A-Share Étude. Goodwill: The Hollow Crown. China Strategy. November 20, 2018

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1 A-Share Étude November 20, 2018 Goodwill: The Hollow Crown China Strategy Uneasy Lies the Head that Wears the Hollow Crown. The latest announcement on goodwill by the CSRC highlights the fact that recent M&A activities have raised the aggregate goodwill of listed companies to more than RMB1.45 trillion. This raises the issue of potential impairment risks. In 2017, impairment charges totalled RMB26.4bn, and this could be higher in , given the CSRC s closer scrutiny and the poor profitability of many companies. Our analysis shows there are 114 listed companies with market cap over RMB10bn that have goodwill making up more than 20% of net assets; the most vulnerable sectors are healthcare, media and consumer. While a high goodwill component does not necessarily imply valuation or leverage issues, investors should closely monitor some of the companies. In the longer term, we believe better guidance on goodwill may reduce financial shenanigans and promote genuine industry restructurings that will improve the efficiency of the economy. At end-september 2018, the aggregate goodwill on the balance sheets of A-share companies has accumulated to over RMB1.45 trillion because of M&A and other factors. This is approximately 3.7% of the total net assets of the entire market. According to Accounting Supervision Risk Warning No. 8, announced on 16th November, the CSRC now requires companies to adopt tighter standards on goodwill impairment. Jasmine Chin Analyst (852) jasminechin@chinastock.com.hk An Zhang Analyst (852) zhangan@chinastock.com.hk Johnson Cheung Research Director (852) johnsoncheung@chinastock.com.hk Total impairment losses in 2017 were RMB26.4bn (with RMB17bn coming from the ChiNext Board and SME Board). Given the more stringent oversight recommended by the CSRC and lower corporate profitability, we believe the write-offs will be even greater in While impairment losses are a non-cash item, they lower a company s reported profit and dividend pay-out ability, and the reduced shareholder s equity can change the valuation and gearing metrics. In the longer term, this is positive policy guidance, as it will enable investors to have a clearer perception of the fundamentals of listed companies. It will expose companies which have grown through M&A and financial engineering. We believe the impact will fall disproportionately on some smaller companies in the sector. We have screened A-share companies with a market cap greater than RMB10bn. There are 114 companies with goodwill comprising more than 20% of net assets. We rank them in this report. Of the 30 companies with the highest goodwill/net asset ratios, 10 are healthcare firms and 13 are consumer companies. Their price-to-book valuation and net debt-to-equity ratios will increase dramatically if they have to make significant impairment charges to goodwill.

2 The accumulated goodwill of A-share companies increased in , when M&A was quite common. Aggregate goodwill increased from 1% of shareholders equity in 2011 to the current 4% (even higher if we exclude banks). Total impairment losses in 2017 were RMB26.4bn (with RMB17bn coming from the ChiNext Board and SME Board). This has severely affected the reported profits of listed companies. Given the more stringent oversight recommended by the CSRC and lower corporate profitability, we believe the level of write-offs will be even greater in In the longer term, this is positive policy guidance, as it will enable investors to have a clearer perception of the fundamentals of listed companies. It will also expose companies which have grown through M&A and financial engineering. Furthermore, goodwill can distort standard comparison ratios, giving a potentially misleading picture of financial leverage and valuations. A company with a large goodwill component on its balance sheet will generate more favorable price-to-book and debt-to-equity ratios than otherwise. We screened companies with a market cap of RMB10bn or above. We analyzed what will happen to a listed company s numbers if it is compelled to make full goodwill impairment charges by tracking the following metrics: - Goodwill as a percentage of shareholders equity to demonstrate the quality of the balance sheet; - Goodwill as a percentage of 2018 annualized net profit to show a company s ability to absorb potential write-offs; - The difference between the apparent price-to-book ratio and the price-to-net tangible assets ratio (or adjusted PBR) after eliminating goodwill and other intangibles for a better valuation comparison with a company s peers; and - The disparity between the apparent net debt-to-equity ratio and net debt-to-net tangible asset ratio to get a truer picture of a company s financial leverage compared to its peers. Our screening uncovered 114 companies with goodwill amounting to 20% of their net assets or more (Appendix A). It is interesting that several sectors seem to have been more active in M&A activity; as a result, their aggregate goodwill is quite high. These sectors include healthcare, media, consumer and TMT. In Figure 1 we show the industry concentration of these companies. Healthcare accounts for 18% of the 114 companies, followed by computer software (15%) and media (13%). Figure 1: Total number of companies with over 20% of net assets accounted for by goodwill Industry Number of companies Healthcare 20 Computer software 17 Media 15 Chemical 8 Others 54 Total 114 We examined the price-to-book valuation of the companies in Appendix A and selected 30 companies whose price-to-book ratios would change the most if they have to make full impairment charges on their goodwill. Figure 2 shows that healthcare companies, consumer companies and other sectors each account for one-third of these companies. Figure 2: Classification of the top 30 with the highest impact on P/BV multiple Industry Number of companies Healthcare 10 Consumer 10 Others 10 Total 30 We analyzed these 30 companies by sector in Figures 3, 4 and 5. Our findings show that they are trading at extremely high prices relative to their net tangible asset value. While this does not make them automatically high risk, we believe investors should monitor these companies in case they find it harder to grow earnings through acquisitions or experience earnings disappointment from impairment charges.

