Archive

Archive for July, 2010

Under New Management — Chinese Corporate Management Is Changing Fast

July 27th, 2010 1 comment

Gold splash censer from China First Capital blog post

“Five years ago, all I had to worry about was producing enough to earn a small profit. Now I spend time dealing with employment issues, environmental regulations, tax policies, trying to increase market share and staying ahead of competitors. The pressure is much worse. ”

Welcome to the suddenly changed and increasingly pressured world of Chinese corporate management. 

This comment comes from the boss of a large, integrated chemical factory in Shandong. He and I were talking recently. He is still a relatively young guy of around 40. But, in his 15 year career as first an engineer, then a manager and finally as factory boss, he has seen the purpose, methods, scope, goals and responsibilities of Chinese management change from top to bottom. 

Like much else in China, company management has undergone a lifetime’s worth of change in a matter of a few years. It’s a byproduct of larger forces at work in China’s economy – the withdrawal of direct state planning and control, the ascendancy of the private sector, China’s entry to the WTO and the opening of China’s markets to imports, the rise of a vibrant consumer market. All of these have made planning and decision-making far more intricate and the stakes far higher for Chinese corporate managers, both in state-owned and private companies. 

In the case of my friend in Shandong, he is working for a company majority owned by the state. In theory, that should make his management tasks far easier. In most cases, the Chinese government – whether at national, provincial or local level – is a very lenient shareholder. In fact, they would appear to the ideal owner for any manager who is looking for easy ride. 

In China as elsewhere, when the state is the owner, no one is really in charge. The Chinese government is not looking for dividends. Most profits stay inside the company.  

Here’s the paradox that Chinese managers all live with: as undemanding as the Chinese government is as a shareholder, they are increasingly demanding as a regulator and law-maker. That is a big reason why corporate management has gotten so much more complex in China. In a short space of time, China has gone from a more laissez-faire stance to one with strict environmental, tax and labor laws that rival those of the US and Western Europe. 

True, these tougher regulations are not yet universally applied or enforced. But, any Chinese manager who chooses to act in total disregard of these rules will eventually find himself in deep, deep trouble. Take labor laws. China continues to introduce new forms of workplace protection that give important new rights to hired staff and restrict the prerogatives of management. Any Chinese with a complaint over pay or conditions can complain directly to the Laodong Ju, or Labor Bureau, a quasi-state body that enforces labor laws. 

The process is not without its hiccups. Management can still intimidate and threaten workers who seek redress. But, the system does work. 

Example: a friend of mine worked for several years as a salesperson for an electronics company based in Shenzhen. She was paid part in commission. She did her job well. For months, then years, the boss held back the commission payments, claiming cash flow problems. This is old style China management: don’t pay, offer excuses. This boss assumed he could continue indefinitely with this trickery, in part because the general view is that female workers in China are more easily cowed or mollified. 

Instead, my friend quit without warning,  went right to the Labor Bureau, which made one call to her ex-boss. No investigation. Just a phone call and a stern warning from the Labor Bureau. My friend got her money – about $20,000 in total – within a week. The boss will now have a much harder time doing what he’s always done – pad his own take-home by cheating workers out of what they are entitled to. Tyrannizing workers is no longer a workable HR strategy for a Chinese management team. 

New environmental rules are, if anything,  even more disruptive of old lax ways of managing business in China. Managers who choose to improve margins by ignoring pollution standards are risking an early unpaid retirement. Example: a client of ours is the leading environmentally-friendly paper manufacturer in Shandong. Two years ago, he had 29 competitors in Shandong. Today, he has only three. 

The other 26 were shut down, virtually overnight, for violating environmental standards. The managers at those factories, most of which were around for many years, now likely understand better than most how much the craft of management has changed in China.  

Elsewhere in Shandong, my friend the chemical company boss, is now making another decision that was unimaginable when he began his career: he is working on a plan for a management buyout of the factory. The business is now 65%-owned by a large local coal mine, which in turn, is owned by the provincial government. 

The buy-out plan is still in its early stages. To succeed, he’ll need to persuade several levels of government – no one is quite sure how many – and also take over some significant liabilities, including debts of about $15mn.  It’s not clear if the current management will need to put up cash to buy the government’s controlling stake, or if, as preferred, they can pay in installments, using cash from the business. 

