Chinese ADRs – arbitrage this privatization

7/4/2015: as we observed the dramatic collapse of Chinese A share market and an indefinite delay of IPO from authority, we may not be able to see more Going Private deals, and for the ones announced, even though the author thinks most deals will still go through, but readers should be cautious of the risks and concerns over deals withdrawal. Thoughts on recent tumble

Amid all the doubts and bear talking (include Bill Gross’s “Short of a lifetime” talk), we see Chinese equity market bumps north. I agree the market is generally overvalued, but it is another topic if we want to short it.

So we see a lot of Chinese ADRs want to go home, there may be opportunities to play 1).sweeter deal; 2).potential new deal. The risks are: 1).the proposal doesn’t go through; 2). end-of-bull market in China will wipe out all the deals. To be fair, the risk are limited, and premium is moderate to high.

Part 0: Background

Needless to say, a lot of the companies, especially those listed on Chi-Next (think a mini Nasdaq) are low quality, maybe just emerged from oblivion, of course they can’t be priced PE 100 in the long term. But the cheap financing has changed a lot of competitive landscapes. The once-struggling underdog could have a comeback if execute well. That is the merits of a bubble.

Meanwhile, most Chinese ADRs listed overseas are tier 1 companies in the industry. For many reasons, including trust issues, complicated VIE structure, opaque governance, misstep in management, bad PR, and looming macro concerns (it’s debating from 2009 yet never realizes), they are usually misunderstood, mis-priced, and largely neglected.

The incentive for these ADRs to do a Public-Private-Public is very high, when they see their peers have PE 100 while they are only valued at 12 on Nasdaq.

To just give a few announced deals:

Ticker Announcement Status /Duration Premium Comments
Nasdaq: VNET 08/13/12 Completed;
284 days
39% The company is undervalued due to Muddy Waters’ attack.
Nasdaq: GAME 04/03/15 Pending;
Exp.15YE
12% The first offer came in 2014.
Nasdaq: GA 03/16/14 Completed;
127 days
5.73% The company is a cash cow, pays generous dividend.
Percent Owned/Sought: 49.3% / 50.7%
Nasdaq: PWRD 01/02/15 Pending;
Exp.15YE
30% Percent Owned/Sought: 6.38% / 93.62%

A dramatic difference between Chinese and U.S. market is the valuation of gaming companies. U.S. capital market usually think gaming companies have weak moat, low user retention, over-reliance on hit titles. An example is King Digital (KING), always trades around PE 8. GA, at the privatization price, was trading around PE 13, and around 6 for quite a while in previous years. The company reported gross margin of 87%, net margin 46% in 2012. Fantastic numbers didn’t echo good valuation, only short sellers and doubters.

Part 1: Bet on higher bid.

So the goal is among all those announced deals, can we expect a higher bid as seen in DATE? These are generally low-risk, moderate-gain plays. For announced deal, better bids are very likely because the management definitely need to move fast and avoid all the litigation.

Xueda Education Group (NYSE:XUE): 1st bid is very low-ball, close to cash value. The company is neglected and undervalued, trades negative EV. Management controls more than 2/3 of votes. Some activism here. Current argument is that the management could use only a little from its cash stash to sweeten the deal. There is a good chance for better deal.

WuXi PharmaTech (NYSE:WX): April 30th announced proposal, offering $46. Now the stock trades $43.68, market cap $3.1B. The company has wide moat, is probably one of the best CRO in China. The market cap is lower than one of its spin-off. Majority is controlled by U.S. institutions. First bid premium is only 15%. It is very likely to give a better offer.

Mindray Medical Internatioanl (NYSE:MR): MBO non-binding offers $30, currently trades at $29. TTM PE is 18. A competitor (SZ:300003) has only 1/6 of sales but is valued twice MR. Deutsche Bank‘s analysts said “…do not expect the related parties to increase the existing offer of $30/share….”, the reason being the management already controls 63.5% of the voting power. I think it is not very thorough analysis as a lot of the institutions can’t hold private securities by mandate. Here a look-through analysis is required. Based on the fact that the offer is quite low-ball and the incentive is big, I give my two cents to a sweeter deal.

China Digital TV (NYSE:STV): The Company’s main business (CA card) is dying. The deal is structured like a reverse takeover with some valuation adjustment mechanism (VAM), and is currently under review by Chinese Commercial Bureau. The approval is expected Q3 of 2015. If approved, the stock is well worth >$9. But the stock may still be a little undervalued because of the VAM.

