We believe Giant Interactive (GA) has defrauded investors and that the U.S. Securities and Exchange Commission will bring charges against the company. We will present evidence that we believe shows Chairman Shi Yuzhu has diverted resources from the company, through a series of "undisclosed" related party transactions, in order to siphon tens of millions of dollars of shareholder cash out of the company and into his own private equity firm. More alarmingly, Giant's "independent director" Jason Jiang, who sits on the audit, compensation and corporate governance committee, is an undisclosed related party to Chairman Shi Yuzhu through their affiliation in Yunfeng Capital. Yunfeng Capital is a private equity firm both Shi Yuzhu and Jason Jiang are founding partners and directors of -- this is a clear conflict of interest and a direct violation of NYSE independence requirement 303A.02 and SEC guidelines. We believe Jason Jiang will be forced to resign.
In addition to the regulatory headwinds, we see numerous red flags surrounding the chairman's recent "non-binding" buyout proposal. We believe Shi Yuzhu has little interest in taking Giant private and more of an interest in liquidating shares at inflated prices. Giant has a record of fairly egregious fraud and money laundering in the past, and we believe the issues covered will encourage even the most speculative private equity affiliate to strongly reconsider risking his or her investor's capital in Giant Interactive. Investors should note that Barings Private Equity is no stranger to walking away from bad businesses even after proposals were made -- see China Ambow and Harbin Electric as recent examples. Absent Giant's purported buyout, investors will certainly be left with a weakening business operating in a hypercompetitive, fragmented gaming market that is experiencing significant pricing competition and consistent share losses. We believe Giant's shares will ultimately be worth far less than the $7 Chairman Shi Yuzhu liquidated 6% (11 million shares) of his Giant stake for in June 2013.
If the Chairman Thinks It's Worth $7, Then We Think It's Worth $7 -- or Less
On Nov. 25, 2013, Giant's board announced that it received a "proposal of going private" for $11.75 from its Chairman Shi Yuzhu. Note that a proposal is not a buyout offer -- it is just that, a proposal.
Year to date, Giant Interactive has returned 109% and is trading at valuations the company hasn't seen in five years. The natural question investors should ask themselves is: Why does the founder propose to take Giant private now? Furthermore, if the chairman believes the company is truly undervalued, as his MBO suggests, why has he continued to liquidate his stake in Giant alongside the run-up? We believe this is a development that should always give investors pause.
To provide context, in April 2013, Shi Yuzhu abruptly resigned as CEO of Giant Interactive. The following month, in June 2013, Shi Yuzhu announced that he would be selling 15.1m of his shares in GA and granting underwriters an additional 2.3m shares for overallotment. After backlash from the investment community, Shi Yuzhu sold 6% of his stake (11m shares) at a price of $7.25 Ads (a YTD +42% premium). Note that $7.25 was a 15% discount to the $8.50 trading price before the initial announcement; implying underwriters weren't exactly bullish on the stock. The transaction came as a surprise to the market and represented the first share sale by Shi Yuzhu since the company went public in 2007. The company explained the share sale as an opportunity for Shi Yuzhu to "diversify his personal holdings" and improve liquidity in the company's shares.
Thus does a conundrum rear its head; fast forward to November 2013, just five months after Chairman Shi Yuzhu sold his first significant stake in the company, when Giant received a less-than-transparent "non-binding" proposal from its chairman and an affiliate of Baring Private Equity Asia to acquire shares for $11.75. That meant effectively buying back his own shares at an astonishing 62% premium to the $7.25 he sold his shares for just five months before. We believe this is a perplexing action that merits a healthy dose of skepticism and increased scrutiny.
Post Buyout proposal, the Chairman Is Still Disposing of His Shares
Click to enlarge images.
Just one month after Chairman Shi Yuzhu put a promise ring on the fingers of shareholders, he turns around and sells another 5% of his stake or 11.8m shares through his investment company Vogel Holdings to Barings Private Equity. Shi Yuzhu's perpetual selling reeks of liquidity issues rather than an honest buyout proposal.
What Does the Chairman Know That We Don't?
- Investors should question why Chairman Shi Yuzhu appears so anxious to dispose of his shares in Giant, selling a combined 11% of his stake in the last six months at far lower valuations than his purported buyout price.
- Investors should also note that transiting the shares through its affiliate Barings Private Equity guarantees that liquidating the chairman's shares would not be transparent as Barings is not required to register share sales with the SEC as Shi Yuzhu would.
