Citic Bank breezes into China’s insular tobacco sector with new investment

The bank seized on a local government debt crunch to buy a stake in regional lender Hongta Bank, providing a conduit into China’s recession-proof cigarette monopoly

Key Takeaways:

• Citic Bank will acquire 14.5% of Yunnan Hongta Bank, which is closely connected to China’s tobacco monopoly
• The move could give Citic Bank, one of China’s more entrepreneurial national lenders, a conduit into supply chain finance across the country’s vast tobacco ecosystem

By Warren Yang

There’s an old saying that where there’s smoke, there’s fire. In the case of China Citic Bank Corp. Ltd. (0998.HK; 601998.SH), where there’s smoke, there may also be a recession-proof, perpetually flowing wellspring of money.

In a filing with the Hong Kong Stock Exchange last Friday, Citic Bank said it received the green light from the Yunnan bureau of the National Financial Regulatory Administration to acquire a 14.5% stake in regional lender Yunnan Hongta Bank.

On the surface, this small investment looks like a drop in the bucket for a national giant like Citic Bank. The filing doesn’t include a transaction value, which indicates that it’s a small deal that doesn’t require more detailed disclosure. Media reports also confirm it’s a minor transaction — with a heavy discount. Without much information, investors may have trouble understanding what’s behind this move.

Only when viewed against the broader backdrop of debt restructuring by local state-owned enterprises (SOEs) across China, and Hongta Bank’s close ties to China’s tobacco monopoly, does this low-key acquisition start making sense.

Anyone familiar with China’s massive tobacco apparatus knows that Hongta is one of the country’s most iconic and historic cigarette brands. That association is no coincidence as Hongta Bank is deeply intertwined with China’s tobacco industry, which is centered in Yunnan province where most of the Chinese crop is grown. Various units of China National Tobacco Corp., the nation’s tobacco monopoly, including Yunnan Hehe (Group) Co. Ltd. and China Tobacco Yunnan, collectively own more than 48% of unlisted Hongta Bank, according to East Money, a financial data aggregator.

This type of equity marriage between banks and the specific industries they lend to is normally frowned upon because of concerns about inappropriate related-party transactions that can raise credit risks. 

But in Hongta Bank’s case, its relationship with China National Tobacco places it comfortably at the center of a lucrative, closed-loop financial ecosystem. Upstream, it treats China National Tobacco’s purchase orders as ironclad collateral. Through its digital platform, Hongta Bank analyzes state assigned-crop quotas and past delivery data to instantly disburse planting loans to tobacco farmers. There are nearly zero risks involved as China National Tobacco routes purchase payments directly back through Hongta to settle the loans.

Downstream, the bank offers a specialized digital lending product that links directly into the China’s cigarette ordering system. When any of the country’s 5 million licensed, mom-and-pop tobacco retailers want to restock inventory but lack cash, Hongta Bank instantly approves micro-loans, clearing same-day payments to China National Tobacco.

Recession-proof monopoly

Because China National Tobacco is a strict, recession-proof state monopoly, these transactions are insulated from economic downturns. With its minority stake, Citic Bank won’t have operational control over Hongta Bank. But the asset can give it an entryway into this highly insular tobacco ecosystem and its low-risk financial environment.

For any outside lender, penetrating that system without insider assistance is an uphill battle. In that context, Citic Bank is effectively securing an institutional gateway to China National Tobacco by taking a seat among Hongta Bank’s top shareholders, opening a door to massive financing opportunities.

Furthermore, the partnership can also lead to a highly efficient co-lending model that addresses capital constraints for Hongta Bank. As a regional lender, Hongta Bank is constrained by its balance sheet capacity — it can only lend so much to its huge base of potential borrowers before bumping against regulatory ceilings.

Citic Bank, on the other hand, boasts an asset base that’s nearly 67 times that of Hongta Bank’s. Now, its new investment gives it access to a low-risk tobacco financing ecosystem at a time when deploying capital safely is increasingly difficult due to a slowing Chinese economy. Through this alliance, Hongta Bank can continue to cultivate high-value, low-risk tobacco relationships through its unique industry ties, while Citic Bank can step in to share the capital burden.

Crucially, this arrangement also allows the two banks to bear credit risks proportionally to the amount of capital each commits. In an environment where major commercial lenders are battling compressed interest margins and property-sector risks, this Hongta Bank stake delivers Citic Bank exactly what it needs: a pool of customers heavily insulated from broader macroeconomic cycles.

Reflecting the tobacco industry’s remarkably low-risk environment, Hongta Bank’s nonperforming loan ratio is well below the average for its regional bank peers. But such low risk also comes with some downside, since loans to such reliable borrowers also typically carry low rates, which doesn’t help improve margins. But sacrificing margins for volume and safety can be an attractive proposition.

Fire-sale asset

So, why would anyone sell a chunk of shares in a well-governed, stable regional bank sitting on a literal tobacco goldmine?

To answer that, we need to look at the seller, namely, Kunming Industrial Development Investment Co. Ltd. Hit by cooling regional economic growth and a peaking local government debt cycle, this Kunming municipal entity has faced immense operational and liquidity strains over the past few years, with a wall of maturing domestic and offshore bonds to repay. Desperate to unlock cash and head off any near-term defaults, Kunming Industrial Investment put its Hongta Bank stake up for public auction in April.

The contradiction of Yunnan’s cooling regional economy despite its lucrative tobacco foundation lies in the rigid nature of the tobacco industry. While the state-led tobacco monopoly provides steady tax revenues, it operates on fixed production quotas and cannot expand to rescue the broader economy during an economic downturn.

Instead, the province’s actual growth engine is heavily reliant on real estate land sales that have stalled with the national property slump, and debt-fueled infrastructure spending. This has left local government financing vehicles deeply exposed to a severe liquidity crunch, ultimately forcing municipal governments to liquidate highly stable, passive assets like Hongta Bank shares just to remain solvent.

After a failed initial auction and a subsequent price slash, the Hongta Bank stake finally sold for 981 million yuan ($144 million), according to media reports. This final price tag represents less than half of Hongta Bank’s book value per share. In short, Citic Bank swooped in and bought a premium asset at a fire-sale discount.

Citic Bank shares fell after the company’s disclosure. Perhaps this reflects general investor disdain of small regional banks, many of which are currently struggling. But Hongta Bank is profitable and well-capitalized, securely positioned to benefit from China’s tobacco monopoly.

Over time, investors may appreciate this strategic move, which then may boost Citic Bank’s valuation. It trades at a price-to-earnings (P/E) ratio of 4.9, lower than 5.7 for industry leader ICBC (1398.HK; 601389.SH) and also behind the 6.8 for China Merchants Bank (3968.HK), considered another one of the country’s more entrepreneurial national lenders.

Citic Bank may have only acquired a cheap minority stake in Hongta Bank. But the back-door entry it now has into China’s tobacco monopoly may provide handy fuel for its profit growth, leaving potential upside for its stock.

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