While the going private transaction of China Mass Media hasn’t yet completed (it is progressing as planned) another Chinese company announced that it reached a definitive agreement for a going private transaction last week. The CEO of China Nuokang Bio-Pharmaceutical is offering $5.80 in cash ($5.75 effectively after a $0.05 ADS cancellation fee). The deal is expected to close in the first quarter of 2013, and with the stock currently around $5.30 a successful transaction could offer an ~8.3% absolute return and an IRR of ~19.4% (assuming a close on the last day of the quarter).
My view on going private transactions in China in general
Everybody is these days aware of the risks related to investing in Chinese companies, and that is exactly the reason why I’m interested in this corner of the market (see also my investment in DSWL). With all US listed Chinese companies trading at depressed valuations you have to figure that there are some real companies out there that are trading significantly below fair value. And given the scale and sophistication of the fraud there are just a few parties in a position to capitalize on the opportunity. The exception are of course insiders: they know perfectly well that they are buying, so you would expect that the management of legitimate companies will try to take their company private if they are in a position to do so.
I think that this is exactly what we are seeing today. Besides the large number of Chinese companies that went to zero there are also a decent number that already went private, or are in the process of going private. Besides the subject of this post and China Mass Media you currently also have:
- Yucheng Technologies
- Fushi Copperweld
- Winner Medical Group
- China Transinfo Technology Corp
- Gushan Environmental Energy
These deals trade in general at a above average spread compared to merger deals in the rest of the world, and the question is of course if this is correctly pricing in a higher risk or if investors are simply burned by their experience in investing in China.
One thing to consider is that undertaking a going private transaction does not accomplish much if you are running a fraudulent company. You can’t complete it, and starting the process and then not completing it doesn’t do you any good either. There are of course always some angles to consider: you can manipulate the stock price and gain through illegal insider trading, or maybe you could transfer money out of the company using a break-up fee. But I think that in most cases something like that would be an unnecessary complex and inefficient way to commit fraud. So I would say that logically a going private proposal from a Chinese company should indicate that management is motivated to complete the transaction.
I wouldn’t blindly buy the above basket. A going private proposal is a good hint that the company is real and that management wants to complete the transaction, but I would want to see that there are no major red flags in the financials (especially w.r.t. issuing debt, raising equity or insiders selling shares). Besides a management that is motivated to complete the transaction, you also want to see that they have the financing to get the deal done. Shareholder approval could also be a roadblock, and last but not least: you do want a sufficient expected return.
China Nuokang Bio-Pharmaceutical
Enough chitchat: time to take a deeper look at Nuokang. The company went public at the end of 2009 (prospectus) and describes itself as follows:
China Nuokang Bio-Pharmaceutical Inc. is a leading, fully integrated, profitable biopharmaceutical company focused on researching, developing, manufacturing and marketing hematological and cardiovascular products. We sell a portfolio of fourteen products, which includes principal products Baquting®, a flagship hemocoagulase, and Aiduo®, a cardiovascular stress imaging agent. Our product pipeline includes product candidates under development in hematological, cardiovascular and cerebrovascular disease diagnosis, treatment and prevention.
Developed in-house and launched in 2001, Baquting, our flagship product, is China’s leading hemocoagulase for the treatment or prevention of bleeding. Through September 30, 2009, we had sold an aggregate of over 38 million units of Baquting to our end-customer base of over 2,400 hospitals across China.
The short public history of the company makes a fraud evaluation harder. Positive is that insiders haven’t sold a share since the public offering (literally!). The CEO, Baizhong Xue, owned 94,508,704 shares after the IPO (representing 60.02% of all shares) and he owns the same number today (now representing 61.2%). Neil Nanpeng Shen, a board member and managing partner of Sequoia Capital China, has controlled 20.1M shares since the IPO representing another 12.77% of shares. As a group insiders own 74.6% of the company today. Another positive sign is that the IPO wasn’t used to cash out insiders, but to raise cash for the business. The CEO sold less than one percent of his shares in the IPO.
The debt side of the story also looks good. The amount of short term debt on the books has decreased the last years and the amount of long term debt has been almost non-existent. Unfortunately the company has never paid out a dividend (I like to see that: it’s an unfakeable cash flow back to shareholders). That said: I don’t think there is a pattern here that indicates that management is trying to get rich by raising money.
Related party transactions are another specific area of concern because these offer the potential for unfair deals at the expense of shareholders. Nuokang seems squeaky clean here, in the latest 20-F only the following was reported:
Transactions with Mr. Baizhong Xue
From time to time, Mr. Baizhong Xue, our chairman and chief executive officer, has extended loans to us and paid business-related expenses on our behalf. We from time to time make advances in respect of business-related expenses incurred by Mr. Xue on our behalf. As of December 31, 2009, 2010 and 2011 amounts due to Mr. Xue were nil, nil and nil, respectively.
Loans and Guarantees
In March 2009, Dengzhou Credit Union extended to us a short-term loan of RMB3.0 million at the interest rate of 7.7%. In September 2009, Industrial Bank Co., Ltd. and China Merchants Bank extended to us short-term loans of RMB60.0 million and RMB15.0 million, respectively, each at an interest rate of 6.372%. While these loans were secured by certain of our property, plant and equipment or land use rights, Mr. Baizhong Xue, our chairman and chief executive officer, also provided guarantees for all these loans. As of December 31, 2011, these loans have all been repaid.
So don’t see any major red flags here w.r.t. fraud, and it seems very logical that a company that is already majority owned by the CEO is going private. If the 13E3 filing can be trusted the CEO does have the necessary financing to take the company private (he needs ~$44M). Don’t think shareholder approval is going to be a problem either: as far as I can tell there is no majority of the minority provision. Nuokang Bio-Pharmaceutical is, just as China Mass Media, domiciled in the Cayman Islands, and only two-thirds of the shares need to vote in favor of the transaction. With Mr. Xue owning 61.2% that doesn’t seem to be a difficult threshold…
Pursuant to the merger agreement, Anglo China and Britain Ukan, companies controlled by Mr. Xue, agreed to vote all of the Shares beneficially owned by them in favor of the authorization and approval of the merger agreement, the Cayman Plan of Merger and the transactions contemplated thereby (including the merger). Mr. Xue beneficially owns approximately 61.2% of the total outstanding Shares.
Investing in China is not without risks, but in this case I think I’m getting paid well for taking the risk. I don’t see anything in China Nuokang Bio-Pharmaceutical history that raises a big red flag, and there also doesn’t seem to be a whole lot that can stop the transaction from going through. Combine that with a wide spread between the offer price and the market price and you have, what looks to me, a nice opportunity.
Author is long China Nuokang Bio-Pharmaceutical