- If the chairman truly believes there is value in GA above 11.75, diluting his stake at any opportunity he gets is an odd way of showing it.
The lack of disclosure also speaks volumes about the chairman's true intentions. We find the proposal incredibly opaque and lacking any real merit. A legitimate proposal traditionally has the following engagements in place, which can give shareholders confidence in management's ability to execute:
- There is no definitive funding.
- There are no definitive partners.
- There is no definitive timeline.
Investors were presented with the following: "We intend to finance the Acquisition with a combination of debt and equity capital. Equity financing would be provided from the Consortium Members and any additional members we accept into the Consortium."
Investors should note that Barings Private Equity Asia is no stranger to partnering with bad businesses and then walking away even after proposals are issued. Note that Giant's proposal is "preliminary" and "non-binding." Investors don't need to look very far to find Barings buyout partnership with China Ambow in March 2013, which cost Barings $43 million on a $57 million investment, shortly after the resignation of four of the company's independent directors and its auditors.
"Education in China is a sector in which Baring Asia has had extensive prior investment experience," said Barings' Chief Executive Jean Eric Salata in a statement prior to its investment. Investors can also add add Harbin Electric to that list. Barings quickly walked away from Harbin Electric in 2011, another U.S.-listed Chinese company, shortly after questions began to arise about the company's fraudulent operations and lack of corporate governance.
What Else Is Giant Hiding?
In 2010 and 2011, Giant Interactive came to symbolize how founders of Chinese tech firms used their companies as personal investment vehicles, often to the detriment of minority shareholders. For Chairman Shi Yuzhu, old habits die hard. On September 2011, GA moved $50m from Giant's balance sheet to purchase "unregistered" shares of Alibaba. Instead of purchasing the shares directly, as any legitimate business would do, Giant opted to purchase (if, in fact, the shares were purchased) the "unregistered" shares through Yunfeng Capital.
What Giant Interactive dubiously failed to disclose to both shareholders and inquiring regulators is that both Chairman Shi Yuzhu and supposed "independent director" Jason Jiang are founding partners and directors of Yunfeng Capital. Note that, for obvious reasons, this related party transaction is not disclosed in any of the company's SEC disclosures or filings -- an obvious violation of SEC guidelines. Furthermore, transiting the money through Yunfeng guarantees that the price Giant paid for the shares (if, indeed, it bought them) would be not be transparent. Investors should question why management believed Yunfeng, the chairman's private equity firm, was an appropriate vehicle to purchase shares and even more appropriate not to disclose the relationship.
Source: Yunfeng's website.
Eighty percent of equity investee losses have come from GA's investment in the chairman's private equity firm, Yunfeng Capital. Even more concerning, GA's investment in Yunfeng has experienced significant equity investment losses, which the company hid from investors by not taking impairment charges. This was enough to garner the attention of regulators. On July 12, 2012, the SEC, through its correspondence with Giant Interactive, inquired into the significant equity losses the company had incurred related to its equity investments and why the company had not taken related impairment charges. Giant noted that "approximately 80% of the losses from the Company's equity method investees came from its share of investment losses in Yunfeng Fund." The company claimed to have paid millions in "structuring fees" to the Chairman's private equity firm. We find Giant's excuse implausible and shareholders should question where the cash really went.
If Giant Can Knowingly Deceive the SEC, Why Not Investors?
On July 26, 2012, the SEC probed Giant Interactive regarding the business activities of the Yunfeng Fund, Giant provided less than transparent answers.
Just a few notable disclosures Giant coincidentally left out:
- Investors should ask themselves if Giant's intention was to be honest and transparent, why was Shi Yuzhu and independent director Jason Jiang's related party affiliation to Yunfeng Capital not disclosed in any of GA's SEC filings, particularly after the SEC raised pointed questions about the business activities of Yunfeng?
- Why did Giant's management team feel it was appropriate to invest in "unregistered" shares of Alibaba (again, if indeed they bought them) through the chairman and independent directors private equity firm without disclosing the relationship to investors and regulators?
- Given GA has a record of fraud and money laundering in the past, how can investors trust the parties involved given an apparent conflict of interest and the lack of any proper disclosure to the public? What else is Giant hiding?
One Giant Puzzle - Another Chinese Margin Miracle
To start, Giant's corporate operating margins of 61% are spectacular. So great, in fact, that they seemingly wallop even their Chinese competitors by thousands of basis points -- a development that should always merit increased scrutiny.
