Leaving the nest

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The vast central province of Hunan is renowned within China as the home of Mao Zedong, popular TV network Hunan Satellite TV and the rock formations that inspired the floating peaks of the US movie “Avatar.” The province also has the lesser-known claim as the birthplace of the country’s massive construction boom.

Hunan is home to China’s two largest engineering machinery makers, Zoomlion Heavy Industry Science and Technology (1157.HKG, 000157.SZ) and Sany Group (600031.SH). That may change, however, if Zoomlion succeeds in expelling its rival.

Despite Zoomlion and Sany’s drastically different origins in the 1990s – the former as a state-owned organization and the latter as a private enterprise – they have grown into similarly colossal companies dueling for the industry crown. The most recent clash came when Sany’s outspoken executives announced plans in late November to move their headquarters and key business units to Beijing to“avoid malicious competition” – a barb almost surely pointed at Zoomlion.

Investor reaction to the move was likely not what Sany expected. Sany’s share price dipped 0.2% between November 22 and December 7 as further reports emerged of a dispute between the companies, while Zoomlion’s mainland shares climbed 5% during the same period.

The Chinese folk wisdom that “lean- ing on a big tree gives one good shade”may help explain the diverging stock prices. If Sany moves its operations as planned, the provincial government will naturally guide more support to Zoomlion, paving the way for the company’s expansion.

Although Hunan province has strong ties to Zoomlion and holds a more than 16% stake in the company, it has supported both companies by turn: It supported Zoomlion in its purchase of Italian concrete machine maker CIFA in 2008 and Sany’s purchase of German machinery company Putzmeister in 2012, although the two companies competed for both acquisitions.

If Sany pulls up its local roots, the province will also extend more infrastructure contracts to Zoomlion. In July, officials in provincial capital Changsha unveiled 195 airport, road and city construction projects amounting to RMB829.2 billion (US$132.9 billion) of investment. Locals say that, heading west from Changsha, there’s a Zoomlion facil- ity every 50 kilometers, and the company has the potential to become even more pervasive.

A giant, but at what cost?

Zoomlion already boasts a valuation of RMB61.6 billion (US$9.87 billion), the largest among China’s exchange-listed makers of engineering machinery. The company holds the largest share of China’s construction crane market and the second largest share of concrete machinery, trailing Sany.

Zoomlion’s fundamentals are strong: Out of China’s six major domestic machinery makers, it was the only one to record both revenue and profit growth(17.8% and 16.8%, respectively) in the first three quarters of 2012. Furthermore, the company is well positioned to acquire smaller competitors who are forced into bankruptcy. Continued real estate restrictions in 2013 are likely to constrain construction demand and trigger a wave of industry consolidation this year, said Lu Juan, a machinery analyst at Guotai Junan Securities.

Industry experts project that China’s engineering machinery industry will grow at an average annual rate of 17% in the next three years to reach a government-set target of RMB900 billion(US$144.3 billion) by 2015. Expected growth in infrastructure investment of 15% this year and 16% in 2014 will drive that change, Lu said. Projects to build out water infrastructure, affordable housing units, roads, airports and rail lines will continue to bolster demand for excavators, loaders, bulldozers and cranes.

But while strong government ties will help boost Zoomlion’s business, they could also drag on the innovation necessary to compete with its rivals. The company attained its current size mainly through concrete-machinery-related mergers and acquisitions in the past decade, and it will need to be more creative to solidify its dominance in a market brimming with competitors like China’s XCMG (000425.SZ) and global giant Caterpillar (CAT.NYSE).

Zoomlion lags behind Sany in its applications for technological patents, and in-house developed products have not been welcomed by the market. After four years of research and development, Zoomlion’s excavators achieved sales of only RMB1 billion (US$160 million) in 2011, or 2% of its total sales – compared with RMB19.5 billion (US$3.13 billion) in excavator sales by Sany.

In addition, Zoomlion’s overseas business is still small after years of development. Sales abroad accounted for 4.8% of the company’s revenue in 2011, compared with 6.8% for Sany. Far from a household name, Zoomlion ranked No. 67 in the Asia Brand Association’s Top 500 Asian Brands in 2012, far below Sany at No. 36.

With competition from Sany, Caterpillar and other companies rising, Zoomlion would be wise to conduct its business as if it too may lose Hunan’s support – in other words, the company should innovate as if its life depended on it. Otherwise, Zoomlion’s sheltered position in Hunan province may turn out to be a mixed blessing.