Servicing debt and having most of one’s wealth tied up in illiquid shares of one’s company are other adaptations now being learned by Chinese management. Each year, their working lives grow harder, more pressured and, for the more talented and nimble ones, far more financially rewarding.  Stride-for-stride with the modernization of China’s economy, Chinese corporate managers have gotten better faster than anywhere else, ever.


 

Shenzhen The World’s Most Active IPO Market So Far in 2010

July 19th, 2010 No comments

Jade object from China First Capital blog post

 

Shenzhen’s Stock Exchange was the world’s busiest and largest IPO market during the first half of 2010. Through the end of June, 161 firms raised $22.6 billion in IPOs on Shenzhen Stock Exchange. The Shanghai Stock Exchange ranked No.4, with 11 firms raising $8.2 billion.

Take a minute to let that sink in. The Shenzhen Stock Exchange, which two years ago wasn’t even among the five largest in Asia, is now host to more new capital-raising transactions than any other stock market, including Nasdaq and NYSE. Even amid the weekly torrent of positive economic statistics from China, this one does stand out. For one thing, Shenzhen’s Stock Exchange is effectively closed to all investors from outside China. So, all those IPO deals, and the capital raised so far in 2010, were done for domestic Chinese companies using money from domestic Chinese investors.

The same goes for IPOs done on Shenzhen’s larger domestic competitor, the Shanghai Stock Exchange. In the first half of 2010, the Shanghai bourse had eleven IPOs, and raised $8.2 billion. That brings the total during the first half of 2010 in China to 172 IPOs, raising $31 billion in capital.

The total for the second half of 2010 is certain to be larger, and Shenzhen will likely lose pole position to Shanghai. The Agricultural Bank of China just completed its IPO and raised $19.2 billion in a dual listing on Shanghai and Hong Kong exchanges. Over $8.5 billion was raised from the Shanghai portion.

One reason for the sudden surge of IPOs in Shenzhen was the opening in October 2009 of a new subsidiary board, the 创业板, or Chinext market. Its purpose is to allow smaller, mainly private companies to access capital markets. Before Chinext, about the only Chinese companies that could IPO in China were ones with some degree of state ownership. Chinext changed that. There is a significant backlog of several hundred companies waiting for approval to go public on Chinext.

So far this year, 57 companies have had IPOs on Chinext. The total market value of all 93 companies listed on Chinext is about Rmb 300 billion, or 5.5% of total market capitalization of the Shenzhen Stock Exchange. On Shenzhen’s two other boards for larger-cap companies, 197 companies had IPOs during the first half of 2010.

The surge in IPO activity in China during the first half of 2010 coincided with the dismal performance overall of shares traded on the Shanghai and Shenzhen stock exchanges. Both markets are down during the first half of the year: Shanghai by over 25%  and Shenzhen by 15%. 

The IPO process in China, both on Shanghai and Shenzhen markets, is very tightly controlled by China’s securities regulator, the CSRC (证监会). It’s the CSRC that decides the number and timing of IPOs in China, not market demand. One factor the CSRC gives significant weight to is the overall performance of China’s stock market. They want to control the supply of new shares, by limiting IPO transactions, to avoid additional downward pressure on share prices overall.

So, presumably, if the Chinese stock markets performed better in the first half of 2010, the number of IPOs would have been even higher. Make no mistake: the locus of the world’s IPO activity is shifting to China.

Reverse Mergers — Knowledgable Comment

July 13th, 2010 No comments

qing calligraphy2

Comments don’t get any better than this one, a detailed assessment of the hazards of reverse mergers. It was added as a comment to an earlier blog post of mine. I’m grateful for the contribution, and humbled by the writer’s knowledge and clear writing style.  Highly recommended.

 

A Reverse Merger (“RM”) is routinely pitched as a cheaper and quicker method of going public than a traditional IPO in China. This may be technically true but the comparison is VERY MISLEADING. 

