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Why this Chinese oil giant subsidiary may not be as great as it looks

Financial strength is a crucial consideration for value investors. Here is an example of the kind of work that can be necessary to build up a proper picture of a company’s health from its balance sheet

21/10/2018

Simon Adler

Simon Adler

Fund Manager, Equity Value

‘Is the company’s balance sheet good enough?’ This is one of the seven ‘Red questions’ we ask of every single business we consider as a potential investment, here on The Value Perspective, and at first glance the answer in relation to Sinopec Engineering would appear to be a resounding ‘yes’. As such, what follows is a good illustration of why investors should always give companies significantly more than a single glance.

Why is financial strength important?

A business’s financial strength is a crucial consideration for value investors because, when you buy a cheap company, you want to give yourself the best possible chance of the wider market catching up with your own assessment of its actual worth. The stronger a cheap company is financially, therefore, the more likely it is to make it through tough market periods and ultimately meet your valuation of it.

As we say, on first sight, Sinopec Engineering – a subsidiary of oil and gas giant Sinopec – has a balance sheet befitting a business owned by one of the world’s largest energy companies. Indeed its ‘enterprise value’ when we looked at it in mid September – a valuation metric calculated by adding a company’s market capitalisation and its debt and other liabilities and then subtracting the cash on its balance sheet – was actually negative. In other words, the business was in the valuation for free!

More specifically, Sinopec Engineering’s balance sheet tells us it has strict net cash of RMB10bn (£1.1bn) plus a RMB15bn loan to its parent company and RMB5bn of time deposits, giving it net financial assets of RMB31bn. To offer some context, that is actually greater than the company’s then RMB36bn market capitalisation.

Those net financial assets are also 17x the lowest EBITDA figure – of RMB1.8bn – Sinopec Engineering has reported in the last six years indicating substantial financial strength. Moreover the company adopts a very conservative definition of net ‘debt’ with all working capital liabilities included, though not the asset of that loan to its parent. Still, even after all that, it has a net cash position.

Digging deeper...

While some may take that as a very positive sign, however, here at The Value Perspective, we see it as an indication some appropriate adjustments might need to be made to this rosy picture. And, as we dug deeper into Sinopec Engineering’s balance sheet, our eye was caught by what are known as ‘past due and not impaired receivables’, which are included in the company’s negative working capital of RMB10bn.

Put simply, this translates as money owed to the business but not yet paid to them despite it being beyond the date the money was due and which should probably have had a haircut given it hasn’t been paid when due! Our analysis shows it is a very large sum that has been increasing significantly. Since Sinopec Engineering listed in 2013, ‘unpaid but not impaired’ as a percentage of ‘net receivables’ has been 9%, 11%, 34%, 42%, 60% and is now 57% while the absolute amounts (all approximate and in Renmimbi) have been 0.5m, 0.7m, 2.8m, 4.9m and now 5.5m!

Or to put it another way – ouch. To be fair, in practice, Sinopec Engineering has net cash on its balance sheet equal to the negative working capital, time deposits in excess of its pension and provision liabilities and then that huge loan – equal to 50% of its market capitalisation – to its parent company. Furthermore, Sinopec the parent company itself looks adequately capitalised so there seems little need to worry about it paying back the loan.

That said, when it came to assigning a risk score to the company, we marked the balance sheet relatively lowly. That may seem harsh given the headline numbers involved and yet, if that large receivable number has to be written off – and we would suggest it should already be accounted for as ‘impaired’ – or, for whatever reason, the Sinopec loan has to be written off, the company’s finances would look a good deal less healthy.

Author

Simon Adler

Simon Adler

Fund Manager, Equity Value

I joined Schroders in 2008 as an analyst in the UK equity team, ultimately analysing the Media, Transport, Leisure, Chemicals and Utility sectors. In 2014 I moved into a fund management role and have had experience managing Global ESG and Pan-European funds.  I joined the Value investment team in July 2016 to focus on UK institutional and ethical-value portfolios.

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