windows of opportunity feb.2019 - eac-consulting · windows of opportunity for inbound...

Windows of Opportunity for Inbound International Investors in China 1 | P a g e

MUNICH | SHANGHAI | MUMBAI | MOSCOW

WINDOWS OF OPPORTUNITY FOR

INBOUND ACQUISITION IN CHINA

Eric Luo, CFA Partner M&A Shanghai Office

[email protected]

Chinese stock market valuation (P/E multiple as an example) is currently trading close to 20-year low as if the fundamental economy is in a disastrous recession. But does the stock market accurately reflect the actual state of the economy?

Yet, the economy is still rattling along. GDP growth in China is expected to remain above 6% in the next 3 years, which is more than double than all other major global economies and a stellar figure being already the 2nd largest economy.

Clearly the crash of the stock market is a victim of the uncertainties primarily driven by the external factors, such as the overhanging trade war against US. However, the external factors that have been bogging down Chinese equity market, have also created a historic window of opportunity for international investors to grow inorganically in China at very attractive valuation.

One of the by-products of the trade tension is the weakening Chinese Yuan since a cheaper currency could act as a shock absorber against additional US tariff and help to boost export. This also partially exacerbated the stock market sell-off since many foreign investors trimmed back their position to reduce Forex exposures. On the other hand, a weaker Chinese Yuan (and very likely to continue to be the case) is another piece of icing on the cake for international acquirers.

STRATEGY

M&A

OPERATION EXCELLENCE


Depressed Capital Market: Shanghai Stock Exchange Composite Index (SSEC) declined from 5,166 on 12 June 2015 to a 4-yr low of 2,486 on 18 October 2018, while Shenzhen Composite Index composing with small-cap companies has witnessed 57% of the original market capitalization melt away for the same period as well. (see Exhibit 1). Although Chinese capital market was trading at its post-bubble trough since 2016, the market rebounded since second half 2017 climbing back to above 3,500 in the end of January 2018. Nevertheless, the capital market hit its lowest in October 2018 since late 2014 as a result of the combined internal and external factors weighing on Chinese stock market: 1) dialed-down domestic economy after decades blockbuster growth. The GDP slowed to 6.5% in 3Q2018, the slowest rate since global financial crisis; 2) dramatic escalation of Sino-US trade tension and uncertainties; 3) headwinds on weakening RMB position against USD. 52-WK high exchange rate (USD6.97) as of 31 Oct 2018 is close to the psychological level of 7 yuan per dollar that cause sell-off of international investors; 4) forced selling of shares caused by the vicious cycle of collateral loans that over US$ 600bln worth of shares have been put up by the founders or major investors of listed company according to Bloomberg.

Exhibit 1 | Shanghai Stock Exchange Composite Index

Source: Shanghai Stock Exchange Data

Consequently, the valuation of China listed company now becomes very attractive and it is widely believed that some A- share stock is significantly undervalued. Using SSEC as key valuation benchmark, the monthly average P/E is heading to the 20-yr lowest level again, ~33% down from January to the end of November in 2018. 1-month average TTM P/E multiples have retreated more than 20% when compared with 1-yr TTM figure for most industries. P/E multiples of cyclical Industries such as building material, Chemical, capital goods are amongst the biggest losers. (See Exhibit 2)

MORE JUSTIFIABLE VALUATION

BENCHMARK LOWERING CHINESE

ENTREPRENEURS’ EXPECTATION ON PRICE

SHANGHAI STOCK MARKET TUMBLED 22.8% FROM ITS 2018 JANUARY PEAK, ~58% FROM ITS 5-YR PEAK


Exhibit 2 | TTM Average P/E by major industry (3, 6 & 12-month)

Source: China Securities Index

From a long-term perspective, average P/E multiple (aggregate market cap/aggregate TTM net income) is very cheap at the moment with 12.7x (as of 19th Dec 2018) which is close to a 20-year low of 9.8x and only 18.2% of the all-time high of 69.6x. (see Exhibit 3)

Exhibit 3 | Shanghai Stock Exchange Monthly Average P/E (1999-2018)

Source: Shanghai Stock Exchange Data The real question is how much impact that the stock market valuation would have on M&A transaction valuation and negotiation in China? In our experiences advising M&A transaction in China, we observed that International buyers and Chinese sellers typically adopt drastically different approach when it comes to valuation. Foreign buyers routinely offer purchase prices based on widely-accepted valuation methods (discounted cash flow, comparable companies, precedent transactions etc.) without taking into account the “Chinese Factors”:

DCF has its major constraints: forecasting a Chinese business

HOW MUCH IMPACT THAT THE STOCK MARKET VALUATION WOULD HAVE ON M&A DEALS IN CHINA?

UNIVERSALLY ACCEPTED VALUATION METHOD MIGHT NOT WORK WELL IN CHINA


beyond 3-5 years is mere conjecture, considering the dynamic Chinese market and how quickly businesses may evolve. Furthermore, the lack of internal planning and -budgeting processes as well as the capability of Chinese enterprises, especially in traditional industries, is so prevalent that it makes forward-looking projection even more challenging. As a cash flow driven valuation method, DCF also inherently tends to undervalue typical Chinese enterprises with oversized fixed assets as compared to their western counterparts. Sometimes, the buyers are inclined to include various risk premiums that may or may not be justifiable, into the discount factor making deals appear unattractive on paper in general.