3 Figure 3: Price-to-Book ratio vs. Adjusted PBR ratio for selected Healthcare companies P/B multiple P/B P/B (Adjusted for Goodwill) SZ 上海莱士 SZ 爱尔眼科 SZ 乐普医疗 SZ 美年健康 SZ 泰格医药 SZ 海普瑞 SH 益丰药房 SH 老百姓 SZ 安科生物 SZ 开立医疗 Ranked by market cap (largest on the left) Figure 4: Price-to-Book ratio vs. Adjusted PBR ratio for selected Consumer-related companies 40 P/B multiple P/B P/B (Adjusted for Goodwill) SZ 世纪华通 SZ 万达电影 SZ 汤臣倍健 SZ 三七互娱 SH 锦江股份 SZ 视觉中国 SH 首旅酒店 SZ 金科文化 SZ 蓝色光标 SZ 恺英网络 Ranked by market cap (largest on the left) Figure 5: Price-to-Book ratio vs. Adjusted PBR ratio for selected companies in other sectors P/B multiple P/B P/B (Adjusted for Goodwill) SH 青岛海尔 SZ 潍柴动力 SZ 广联达 SZ 先导智能 SZ 中际旭创 SZ 四维图新 SH 闻泰科技 SZ 蓝帆医疗 SZ 国瓷材料 SZ 中科创达 Ranked by market cap (Largest on the left)

4 Appendix A: Companies with over 20% of net assets contributed by goodwill Ticker Company Market Cap (RMB mn) Goodwill Shareholder's P/B Sept 2018 equity Price/ Goodwill/ Adjusted Net asset Net Assets Goodwill/ Annualized Net Profits Net profit Net debt/ Sept 2018 Equity Net debt/ Adjusted Net Assets SZ 金科文化 14,528 6,377 6, % % 806% SH 锦江股份 21,668 11,521 12, % % 1719% SZ 蓝帆医疗 16,774 6,345 7, % % 270% SZ 万达电影 40,601 9,660 12, % 5.7 1,268 65% 274% SZ 蓝色光标 11,303 4,714 6, % % 553% SZ 美年健康 52,161 4,597 6, % % 415% SZ 潍柴动力 61,470 23,414 37, % 2.2 8, % 779% SH 老百姓 17,211 1,806 2, % % 304% SH 益丰药房 19,816 2,070 3, % % 167% SZ 数知科技 11,906 6,373 10, % % 15% SZ 掌趣科技 11,719 5,392 9, % % -19% SH 青岛海尔 88,707 21,198 35, % 2.0 7, % 560% SH 首旅酒店 17,228 4,773 8, % % 221% SZ 南洋股份 12,318 4,595 7, % % 37% SZ 恺英网络 10,289 2,944 5, % % 16% SH 均胜电子 21,406 8,215 14, % 5.0 1, % 482% SZ 紫光股份 55,144 13,992 26, % 5.1 2,034 49% 105% SZ 捷成股份 13,776 5,547 10, % % 121% SZ 瑞康医药 14,099 4,428 8, % 2.6 1, % 524% SZ 世纪华通 50,874 7,464 14, % % -18% SZ 上海莱士 97,105 5,705 11, % ,295-4% -8% SZ 神州高铁 11,752 3,621 7, % % 60% SH 广汇汽车 38,048 18,668 36, % 3.8 3, % 400% SZ 视觉中国 18,495 1,383 2, % % 88% SH 浙数文化 11,613 3,940 7, % % 15% SZ 国瓷材料 11,361 1,524 3, % % 46% SZ 我爱我家 13,803 4,514 9, % % 136% SZ 四维图新 21,567 3,325 6, % % -2% SH 人福医药 15,960 6,655 13, % % 232% SH 中化国际 15,081 5,239 11, % 2.2 1, % 498% SZ 北斗星通 11,101 1,985 4, % % 42% SZ 银亿股份 22,678 7,189 16, % 5.3 1, % 253% SZ 智度股份 11,009 2,511 5, % % 33% SZ 千方科技 18,976 3,334 7, % % 60% SZ 诚志股份 17,755 6,970 16, % % 30% SZ 科大智能 11,862 1,780 4, % % 96% SZ 华宇软件 11,382 1,661 4, % % 18% SZ 三七互娱 27,071 2,540 6, % 1.4 1,340 23% 39% SZ 深圳华强 14,484 1,848 4, % % 144% SZ 海普瑞 23,572 2,322 5, % % 149% SZ 亿帆医药 14,122 2,596 6, % % 35% SZ 汤臣倍健 30,111 2,238 5, % % 36% SZ 华邦健康 10,703 3,606 9, % % 167% SZ 爱尔眼科 67,664 2,165 5, % % 70% SH 智慧能源 10,165 1,926 4, % % 375% SH 闻泰科技 19,424 1,300 3, % % 518% SZ 众泰汽车 10,422 6,579 17, % % 95% SZ 泰格医药 23,978 1,052 2, % % 25% SZ 中际旭创 22,919 1,717 4, % % 89% SH 步长制药 25,181 5,011 13, % 3.0 1,232 21% 34% SZ 旋极信息 16,595 1,942 5, % % 31% SZ 北讯集团 10,078 2,433 6, % % 251% SZ 航天发展 12,195 2,051 5, % % 15% SZ 常山北明 10,049 2,150 5, % % 153% SZ 美的集团 281,069 29,622 82, % , % 229% SZ 海联金汇 13,802 2,502 7, % % 52% SZ 龙蟒佰利 27,290 4,986 14, % 1.9 2,008 47% 74% SZ 光环新网 22,171 2,398 6, % % 98% SZ 利亚德 22,454 2,689 7, % % 84% SZ 顺网科技 10,720 1,099 3, % % -65% SZ 开立医疗 12, , % % 40%

