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Out of Focus: China’s First Big LBO Deal is a Headscratcher

August 30th, 2012 1 comment

The first rule of capitalism is the more buyers you attract, the higher the price you get. So, having just one potential buyer is generally a lousy idea when your goal is to make as much money as possible.

What then to make of the recently-announced plan by an all-star team of some of China’s largest PE firms, including CDH, Fountainvest, CITIC Capital, as well global giant Carlyle,  to participate in a $3.5 billion proposed leveraged buyout deal to take private the NASDAQ-listed Chinese advertising company Focus Media. Any profit from this “take private” deal, as far as I can tell,  hinges on later flipping Focus Media to a larger company. That’s because the chances seem slight a privatized Focus Media will be later approved for domestic Chinese IPO. But, what if Focus turns out to be flip-proof?

With so much money — as so many big name PE firms’ reputations —  on the line, you’d think there would a clear, persuasive investment case for this Focus Media deal. As far as I can tell, there isn’t. I have the highest respect for the PE firms involved in this deal, for their financial and investing acumen. They are the smartest and most experienced group of PE professionals ever assembled to do a single Chinese deal. And yet, for the life of me, I can’t figure out what they are thinking with this deal and why they all want a piece of this action.

If the goal is to try to arbitrage valuation differences between the US and Chinese stock markets, this deal isn’t likely to pan out. It’s not only that Focus Media will have a tough time convincing China’s securities regulator, the CSRC, to allow it to relist in China. Focus Media is now trading on the NASDAQ at a trailing p/e multiple of 18. That is on the high side for companies quoted in China.

Next problem, of course, is the impact on the P&L from all the borrowing needed to complete the deal. There’s been no clear statement yet about how much equity the PE firms will commit, and how much they intend to borrow. To complete the buyout, the investor group, including the PE firms along will need to buy about 65% of the Focus equity. The other 35% is owned by Focus Media’s chairman and China’s large private conglomerate Fosun Group. They both back the LBO deal.

So, the total check size to buy out all other public shareholders will be around $2.4 billion, assuming they investor group doesn’t need to up its offer. If half is borrowed money, the interest expense would swallow up around 50% Focus Media’s likely 2012 net income. In other words, the LBO itself is going to take a huge chunk out of Focus Media’s net income.  In other words, the PE group is actually paying about twice the current p/e to take Focus Media private, since its purchase mechanism will likely halve profits.

A typical LBO in the US relies on borrowed money to finance more than half the total acquisition cost. The more Focus Media borrows, the bigger the hit to its net income. Now, sure, the investors can argue Focus Media should later be valued not on net income, but on EBITDA. That’s the way LBO deals tend to get valued in the US. EBITDA, though,  is still something of an unknown classifier in China. There isn’t even a proper, simple Chinese translation for it. Separately, Focus Media is already carrying quite a bit of debt, equal to about 60% of revenues. Adding another big chunk to finance the buyout, at the very least,  will create a very wobbly balance sheet. At worst, it will put real pressure on Focus Media’s operating business to generate lots of additional cash to stay current on all that borrowing.

I have no particular insight into Focus Media’s business model, other than to note that the company is doing pretty well while already facing intensified competition. Focus Media doesn’t meet the usual criteria for a successful LBO deal, since it isn’t a business that seems to need any major restructuring, refocusing or realignment of interests between owners and management.

Focus Media gets much of its revenue and profit from installing and selling ads that appear on LCD flatscreens it hangs in places like elevators and retail stores. It’s a business tailor-made for Chinese conditions. You won’t find an advertising company quite like it in the US or Europe. In a crowded country, in crowded urban shops, housing blocks and office buildings, you can get an ad in front of a goodly number of people in China while they are riding up in a jammed elevator or waiting at a checkout counter.

The overall fundamentals with Focus Media’s business are sound. The advertising industry in China is growing. But, it’s hard to see anything on the horizon that will lift its current decent operating performance to another level. Without that, it gets much harder to justify this deal.

This is, it should be noted, the first big LBO ever attempted by a Chinese company. It could be that the PE firms involved want to get some knowledge and experience in this realm, assuming that there could be more Chinese LBOs coming down the pike. Maybe. But, it looks like it could be pretty expensive tuition.

Assuming they can pull off the “delist” part of the deal, the PE firms will need to find a way to exit from this investment sometime in the next three to five years. Focus Media’s chairman has been vocal in complaining about the low valuation US investors are giving his company. In other words, he believes the company’s shares can be sold to someone else, at some future date, at a far higher price. (He personally owns 17% of the equity.)

Who exactly, though, is this “someone else”? Relisting Focus Media in China is a real long shot, and anyway, the current multiples, on a trailing basis, are comparable with NASDAQ’s . This is before calculating the hit Focus Media’s earnings will take from leveraging up the company with lots of new debt. How about the Hong Kong Stock Exchange? Focus Media would likely be given a warm welcome to relist there. One problem: with Hong Kong p/e multiples limping along at some of the lowest levels in the world, the relisted Focus Media’s market value would almost certainly be lower than the current price in the US. Throw in, of course, millions of dollars in legal fees on both sides of the delist-relist, and this Hong Kong IPO plan looks like a very elaborate way to park then lose money.

That leaves M&A as the only viable option for the PE investor group to make some money. I’m guessing this is what they have on their minds, to flip Focus Media to a larger Chinese acquirer.  They may have already spoken to potential acquirers, maybe even talked price. The two most obvious acquirers, Tencent Holdings and Baidu, both may be interested. Baidu has done some M&A lately, including the purchase, at what looks to many to be a ridiculously high price, of a majority of Chinese online travel site Qunar.  So far so good.