As you mentioned a few times in your blog, an RM is not a capital raising transaction. No shares are sold for cash in the transaction. It will receive little attention from analysts ! The RM is often coupled with a PIPE financing. However, the amount of PIPE financing that can be raised is very limited. Additionally, PIPE financing is typically expensive relative to other financing options and may contain onerous terms. 

Generally, completing a $50 million IPO will roughly run a company 18% of the offering proceeds, including underwriter discounts, under pricing, and legal, accounting, filing, listing, printing, and registrar fees, or $9 million. 

Conversely, an RM was advocated as “costs only between $100,000 and $400,000 to complete”. This is the most tricky and misleading part, because this cost range does not include the value of the equity stake retained by the shell promoter and its affiliates. And most Chinese company does not understand this. 

Generally when the RM closes, the Chinese Operating Company is issued Shell Company shares only equal to 80% to 90% of Shell Co’s post-merger outstanding shares. The the remaining 10% to 20% of shares are retained by the owner of the Shell Company, the promoter and its affiliates.

Hence, in addition to the $100,000 to $400,000 in cash paid by Chinese Operating Co to complete the RM, the Chinese Operating Co has also “paid” a 10% to 20% stake in its company. If the market capitalization is $50 million post-RM, this stake is worth $5 to $10 million. 

So RM is not cheaper at all ! It is Usually an option for second and third tier companies to obtain financing via a PIPE, and Some PIPE investors may not be long-term investors. An active trading market for stock may not be developed through a RM. Company will probably not qualify to trade on the Nasdaq and will likely end up trading in the pink sheets or the bulletin board. 

Kleiner Perkins in China — Update

July 10th, 2010 No comments

Budai

Congratulations to Kleiner Perkins Caufield & Byers on the successful NASDAQ IPO of its portfolio company AutoNavi, a Chinese mapping company that supplies maps for GPS navigation systems. KP owned 4.3% of the company prior to its recent IPO. At time of IPO, Kleiner owned 6,527,520 ordinary shares of AutoNavi, now worth around $25mn. That equates to a 2.5X rate of return over the four years KP held the investment.

The AutoNavi investment was made by KP’s main office in California, not Kleiner Perkins China, which was set up in 2007 to lead the US firm’s investing activities in China, and is still waiting for its first exit. According to KP China’s website , the AutoNavi investment is managed by KP China.

Two other venture capital firms also held AutoNavi shares at the time of IP, Walden International and Sequoia.

TMK Power Industries – Anatomy of a Reverse Merger

July 4th, 2010 3 comments

lacquer box from China First Capital blog post

Two years back, I met the boss and toured the factory of a Shenzhen-based company called TMK Power Industries. They make rechargeable nickel-metal hydride, or Ni-MH,  batteries, the kind used in a lot of household appliances like electric toothbrushes and razors, portable “Dustbuster” vacuum cleaners, and portable entertainment devices like MP3 players. 

At the time, it seemed to me a good business, not great. Lithium rechargeable batteries are where most of the excitement and investment is these days. But, TMK had built up a nice little pocket of the market for the lower-priced and lower-powered NI-MH variety. 

I just read his company went public earlier this year in the US, through a reverse merger and OTCBB listing. I wish this boss lots of luck. He’ll probably need it.

Things may all work out for TMK. But, at first glance, it looks like the company has spent the last two years committing a form of slow-motion suicide. 

Back when I met the company, we had a quick discussion about how they could raise money to expand. I went through the benefits of raising private equity capital, but it mainly fell on deaf ears. The boss let me know soon after that he’d decided to list his company in the US.

He made it seem like a transaction was imminent, since I know he was in need of equity capital. Two years elapsed, but he eventually got his US listing, on the OTCBB, with a ticket symbol of DFEL. 

Here is a chart of share price performance from date of listing in February. It’s a steep fall, but not an unusual trajectory for Chinese companies listed on the OTCBB. 

 TMK share chart

From the beginning, I guessed his idea was to do some kind of reverse merger and OTCBB transaction. I knew he was working then with a financial advisor in China whose forte was arranging these OTCBB deals. I never met this advisor, but knew him by reputation. He had previously worked with a company that later became a client of mine. 

