are in an arms race to inject assets,” reckons the Securities Daily. 21CN also notes that ­– while shipbuilders in the private sector may have to wait years for a revival in global demand – CSSC and CSIC can draw on their military backgrounds to give their listed subsidiaries a boost.

“Further asset injections are the obvious way to revitalise their units,” says 21CN. “What we have seen could be just be the tip of the iceberg under the mixed ownership reforms.” (See WiC230 for our first mention of the mixed ownership concept.)

Some analysts went as far as speculating that GSI could even get involved in China’s grand project to build its own aircraft carrier, as CSSC and CSIC have been providing scientific research and industrial facilities for the navy.

“Sooner or later China will build its own aircraft carrier. It could happen in 2015 at the soonest. It is a sure win to bet on a company (GSI) which is a potential builder of the Chinese carrier,” proposed a columnist in Hong Kong’s Apple Daily, who also works for Chinese fund house Yinsheng Capital.

Another columnist at the South China Morning Post warned that Chinese defence stocks are driven more by market speculation than fundamentals. Perhaps that’s inevitable when information about order books can be in short supply because of rules on state secrets. For instance, a planned IPO of Anhui Military Industry Group has been held up since May, in part because media questioned the level of disclosure at the leading supplier of mortar shells to the People’s Liberation Army (see WiC240).

The South China Morning Post asks similar questions about GSI’s potential transformation. “How are our regulators going to hold liable those working for state defence companies if they can simply refuse to speak up in the name of military secrecy?” it asks.

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