The risk is that neither of these two giants will agree to pay a big price down the line for a company that could buy now for much less. The same logic applies to any other Chinese acquirer, though they are few and far between. I’d be surprised if Tencent or Baidu haven’t already run the numbers, maybe at Focus Media’s invitation. But, they didn’t make a move. Not up to now.

Could it be they don’t want to do the buyout directly, out of fear it could go wrong or hurt their PR? Maybe. But, I very much doubt they will be very eager to play the final owner in a very public “greater fool” deal.

I’m fully expecting to be proven wrong eventually by this powerhouse group of PEs, and that they will end up dividing a huge profit pile from this Focus Media LBO. If so, the last laugh is on me. But,  as of now, the Focus deal’s investment logic seems cockeyed.

 

 

One Star Fits All

August 20th, 2012 No comments

China First Capital blog post

Imagine a world of where every product had a single celebrity endorser. The same star would advertise on behalf of car companies, detergent, liquor, travel. Sound implausible? Welcome to the world of Chinese celebrity product endorsement, where kungfu star Jackie Chan is such a fixture of product advertising, both commercials and billboards, that no one knows for certain how many different brands he advertises.

With the help of a friend, I recently compiled a list of 16 companies Jackie Chan now shills for. There are certainly others. The list includes some brands familiar to Western audiences, like Mitsubishi Motors and Canon EOS cameras. But, most of the products are ones targeting China’s domestic market. These include a dumpling company, an air-conditioner manufacturer, an anti-baldness shampoo, green tea bags, and a laundry detergent. During the broadcast of the 2012 London Olympics, Jackie Chan-fronted commercials got far more tv time in China than Michael Phelps or any Chinese medal winner .

In the US and Europe, the generally held view is that a celebrity should endorse only one product.  Endorsement contracts usually specify this. Once a brand pays out a lot of money to get a celebrity, they don’t want that investment squandered, in part, by the same celebrity pitching for another product, even an unrelated one.

So, Robert DeNiro has appeared in American Express advertising, and nowhere else. Jennifer Aniston pitches L’Oreal shampoo, and that’s it. For awhile, golfer Tiger Woods was the one notable exception to this rule of promotional monogamy, promoting several different products at once. His marital philandering brought an end to his endorsement philandering. Every big brand but Nike has dropped him.

But, Jackie Chan in China is an advertising law unto himself. He is, without question, the most visible man in China, a wall-to-wall presence in people’s lives. The only face Chinese seen more often is Mao Zedong, whose portrait is on every banknote circulated in the country.

Simply understood, in today’s consumer market in China, paper with Mao’s face buys products with Jacky Chan’s on it.

Unlike Mao, Jacky Chan’s popularity and ubiquity in China are both a little beyond the scope of my comprehension. Start with the fact Jacky Chan is from Hong Kong, not the Chinese mainland, and his clunky Mandarin betrays that fact. Kungfu movies aren’t particularly popular in today’s China. At 58, he’s hardly a matinee idol. Most of his film work these days is in English, like the recent remake of “The Karate Kid” and “Kungfu Panda”.

China has plenty of home-grown stars. Two of them, the actresses Zhang Ziyi and Gong Li, also do a lot of product endorsements. These two share a key attribute that makes Jackie Chan valuable as a pitchman: they’ve achieved fame outside China.

These three are in a class by themselves among celebrity endorsers in China, precisely because they are the only three with real name recognition outside the country. If you want to be a truly big star in China, become even a minor one in the US.

Most of the products endorsed by Jackie Chan are sold only in China. Some, like Cree air-conditioners, among the leading brands. Others, like Fenhuang Cola, are also-rans. Nothing, though, seems to dent his value as a pitcher of products to China’s masses.

All celebrity endorsements are a paid attempt at rub-off glamour. With Jackie Chan, no matter how often that glamour gets rubbed, it never seems to dull.

 


Stir-Fried Rat Anyone?

August 8th, 2012 1 comment

Rat painting from China First Capital blog post

I was still drowsy from sleep early one morning when I heard a rustle and saw a brown flash dart across my kitchen counter. A rat. For sure. I then found some telltale signs in one of my cupboards – a plastic bag torn open and peanut skins littered all around.

My immediate thought was, “If only Chinese ate rats, there’d be fewer of them”. I’d always heard rats were one of the few animals that Chinese would not consider a meal-in-waiting.

Turns out, I was wrong about that, as this article I dug up from China Daily points out: Click here to read.

A lot of insight and wisdom, as well as the occasional bit of crackpot thinking, is contained in Chinese “chengyu”(成语), the often-ancient sayings still frequently used in daily speech. It’s no surprise that one such chengyu is used to promote the special virtues of eating rat. It avers “one rat is as nutritious as three chickens.”

That there’s zero empirical basis for this claim is clearly no impediment to its use.  A more considered chengyu would be “eat rat and catch all kinds of nasty diseases for which there is no known cure”.

The Cantonese are widely known as the most adventurous eaters in China. There are multiple chengyu about this as well, mainly variations on the theme that Cantonese will eat anything with four legs except a table, and anything that flies except a helicopter.

Rat meat is obviously an acquired taste in China, and not a common source of protein like, for example, dog meat. If it were more prized on the table, there’d be less chance of  encountering one in my kitchen cabinet.

Equally, though, there’d be more seriously ill Chinese. On balance, I’d rather have them thrive as domestic pests, than become a toxic part of the food chain.