The advisor had arranged an OTCBB deal for this client whose main features were to first raise $8 million from a US OTCBB stock broker as “expansion capital” for the client. The advisor made sure there wouldn’t be much expanding, except of his own bank account and that of the stock broker that planned to put up the $8mn. 

Here’s how the deal was meant to work: the advisor would keep 17% of the capital raised as his fee, or $1.35mn.  The plan was for the broker to then rush this company through an expensive “Form 10” OTCBB listing where at least another $1.5 mn of the original $8mn money would go to pay fees to advisors, the broker,  lawyers and others. The IPO would raise no money for the company, but instead all proceeds from share sale would go to the advisor and broker. The final piece was a huge grant of warrants to this advisor and the stock broker that would leave them in control of at least 15% of the post-IPO equity. 

If the plan had gone down, it’s possible that the advisor and broker would have made 2-3 times the money they put up, in about six months. The Chinese company, meanwhile, would be left to twist in the wind after the IPO. 

Fortunately for the company, this IPO deal never took place. Instead, I helped the company raise $10mn in private equity from a first class PE firm. The company used the money to build a new factory. It has gone from strength to strength. Its profits this year will likely hit $20mn, four times the level of three years ago when I first met them. They are looking at an IPO next year at an expected market cap of over $500mn, more than 10 times higher than when I raised them PE finance in 2008. 

TMK was not quite so lucky. I’m not sure if this advisor stayed around long enough to work on the IPO. His name is not mentioned in the prospectus. It does look like his kind of deal, though. 

TMK should be ruing the day they agreed to this IPO. The shares briefly hit a high of $2.75, then fell off a cliff. They are now down below $1.50. It’s hard to say the exact price, because the shares barely trade. There is no liquidity.

As the phrase goes, the shares “trade by appointment”. This is a common feature of OTCBB listed companies. Also typical for OTCBB companies, the bid-ask spread is also very wide: $1.10 bid, and $1.30 asked. 

Looking at the company’s underlying performance, however, there is some good news. Revenues have about doubled in last two years to around $50mn. In most recent quarter, revenues rose 50% over the previous quarter. That kind of growth should be a boost to the share price. Instead, it’s been one long slide. One obvious reason: while revenues have been booming, profits have collapsed. Net margin shrunk from 13% in final quarter of 2009 to 0.2% in first quarter of 2010. 

How could this happen? The main culprit seems to be the fact that General and Administrative costs rose six-fold in the quarter from $269,000 to over $1.8mn. There’s no mention of the company hiring Jack Welch as its new CEO, at a salary of $6mn a year. So, it’s hard to fathom why G&A costs hit such a high level. I certainly wouldn’t be very pleased if I were a shareholder. 

TMK filed its first 10Q quarterly report late. That’s not just a bad signal. It’s also yet another unneeded expense. The company likely had to pay a lawyer to file the NT-10Q to the SEC to report it would not file on time. When the 10Q did finally appear, it also sucked money out of the company for lawyers and accountants. 

TMK did not have an IPO, as such. Instead, there was a private placement to raise $6.9mn, and in parallel a sale of over 6 million of the company’s shares by a variety of existing shareholders. The broker who raised the money is called Hudson Securities, an outfit I’ve never heard of. TMK paid Hudson $545,000 in fees for the private placement, and also issued to Hudson for free a packet of shares, and a large chunk of warrants.

Hudson was among the shareholders looking to sell, according to the registration statement filed when the company completed its reverse merger in February. It’s hard to know precisely, but it seems a fair guess that TMK paid out to Hudson in cash and kind over $1mn on this deal. 

The reverse merger itself, not including cost of acquiring the shell, cost another $112,000 in fees. At the end of its most recent quarter, the company had all of $289,000 in the bank. 

These reverse merger and OTCBB deals involving Chinese companies happen all the time. Over the last four years, there’s been an average of about six such deals a month.

This is the first time – and with luck it will be the only time – I actually met a company before they went through the process. Most of these reverse merger deals leave the companies worse off. Not so brokers and advisors. 

Given the dismal record of these deals, the phrase 美国反向收购 or “US reverse merger” , should be the most feared in the Chinese financial lexicon. Sadly, that’s not the case.