JA Solar (NASDAQ:JASO): This solar cell company has a robust financial statements. MBO bid at $9.69, currently there is 9.7% premium left. TTM EV/EBITDA is 3.74. Even we don’t have a better deal, it is a good premium.

Part 2: Bet on next privatization deal.

One thing for sure is that if they can, all the ADRs want to go private and list on A-shares. A lot of discussions are around VIE structure, the difficulty of currency conversion, shareholder negotiation and etc. But clearly the incentive is really high.

Even if some of the companies don’t have such plan, other deals will pump up among speculation.

I used the list at http://topforeignstocks.com/foreign-adrs-list/the-full-list-of-chinese-adrs/.

Filtering criteria are:

1). the market cap should not be too big: there is no way BABA / BIDU going private easily;

2). the market cap should not be too small: think the fees are more than $5m.

3). the company’s IPO is not within one year.

4). the company is undervalued and inactive. Here undervalue could mean a). The company is undervalued using traditional metrics like PE, EV/EBITDA, Sum-of-the-parts, etc.; b). The company is undervalued comparing to their domestic peer. It is best if the company has some direct competitor already listed in A shares, so we could have a rough idea how much incentive is there; c). The company is industry leader but valued as mediocre. Especially if the company can’t do financing cheaply and insiders can’t sell stocks easily, the incentive is huge.

5). Better if the industry is a “hot” industry in the A shares, this means the company will be more likely pursued by PE funds, who will help to provide bridge loans. My preferences go to TMT, Media, E-commerce, Biotech, and Financial services.

6). the company can’t burn cash like a startup. There is some requirement to be listed in the A shares: a). accounting profitable for the last 3 years, and accumulative accounting profit should exceed 30 million RMB (around $4.8m); b). Accumulative operating cash flow for the last three year should exceed 50 million RMB (around $8m), or sales exceed $48m; b). Intangible assets should not exceed 20% for last reporting period. The rules are expected to loosen in the future, otherwise the company could bypass by acquiring a shell company.

7). the company’s business is in mainland China, and there is no need for USD financing. Companies like YOKU, CMCM disqualified.

8). Ownership: I didn’t find a winning pattern. Generally speaking, if the bid comes from a fund, not from management, because the lack of voting power, PE fund would be more likely to raise the bid; however, we see sometimes management form a consortium with leading fund, it reduces the likelihood of bid raise.

9). not too much debt: in alternative energy sector, a lot of the solar cell module producers are heavily indebted, it is difficult to convince PE fund to put up a large sum and finance its working capital for maybe two years while the return is uncertain.

So I narrowed the list to the highlighted ADRs as possible privatization targets.

Ticker Industry  Market Cap Est P/E Next Year IPO price to last close Debt /Capital
MY Alternative Energy  $499 M -81% 13.68
NOAH Financial Services  $1917 M 16.53 131% 2.51
DL General Retailers  $578 M 17.42 147% 14.42
DANG General Retailers  $812 M 24.59 -59%
FENG Media  $645 M 12.11 -25%
BONA Media  $740 M 26.48 43% 41.96
JRJC Software&ComputerSvc  $111 M -68%
NQ Software&ComputerSvc  $385 M 8.42 -46% 23.58
CCIH Software&ComputerSvc  $394 M 19.44 -42% 8.41
ACTS Tech.Hardware&Equip.  $114 M -79% 16.85
VIMC Tech.Hardware&Equip.  $283 M 10.82 19% 12.68

Updates

1. 06/12/2015: Bona Film Group Limited (NASDAQ: BONA) announced preliminary “Going Private” offer , the price is $13.7 per ADS, which is about 23.6% premium above the average price of last 30 trading days.

2. 6/17/2015: Qihoo 360 (NYSE: QIHU) announced preliminary non-binding proposal for $77 in cash per ADS. This is a premium of 16% over last close. As the time of writing, there is 8.5% premium left on the table.

It is interesting to find Sequoia Capital China is behind most of the recent deals.

3. 6/19/2015: AirMedia Group Inc. (Nasdaq: AMCN) announced “Going Private” proposal from its management. The buyer group now controls 38% of all ordinary shares. The company is under limelight as it collapsed almost 50% in four days prior to the bid.

4. 6/22/2015: Vimicro International Corporation (NASDAQ: VIMC) announced “Going Private” proposal from CEO and board member for $13.50 per ADS. VIMC belongs to the most-pursued category.

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