5 Appendix A: Companies with over 20% of net assets contributed by goodwill (continued) Ticker Company Market Cap (RMB mn) Goodwill Shareholder's P/B Sept 2018 equity Price/ Goodwill/ Adjusted Net asset Net Assets Goodwill/ Annualized Net Profits Net profit Net debt/ Sept 2018 Equity Net debt/ Adjusted Net Assets SH 上海家化 18,714 2,011 5, % % 93% SZ 华峰超纤 12,108 1,733 5, % % 62% SZ 新纶科技 14,530 1,743 5, % % 94% SZ 华润三九 24,502 3,550 10, % 2.3 1,137 41% 62% SZ 先导智能 23,055 1,092 3, % % 155% SZ 跨境通 19,787 2,535 7, % % 70% SZ 宋城演艺 32,524 2,787 8, % 1.8 1,139-7% -10% SZ 神州信息 10,896 1,738 5, % % 121% SZ 中鼎股份 13,917 2,777 8, % 2.0 1,062 69% 103% SZ 天茂集团 32,411 6,186 18, % 2.6 1, % 1064% SZ 乐普医疗 54,287 2,214 6, % 1.4 1,176 85% 126% SH 上海医药 55,595 12,286 38, % 2.3 3, % 235% SZ 高新兴 11,894 1,700 5, % % 36% SH 鹏博士 11,832 2,165 7, % % 286% SH 复星医药 71,615 8,758 28, % 2.8 2,339 98% 142% SZ 华谊兄弟 15,456 3,060 10, % % 89% SZ 安科生物 15, , % % 27% SH 百川能源 13,740 1,238 4, % % 124% SZ 合众思壮 10,574 1,159 3, % % 145% SH 南京新百 14,957 3,790 13, % ,131 29% 41% SZ 万达信息 15,282 1,005 3, % % 139% SZ 巨星科技 10,494 1,840 6, % % 19% SH 山鹰纸业 15,357 3,372 12, % 1.1 2, % 216% SZ 二三四五 18,749 2,408 8, % 1.7 1,078 6% 9% SZ 一心堂 13,450 1,066 3, % % 61% SZ 国盛金控 24,092 3,163 11, % % 189% SH 瀚叶股份 12,084 1,187 4, % % 22% SH 中远海控 38,288 5,976 22, % 2.1 2, % 843% SZ 中天金融 34,116 5,442 20, % 0.9 4, % 258% SZ 中科创达 10, , % % 13% SZ 南极电商 20, , % % 5% SZ 东山精密 20,789 2,190 8, % % 326% SZ 昆仑万维 16,807 1,535 5, % 1.0 1,125 43% 58% SZ 岭南股份 9,986 1,099 4, % % 269% SZ 联络互动 10,080 1,539 6, % % 105% SZ 渤海租赁 26,346 8,782 35, % 2.6 2, % 882% SZ 隆平高科 17,750 1,328 5, % % 156% SH 华创阳安 16,178 3,640 15, % % 164% SZ 游族网络 14, , % % 57% SZ 华灿光电 11,196 1,432 6, % % 129% SZ 美亚柏科 11, , % % 7% SH 卓郎智能 14, , % % 329% SH 首创股份 22,060 2,877 12, % % 389% SZ 启明星辰 18, , % % 25% SZ 胜利精密 10,049 1,992 9, % % 141% SZ 广联达 28, , % % 12% SZ 聚光科技 11, , % % 104% SZ 东方国信 13,166 1,004 4, % % -1% SZ 翰宇药业 9, , % % 11% SZ 紫光国微 20, , % % 30% SZ 延安必康 31,550 2,017 9, % % 117% SZ 合力泰 15,457 2,284 11, % 1.5 1, % 159% SH 长电科技 17,792 2,643 13, % % 157%

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