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Why are US listed Chinese companies which became public through a reverse merger seeming severely discounted from Chinese companies which had an initial public offering? What steps are necessary for a company such as CHBT to break free from that discount? I set out to answer those questions in this analysis.

The following chart is a bit crowded, but I think it's interesting. Also, I spent a lot of time on it so I'm going to show it anyways. What I did was plot the trailing twelve month PE ratio for the past four years for 40 different stocks - 20 which did IPOs and 20 which did reverse mergers. The IPO stocks are plotted in shades of blue. The reverse merger stocks are plotted in shades of brown, red and pink, along with orange and yellow. CHBT is plotted in green just so it is noticeable. Not all the stocks are noted on the legend because the number apparently exceeded the maximum allowed. However here is the list of stocks which I plotted.


Reverse merger stocks: OTCQB:CHBT, HRBN, CAAS, FSIN, SYUT, ADY, OTC:DEER, OTCPK:YUII, YONG, OTC:SDTH, GFRE, HOGS, SKBI, OTC:SOKF, HEAT, OTC:CHNG, OTCPK:CMFO, OTCPK:CSKI, OTC:PUDA, OTCPK:CCME (technically, CCME was a special purpose acquisition vehicle but I included it with the reverse mergers).

click to enlarge images

At first glance, one does notice the cluster of brown lines concentrated towards the bottom of the chart and the blue lines for the most part noticeably higher, indicating the generally higher valuations for IPOs compared to reverse mergers. There are some anomalies in the data which one must be careful about. The EPS figures used to calculated the ttm PE ratios were pulled from ADVFN. There are some issues with charges to earnings affecting the EPS numbers. For example CHBT, which is plotted in green, is shown as having a ttm PE ratio of between 30-40 since March 2010, which is clearly misleading. Also, circled in pink, several companies including HRBN and YONG are shown having reached ttm PE ratios of 40-50 in the fourth quarter of 2009. Again however, this was due to charges which reduced earnings and thus inflated the PE ratios.

However what I'd really like to draw attention to are the following.

1) The concentration of brown lines below a 10 PE starts around the fourth quarter of 2008 - the onset of the financial crisis. Prior to that, the brown lines were a little more dispersed and there was a healthier range of multiples with the average appearing to be around 15x ttm earnings, with some reaching as high as 30x ttm earnings. This suggests that as confidence returns the reverse merger stocks have room to around double from current levels just from multiples returning to pre-crisis levels.

2) While there are some IPOs with much higher multiples, this is because the 'sexier' companies are among the IPOs - the internet companies, the high visibility companies, the 'household name' type companies. It's easy to forget the less successful IPOs, such as FFHL (Fuwei Films), QXM (Qiao Xing Mobile Communication), KONG (KongZhong) and HRAY (Hurray Holdings).

3) There are some examples of companies which have managed to break free from the 'reverse merger discount' to varying degrees. One such example, shown in red is SYUT (Synutra International). Circled in red, SYUT traded at 30-80x ttm EPS for over a year. The drop in August of 2008 was when Synutra's products were among those found to be tainted with Melamine. Prior to the Melamine incident, SYUT was on a trajectory very similar to the one CHBT is on currently. Here are SYUT's sales, net income and EPS for the fiscal years ending in March 2006 through 2010:

Year Sales Net Income EPS
03/2006 132.69 11.03 0.23
03/2007 216.60 19.87 0.51
03/2008 362.09 45.66 0.85
03/2009 312.53 -100.55 -1.86
03/2010 291.89 -24.62 -0.46

It is interesting to look at these on SYUT's price chart. Below is a chart format I use which shows lines for trailing twelve months EPS times various PE ratios.

CHBT compares vary favorably with where it is currently at (roughly $30 million in net income and $1.40 in EPS over the trailing twelve months and roughly $300 million market cap).

4) Another example, also in the dairy industry, is ADY (American Dairy). While SYUT was found to have product tainted with Melamine, ADY was found not to have any tainted products. Shown in yellow, ADY's shares traded as high as 30x ttm EPS on the expectation that it would benefit from competitors' woes. However after ADY's sales surge proved to be temporary, the stock gave back it's gains.

5) Shown in orange, CAAS (China Automotive Systems) has managed to maintain a higher than average multiple over time. I believe that part of the reason for CAAS's higher multiple is it's track record of consistent EPS growth.

Year Sales Net Income EPS
12/2005 63.57 3.32 0.15
12/2006 95.77 4.81 0.21
12/2007 133.60 8.86 0.37
12/2008 163.18 12.44 0.46
12/2009 255.60 23.41 0.78

I believe these examples illustrate that CHBT will eventually be rewarded with a higher multiple if it continues it's track record of consistent EPS growth. Looking over these examples I am more inclined to believe that the low multiples seen among the reverse merger companies has more to do with them proving that they can grow from young small cap companies to mature mid cap companies than the fact they became public through reverse merger. Attracting better known analyst coverage could certainly help. As could hiring a top four auditor, although there are still examples of reverse merger companies with top four auditors and strong growth prospects (such as CCME and YONG) which are trading at low valuations. Lastly, more favorable overall market sentiment would also help CHBT achieve a higher multiple than otherwise possible.

Disclosure: Author is long JOBS, HRBN, CHBT. No position in any other stocks mentioned.