A tale of two smelters

Shandong billionaire: Zhang

Aluminum Corp of China (Chalco) is one of the worst-performing state firms of recent times. Over the five financial years between 2011 and 2015, it ran up Rmb22 billion ($3.3 billion) of red ink. By comparison, its private sector rival China Hongqiao seems to be operating its aluminium smelters on a different planet. Since its Rmb5.2 billion IPO in Hong Kong in 2011, it has been very profitable, while its state counterparts suffer from overcapacity and falling prices. Hongqiao has reported earnings of almost Rmb26 billion over the last five years and it achieves them on annual revenues roughly a quarter of Chalco’s.

Hongqiao is the sister firm of the Shandong-based textile-to-power conglomerate Weiqiao Group, founded by Zhang Shiping, one of the coastal province’s richest men. It has benefited from connected transactions with its sister companies – notably buying cheaper electricity from Weiqiao (see WiC152 on how Zhang took on the mighty State Grid). Energy is the main cost for smelters, generally estimated to be at least a third of operating expenses.

But can these deals alone explain Hongqiao’s vastly superior performance over its state-run rival?

In November last year, a website called Hongqiao Exposed questioned whether Hongqiao had made proper disclosures of its connected transactions and, worse, inflated its profits. A month later the company put out a detailed statement refuting the report (the anonymously-authored website is still online).

However, the doubters were back this month, this time in the form of a damaging report by a research house called Emerson Analytics.

Chinese firms that have listed overseas have been the target of independent research outfits many times before (most famously when Muddy Waters went after Sino-Forest). The research reports are usually followed by aggressive short-selling. But in a study titled ‘China Hongqiao – Electrifying Margins to Absurd Levels’, Emerson questioned how self-generated electricity could work such magic in a faltering sector (Chalco also runs a number of power plants, it noted).

After talking to former staff and poring over industry data, Emerson concluded that the Shandong firm could have understated the true cost of its electricity generation by 40%. It made other allegations too, including that Hongqiao had received external subsidies from related parties for the supply of the raw material alumina worth Rmb6.1 billion between 2007 and 2015, and that it had under-reported the production costs of self-produced alumina by Rmb2 billion between 2012 and 2015.

As a result Emerson claimed the true value of Hongqiao’s shares was HK$3.1, or about 60% less than when the report was published.

Investors were listening and Hongqiao’s share price dropped more than 8% before trading was suspended. The company fired back that Emerson and its partners could have short positions in the company’s stock, adding that the report contained “error of fact, misleading statements and unfounded malicious accusations”. It also threatened legal action.

Besides Hongqiao’s promise of a detailed rebuttal, investors will soon receive its annual results for 2016, after the firm’s previous forecast that full-year profit was likely to climb 70% from the Rmb3.6 billion generated in 2015. The improvement, it said, was because prices for aluminium products have increased.

But Hongqiao still needs to work on reviving investor confidence. As of this week its share price had stabilised in Hong Kong, buoyed by a wave of buying from mainland Chinese investors through the Shanghai and Shenzhen stock connects.

That contributed to Hongqiao’s market value of HK$52.7 billion, or about 10 times projected 2016 profits. But by comparison Chalco is worth HK$75.6 billion, trading at a lofty price-to-earnings ratio of 260 times.

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