Not All Chinese Stocks Are Frauds - Expect Surviving Companies to Trade Up

by: Stone Fox Capital

Over the last few months, numerous China stocks have been accused of frauds and in several cases the company has either fessed up or the CFO/auditor has abruptly quit. See RINO International (OTC:RINO) and China MediaExpress (OTCPK:CCME) for examples. Even though the universe of China stocks listed on US exchanges is now above 1,000, the market is in full panic mode, reminding us of the financial crisis in the US in 2008. Sure, frauds exist, but not every stock is a fraud.

Clearly, it isn't out of the realm of reality that dozens more China stocks are scams, even including some of the large internet IPOs recently listed. Though that was the mindset with just about all stocks during the financial crisis and now some of the leading companies, like Caterpillar, (NYSE:CAT) recently hit all time highs. It didn't pay to panic on quality companies then, just like it won't now for Chinese stocks.

With most small Chinese firms trading with ridiculously low P/Es in the 2-3 range, numerous companies have had management led buyout offers. As I mentioned a few months ago in an article on Fushin Copperweld (NASDAQ:FSIN), it is critical to the sector for several of these deals to be completed in order to establish a level of credibility that will lead to higher valuations. Clearly, the fact that the FSIN deal and other high profile deals like Harbin Electric (NASDAQ:HRBN) haven't finalized yet have further highlighted the concern in the sector.

If the stocks are so cheap and the earning assets are real, than why wouldn't management, along with sophisticated buyout firms, not load up on these awfully cheap stocks? They can then re-list them on the Hong Kong Exchange for huge gains.

A few recent examples show that buyout firms are looking more and more into the space. HRBN's CEO, along with Abax Capital, submitted a proposal on April 20 that is still being reviewed by the BOD. China Development Bank has supposedly agreed to provide most of the financing and yet the market still doesn't believe in the deal according to the table below. China Fire & Security Group (NASDAQ:CFSG) received an offer from management and Bain Capital. Both Abax and Bain are well respected equity funds, but the market remains very skeptical of any values in the sector.

Some details on those two deals.

Via Bloomberg:

Peter Siris, a managing partner at Guerrilla Capital Management in New York, said he had breakfast with Yang on May 26 at the Club Lounge in the Sofitel Hotel in Harbin, China. Siris held about 400,000 shares of Harbin Electric as of March 31 and has been adding to his position, he said.

“People are willing to make up stuff, make up evidence they claim they have,” said Donald Yang, Hong Kong-based managing director at Abax. “This is almost a wild west, you don’t feel like this is a regulated market.”

It will cost Tianfu Yang about $463.8 million to take Harbin Electric private, according to a May 1 regulatory filing. On April 29, the company received a letter from China Development Bank committing to a $400 million term loan facility to fund the purchase, the filing said. A week earlier Abax said it would contribute financing of up to $63.8 million.

“I’m very skeptical and have my doubts that Yang can pull this off,” said Yemi Oshodi, managing director of M&A and special situations trading at New York-based WallachBeth Capital LLC. “If it seems too good to be true, it probably is.”

Via Reuters Dealtalk:

Such buyouts, known in banking circles as "take China privates," involve delisting companies from the U.S. or Singapore, and eventually relist them in Hong Kong or China to increase their market values. The deal sizes are relatively small, but history shows there is a decent upside potential for the right target.

Morgan Stanley Private Equity's delisting of Sihuan Pharmaceutical Holdings Group Ltd (0460.HK) is regularly cited as an example of returns that can be made with the right target.

MSPE took Sihuan private in Singapore in 2009, identifying a company that required no additional work before relisting in Hong Kong in October 2010. The stock jumped 28 percent on its IPO, with top-end pricing valuing the company at 26.7 times 2011 earnings.

Below is a list of some China management led takeovers and the discounts offered. Even in 'good deals', the discount is around 10%, while the questionable ones offer investors potential gains from 29 to 109%. Completing several of these deals are crucial for the sector to gain reasonable valuations.

China Buyout Discounts

Stock Offer Date Offer Price Closing Price (6/8) Offer Discount
CFSG 5/20/11 $9.00 $8.28 8.7%
CISG 5/16/11 19.00 15.50 29.0
CPC 3/21/11 8.10 7.32 10.7
CSR 4/20/11 6.50 4.45 46.1
FSIN 11/3/10 11.50 5.51 108.9
FTLK 3/25/11 7.20 6.65 8.3
PUDA* 4/29/11 12.00 6.00 100.0

* PUDA's stock is currently halted at $6 and has not had a chance to trade based on the offer.

As one can see from the table above, investors remain very skeptical even in the case of Funtalk China Holdings (NASDAQ:FTLK) that has an offer from Fortress. It trades with an 8% discount. Not only does it still trade at a discount, but a similarly priced deal in the US would likely trade at a premium with the expectations of a raised offer or a competitive bid.

As a few of these deals close and time passes on all the fraud allegations, look for the remaining Chinese stocks to trade up. If a Chinese company hasn't been accused of a viable fraud soon, it's likely that the company has been vetted by enough analysts and will survive. Or conversely, the shorts were unable to find any problems as they are clearly looking under every rock at the moment.

Just like in the US as the financial crisis finally waned, the surviving companies rebounded sharply. Expect a similar reaction in these cases. Likely, the low hanging fruit have been picked off by the shorts already. Completed buyouts will signal a more equal playing field where all China stocks can't be discarded. For now, potential gains are huge for investors willing to do the due diligence, but the sector remains a minefield until further management led action signals an all clear signal.

Disclosure: I am long PUDA.