China's Great Growth Engine Sputters

9/14/2015


China's government has lowered interest rates five times since November. It has devalued its currency in a bid to boost exports by making them more affordable to the rest of the world. It has banned large shareholders from selling stock and nudged Chinese brokerages to suspend short-selling. Even state-run newspapers have encouraged citizens to invest in stocks, one running the unambiguous headline, "Go! Buy HongKong Stocks!"

China's most recent pledge to spend more on infrastructure and cut taxes for small businesses has helped its markets recover some ground in September. But the Shanghai SE Composite Index remains down 37% over the past three months, while the Hang Seng Index (Hong Kong's stock exchange) is down 22%. While the government's fitful meddling hasn't boosted investor confidence, it has betrayed officials' anxiety.

The reversal in Chinese stocks can be partly blamed on an overheated market needing to catch its breath — the Shanghai SE is still up 42% over the last year — and slowing growth in the underlying economy. Blue Chip Economic Indicators expects China's 2015 gross domestic product (GDP) to expand 6.6%, down from the 6.9% growth projected at the end of 2014, 7.1% projected 12 months ago, and 9.8% average growth over the past 25 years. The 6.6% would mark China's slowest annual gain since 1990. To further muddy the waters, the accuracy of the Chinese government's official statistics has come into question.

For U.S. investors, the biggest concern lies in the potential spillover effect — the possibility of China tipping the fragile global recovery into another recession.

U.S. direct exposure to China appears fairly limited. Exports to China represent less than 1% of U.S. gross domestic product and 7.5% of all U.S. goods exported last year. China ranks third as a destination for U.S. exports; Canada and Mexico are higher. Export growth was moderating before this year's slowdown — U.S. goods exported to China rose just 2% last year, the weakest gain since 2009.

Just 2% of sales for S&P 500 companies come from China, estimates Goldman Sachs ($186; GS). And just 16 companies in the S&P 500 rely on China for more than 10% of sales, says The Wall Street Journal, citing research from Wells Fargo Securities.

BANK EXPOSURE TO CHINA
Geographic sales data can understate risk for some companies, especially banks that hold foreign loans, government bonds, stocks, or other derivative instruments on their balance sheets. The banks below reported exposure to China for the most recent quarter.
--- Total Exposure To China (Billions) ---
Company (Price; Ticker)
June
2014
($)
June
2015
($)
%
Change
Citigroup ($51; C)
22.20
21.10
(5)
J.P. Morgan Chase ($62; JPM)
18.00
17.70
(2)
Bank of America ($16; BAC)
13.78
11.29
(18)
Morgan Stanley ($34; MS)
2.55
4.49
76
Wells Fargo ($52; WFC)
5.29
3.13
(41)

Yet China has become a source of growth for U.S. companies amid the weak recovery in North America and Europe. The sudden decline in U.S. stock prices partly reflects rising risks regarding the growth prospects of these companies. Several of our recommended stocks have significant exposure to China, as shown at the bottom of the page.

In reporting June-quarter results, U.S. companies described weaker Chinese demand for such products as elevators, construction equipment, and semiconductors. Yet Apple ($110; AAPL) and luggage maker Samsonite International said last month that sales remain strong there, signaling two things: Chinese consumers are still confident about their personal finances, and the effects of China's slowing growth may be unevenly distributed.

China is reportedly trying to reposition its economy as one based on consumer services rather than industrial production. Underscoring that shift, China's steel production is projected to decline in 2015 for the first time in 40 years. Meanwhile, China's manufacturing activity fell to a three-year low in August.

Among the biggest losers in China's new economy are commodity producers. China consumes 45% of the world's steel and ranks second among all countries in oil consumption. Oil prices have slumped, and in late August, Thomson Reuters/CoreCommodity CRB Index of 19 commodities touched its lowest point since December 2002.

Below we review three recommended stocks that generate more than 10% of their sales in China.

Lam Research's ($71; LRCX) stock has declined 14% over the past three months, partly due to its presence in the highly cyclical semiconductor-equipment industry. China is Lam's fourth-largest end market, representing 13% of sales in fiscal 2015 ended June, up from 9% two years earlier.

However, Lam enjoys relatively high exposure to 3D NAND, a type of flash memory becoming increasingly popular. One of Lam's biggest customers, Micron Technology ($17; MU) plans to ramp investment in 3D NAND facilities, last month raising its guidance for capital spending in fiscal 2016 ending August, implying growth of 39% to 53%. Lam is a Buy and a Long-Term Buy.


Lear ($105; LEA) generated 12% of sales from China last year. In July, Lear lowered its 2015 production target for China but raised its full-year guidance for core operating earnings and free cash flow, encouraged by profitability improvements. Management says its business remains profitable in China, which accounts for nearly one-third of the company's $2 billion backlog.

Lear is projected to grow per-share profits 21% in the 12 months ending June, well above its peer-group average. At just 10 times estimated earnings, Lear's stock trades at a 32% discount to its peers. Lear is a Focus List Buy and a Long-Term Buy.


Skyworks Solutions' ($86; SWKS) exposure to China is somewhat misleading. Chinese-based manufacturers generated 69% of its revenue in fiscal 2014 ended September. But as an end market — where products that contain the company's semiconductors are eventually sold — China accounted for a more moderate 20% to 25% of sales. Given the robust demand for iPhones among Chinese consumers, Skyworks, a key component supplier for Apple, seems capable of maintaining its operating momentum.

Skyworks' per-share profits are projected to surge 23% for the 12 months ending June, compared to 14% for the average S&P 1500 semiconductor stock. Yet Skyworks' trailing P/E ratio of 18 lags its industry average of 20. Skyworks is a Buy and a Long-Term Buy.

SALES DESTINATIONS
Geographic disclosure of sales varies by company. Below we present recommended stocks that broke out sales in the past fiscal year for China and the Asia-Pacific region. More than half of our 28 recommended stocks generate at least 70% of sales in the U.S.
Company (Price; Ticker)
% Of Sales
In China
China
Skyworks Solutions ($86; SWKS)
69
Apple ($110; AAPL)
17
Nvidia ($22; NVDA)
16
Lam Research ($71; LRCX)
13
Lear ($105; LEA)
12
Jones Lang LaSalle ($146; JLL)
3
CBRE ($32; CBG)
1
Company (Price; Ticker)
% Of Sales
In Asia
Asia
Skyworks Solutions ($86; SWKS)
95
Lam Research ($71; LRCX)
77
Nvidia ($22; NVDA)
67
Apple ($110; AAPL)
32
F5 Networks ($120; FFIV)
20
Jones Lang LaSalle ($146; JLL)
20
Goodyear Tire & Rubber ($30; GT)
11
CBRE ($32; CBG)
6
J.P. Morgan Chase ($62; JPM)
6
Company (Price; Ticker)
% Of Sales
In U.S.
U.S. 
CVS Health ($100; CVS)
100
Community Health ($52; CYH)
100
Kroger ($34; KR)
100
Southwest Airlines ($38; LUV)
99
CDW ($40; CDW)
96
HCA Holdings ($86; HCA)
96
Comcast ($57; CMCSa)
94
Disney ($102; DIS)
94
C.H. Robinson ($69; CHRW)
88
Robert Half Int'l ($51; RHI)
77
J.P. Morgan Chase ($62; JPM)
74
Gilead Sciences ($104; GILD)
73
Foot Locker ($71; FL)
70
Shire ($226; SHPG)
70
Notes: Alaska Air ($82; ALK) generates virtually all revenue in North America. Lincoln Financial ($49; LNC) and U.S. Bancorp ($41; USB) say foreign operations are not material to results.

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