Gavekal Capital: Chinese Companies Keeping the Dream Alive with Leverage and Channel Stuffing

Monday, April 27, 2015

Chinese Companies Keeping the Dream Alive with Leverage and Channel Stuffing

Last week we wrote that 2014 marked another year in which Chinese companies increased the leverage on their balance sheets. In fact 2014 marked the 10th consecutive annual increase in aggregate leverage as measured by total liabilities as a percent of equity. Meanwhile profit margins are down by more than half over the same period.

What we didn't mention in that post last week is that the amount of "channel stuffing" - the reciprocal increase of working capital accounts among companies - has also continued to explode. Think of "channel stuffing" as recording a sale by issuing the customer trade credit, which shows up as credit to accounts receivable for the seller and a debit to accounts payable to the customer. The customer can then issue its own downstream trade credit, and so on, such that sales for the entire "channel" are higher than they would otherwise be at the expense of greater working capital liabilities and assets (AKA leverage).

Identifying "channel stuffing" is actually quite easy. All one needs to do is measure the aggregate level of working capital accounts as a percent of sales through time. Lines 3 and 4 in the below table measure exactly that. What we find is that accounts receivable as a percent of sales increased from less than 6% to more than 11% between 2006-2013 and then absolutely exploded in 2014 to 13.2%, the largest single-year increase as far back as we have data. Meanwhile, accounts payable as a percent of sales increased from about 10% to almost 17% from 2006-2014.

But it doesn't stop there. Companies are also carrying almost 50% more inventory today as compared to 2006 (line 5 below), implying production activity has not yet adjusted down to the lower level of sales growth. Higher levels of inventories put pressure on prices as companies are incented to lower selling prices to reduce the inventory level. This may be one reason profit and cash flow margins have crumbled lower since 2009.


*The above data is based on the aggregate summation statistics for CSI 300 constituents excluding financial and utility companies

This post has been updated. An earlier version made an incorrect currency adjustment for the "AR % of Sales" line item in the table above. All other data was unaffected.