By Verena Kallas
Stocks of many U.S.-listed Chinese firms are trading at significant discounts to their counterparts in similar industries in Hong Kong or mainland China, as well as in the U.S. itself. The Halter USX China Index (^HXC) which tracks companies whose common stock is publicly traded in the U.S. and the majority of whose business is conducted in China, has been trailing other U.S. stock indices. U.S. investors can take advantage of this and buy the cheapest companies before they are bought out. Investors take note, however, that this is a high-risk, high reward proposition.
A disciplined approach is necessary. Not all Chinese companies are compelling buy-out targets. Investigations by U.S. regulators and allegations of fraud from short-sellers have depressed the values of the so-called China orphans. Communication problems, differences in accounting rules, a lack of transparency, and unusual corporate structures are some of the causes for disagreements over what these companies are actually worth. For the smaller of these firms, low P/E values can also be due to lack of research coverage, a high concentration of shares among their major shareholders, and limited trading volume.
For companies that need to raise capital and are thinking about selling stock, low trading multiples mean that they would not be able to raise as much money in the U.S. as they would elsewhere. The frustration is most acute for those firms that originally listed in the U.S. through a reverse merger – a transaction whereby a shell company (a corporation with no business operations) that is already listed on an American exchange acquires the Chinese company that is seeking an U.S. listing.
Such a manoeuvre helps the Chinese company to become a publicly traded entity at a fraction of the cost and without the same rigorous disclosures as for a traditional IPO. Some of the firms that were listed using this process have been accused of accounting violations, if not downright fraud. A few have used auditors with questionable backgrounds, such as Kabani & Co., Frazer Frost, and MSPC.
The SEC has cautioned investors about buying shares in companies formed by reverse mergers, and the accounting practices of some Chinese companies that gained a U.S. listing this way have been subject to increased regulatory scrutiny.This has resulted in the U.S. exchanges freezing or delisting the shares of a number of China-based firms this year. Other firms have restated their financials after receiving non-compliance notices from the exchanges where they trade.
Although the cases of fraud and misrepresentation are relatively few, they have negatively affected the reputations and trading multiples of many China orphans. The current share prices of these companies undervalue them if compared to their book or net asset values. Many are therefore reevaluating the high listing costs and regulatory burdens associated with a U.S. listing.
Quite a few China orphans, often in traditional industrial businesses, have terminated their U.S. listing by going private, and more are expected to follow. Among the companies that have completed their privatization in 2011 are Chemspec International, China Fire & Security, Funtalk China Holdings, Harbin Electric, and Tongjitang Chinese Medicines. Some LBOs are still pending, including those of Andatee China Marine Fuel Services (AMCF), China Advanced Construction Materials Group (CADC), China GrenTech Corporation (GRRF), and Shanda Interactive Entertainment (SNDA).
If the Chinese companies that leave the U.S. relist, it is likely to be in Hong Kong, Asia's third-biggest stock market. Foreign companies are not yet allowed to list on China’s domestic exchanges. That category includes overseas-listed Chinese firms that restructured into offshore entities, even though their operations and assets are predominantly in mainland China. Listing in Shanghai or Shenzhen would require the China orphans to restructure into domestic Chinese firms. However, Beijing has signaled its intention to set up an international board in Shanghai, which may open the way for such firms to come to the mainland.
Other reputable China orphans that would be likely candidates for privatization would be those with high levels of insider ownership and single-digit price to earnings ratios. The following five companies qualify:
American Lorain (ALN): American Lorain is a processed snack, convenience and frozen foods producer. They are the largest manufacturer of processed chestnut products in China, and recently expanded their offering of frozen rice products. ALN’s founder Si Chen, who is also chairman, CEO and president, owns 46.6% of the company. ALN is currently priced at bankruptcy level with a trailing P/E ratio of 2.19, compared to a book value per share of 4.06. ALN’s market cap is $45.5 million.
China Marine Food (OTCPK:CMFO): China Marine Food produces and sells dried seafood snack foods, trades fresh marine catch and sells algae-based drinks. Demand for their Hi-Power beverage brand is expected to lead to strong organic sales growth. As of September 30, 2011, founder and Chief Executive Officer Pengfei Liu owned approximately 41.0% of CMFO stock. CMFO has a trailing P/E multiple of 2.76, well below its per-share book value of 4.31, and a market cap of $38.31 million.
China Shengda Packaging Group (CPGI): China Shengda Packaging Group is active in the design, manufacture, and sale of paper cartons and packaging solutions to consumer and industrial goods manufacturing companies in China. The company also manufactures and sells paper products. Members of the Fang family own about 54% of CPGI. Its equity value is $38.40 million and its ttm price to earnings ratio is 2.82, slightly above its book value of 2.49 per share.
Lihua International (LIWA): Lihua International makes copper replacement cable and wire products. As the cost of copper has increased, so has the cost of LIWA’s finished goods. LIWA’s CEO Jianhua Zhu owns about 46% of the company through Magnify Wealth Enterprise; its total equity value is $148.24 million. LIWA’s trailing P/E is 2.98, less than half of per-share book value of 6.93.
Winner Medical Group (WWIN) Winner Medical Group is a China-based firm engaging in the research, development, manufacture, and marketing of cotton-base medical dressings and medical disposables. The company also offers consumer sanitary and cosmetic products. WWIN has a high level of insider ownership: 55% is owned by founder and CEO Jian Quan Li, and all officers and directors as a group own close to 75% of the company. WWIN’s market cap is $63.85M. Its trailing P/E ratio is 5.57, close to its book value per share of 5.20.