Management claims R&D is the lifeline of their business, yet we find that over the last three years, Giant has consistently chose to reinvest its capital in speculative off balance sheet investments that provide no strategic value and are purely financial in nature rather than on developing their alleged 87% gross margin and 61% operating margin gaming portfolio. From FY 2010 to FY 2012, Giant spent $28.2m, $36.6m, and $52.5m for an aggregate of $117.2m. Conversely, Giant has spent $186m on financial investments over the same period. Yet we find no real income these investments. Like a typical Chinese fraud, Giant's balance sheet is akin to a personal financing tool for the chairman. This behavior was so peculiar it even caught the attention of the SEC, which requested that GA elaborate on these investments and revise its risk factors to include this risk to shareholders in a July 12, 2013 correspondence.
Shareholders should ask themselves if Giant's gaming business were really growing at ~15%-20% annually with 61% operating margins, why is management so eager to allocate capital toward financial investments that provide zero strategic value? Does Giant really generate all of its profits from its gaming business?
Investors should note that Giant operates in a highly competitive, fragmented gaming market where other competitors have seen their margins converge. Other Chinese leaders like Shanda Games (GAME) and Changyou (CYOU) have largely struggled amid increased competitive pressures and decelerating revenue growth. For instance, online game revenues for Changyou grew just 7% in Q3, while Shanda's actually fell 11%, with no signs of improvement anytime soon.
Speculative Investments Made by Giant
- $126m in real estate trusts, including property projects in Ningbo and Chengdu that is managed by China Resources SZITIC Trust Co. Ltd. and property projects managed by Huaneng Guicheng Trust Co. Ltd.
- $50m in Shi Yuzhu and Jason Jiang's private equity firm Yunfeng Capital.
- $5.6m in a convertible bond from Minsheng Bank, of which Shi Yuzhu is a major shareholder and a board member.
- $4.8m equity investment in Beijing Innovation Work Investment center, an early-stage China-based internet and technology investment fund.
Independent Director Jason Jiang Will Be Forced to Resign
Independent director" Jason Jiang will be forced to resign from Giant Interactive's board of directors. Giant's appointed "independent director" is a business partner to Chairman Shi Yuzhu, through their affiliation with Yunfeng Capital, a private equity firm both parties are founders and directors of -- a glaring conflict of interest and clear violation of NYSE independence requirement 303A.2. Note that Jason Jiang was recently put on the "special independent" committee to evaluate management's recent buyout offer.
Source: Yunfeng's website.
We believe Giant deliberately appointed Jason Jiang to perpetuate the chairman's misdeeds. Nine months before Giant Interactive moved cash into Yunfeng, then "Independent Director" David Yu was forced to resign. Giant noted that because Mr. Yu was an affiliate of Yunfeng, whom the company would do business with in the future, he would no longer meet NYSE independence requirements.
Giant interactive then replaced David Yu with Jason Jiang, whom GA also claimed is an "independent" director, yet it is clear Jason Jiang is an affiliate of Yunfeng and a friend of chairman of Shi Yuzhu. To compound matters, Jason Jiang sits on the compensation, corporate governance, and audit committee -- the committee in charge of reviewing related party transactions. Since Jason Jiang's appointment, Giant has made questionable investments in real estate and other speculative investments, which suggest that Jiang's appointment has perpetuated Shi Yuzhu's use of Giant's balance sheet as his own personal piggy bank.
GA is trading at an artificially inflated price of nearly $11.25 on a P/E of 13x (vs. peers of ~9x). The only reason for this elevated price is the hope of an MBO, and absent those hopes GA shareholders would certainly be left with a weakening business trading at levels far lower than the $7 Chairman Shi Yuzhu liquidated 6% of his Giant Stake for in 2013. We believe the issues covered will encourage even the most speculative private equity affiliate to strongly reconsider risking their investor's capital in GA. We believe Barings will walk away from this bad business, as it has from so many other flawed U.S.-listed Chinese companies in the past.
We believe It is important to get the entire story and give the company a chance to explain itself, thus we have made repeated attempts to address our concerns with management and investor relations to no avail. Ultimately, Giant Interactive shareholders will be forced to look at their promise ring with wonder, doubting if it was ever anything more than a cubic zirconia.
Giant's VIE structure demands that shareholders have full faith in the integrity of the chairman, because it is Shi Yuzhu who ultimately owns and controls the operating business in China. We believe that Giant's chairman has irrevocably broken the trust of shareholders, rendering, in our view, the company's shares only as valuable as the chairman's apparent respect for his fiduciary duties.