Market Approach may not accurately reflect the intrinsic value. Major reasons: 1) Lack of transparent valuation information of precedent transactions in China and, 2) the complicated deal structure which largely affects the purchase price and 3) overly strong dependences on the trading multiples of comparable companies. There is a famous saying by Sun Tzu, one of the greatest military strategists in China, “If you know your enemies and know yourself, you will not be imperiled in a hundred battles”. In reality, many Chinese entrepreneurs simply do not understand the technical terms associated with traditional valuation methods, let alone a complicated DCF model. Nevertheless, this does not mean that they do not have their own ways going about valuating their own company. Just to name an example, many traditional Chinese enterprises with heavy fixed assets (esp. land use rights and property) tend to value the companies based on the fair market value of their net assets in addition to a P/E multiple benchmarked with comparable listed companies, multiplied by its own net income. Hence, it is critical in the overall valuation consideration to develop convincing arguments in a language that your “enemy” understands.

For most transactions in China, DCF only plays the important role of “internal justification” for international buyer. Chinese entrepreneurs are either inclined to their “gut feeling” or make strong reference to the valuation of their trading comparable on A-share. Intangible value as listed companies – the status of listed companies in China comes with significant premium as they are more transparent in financials and access to stock market is limited and highly regulated by CSRC (a stringent IPO examination and approval process applies). At the same time, listed companies also benefit from credibility, higher brand recognition, reputation and better access to

CHINESE SELLERS MAKE STRONG REFERENCE TO THEIR “GUT FEELINGS” AND/OR VALUATION OF THEIR TRADING COMPS IN CHINA


financing, etc. According to our transaction experience involved with entrepreneurs of POEs in China, it is generally more acceptable for private business owner to accept the notion of small-cap risk premium, liquidity discount being a private company and compared with trading peers when it comes to valuation with effective communication.

It is not uncommon in China that many entrepreneurs view IPO as preferred means of exit over trade sales due to historically higher valuation. Since end of 2017, the increasing IPO refusal rate coupled with less attractive valuation and time-consuming process have made such exit option far less attractive. Based on the CSRC statistic, only 87 companies were approved to get listed during Q1-Q3 2018, equivalent to the total IPO approvals in the 4Q 2017. (see Exhibit 4)

Exhibit 4 | # of IPOs and IPO Scale in China Mainland Capital Market

Source: CSRC Statistic

There is no sign that CSRC has intention to accelerate approval pace in at least 1H 2019 but in contrast, CSRC is more likely to keep the IPO on tight leash to control the supply side of the equation. Such conservative sentiment prevails in the capital market especially if the bearish market continues, CSRC may even suspend the IPO approval process again as it did numerous times before.

The other viable alternatives left for companies, especially those VC/PE backed, looking to exist is selling to an international strategic investor if the current capital market situation and IPO approval rate sustain.

DECELERATED IPO APPROVAL RATE FURTHER LIMITS THE MONETIZATION CHANNELS OF PRIVATE ENTREPRENEURS AND PE/VC INVESTORS


Continuous growth of economy in China – Indeed, it is true that the decades of blockbuster growth China has achieved will not last forever and inevitably slow down at certain point. However, it is far too early to draw conclusion that Chinese economy is in big trouble. Even at its new, slower growing pace, China GDP grows at 6.5% by 3Q 2018 and is expected to maintain at the level of above 6% for next 3 years, which is more than double than that of all other major global economies. (see Exhibit 5).Therefore, an excessively pessimistic view is unwarranted and we believe that the long-term China growth story remains intact.

The market might have overreacted towards the pending trade

war. Even though it is the fact that trade war will certainly have negative impact on especially Chinese export, but economists estimate that China growth might be only slowed by as much as half point percent based on the announced tariff. Though the uncertainty on how long the trade dispute will last and whether the tension will be escalated or eased remains, China and US have already agreed a 90-day cease-fire in trade conflict post-G20 Summit that Beijing and Washington will try to make progress on trade difference within 3 months.

Exhibit 5 | GDP Growth Rate (China, USA, Japan & EU)

Source: Statista GDP by country

China Yuan exchange rate was quite resilient during mid-April till mid-June 2018, it only started to depreciate in 2H 2018 and was close to the crucial psychological level (USD7) in 31 October, depreciating over 8.8% in 4 months. It is likely that the CCB (Chinese central bank) will keep a cheaper currency to act as a shock absorber against US tariff and also help to boost export. Moreover, the weak Chinese Yuan position against USD or EUR will not be altered in short-to-medium run due to the mix of following internal and external factors:

6,8%

2,2% 1,7%2,7%

6,5%

2,9%

1,1%2,2%

6,3%

2,5%

0,9%2,0%

6,2%

1,8%

0,3%

1,8%

6,0%

1,7%0,7%

1,7%

China USA Japan EU

2017 2018 2019 2020 2021

CHINA GROWTH STORY REMAINS INTACT

AND HEALTHY OUTLOOK

GDP GROWTH IN CHINA IS EXPECTED TO BE ABOVE 6% FOR THE NEXT 3 YEARS DESPITE EXTERNAL HEADWINDS SUCH AS TRADE CONFLICT, SIGNIFICANTLY OUTPERFORMING OTHER MAJOR GLOBAL ECONOMIES

A CHEAPER CURRENCY COULD ACT AS A SHOCK ABSORBER AGAINST US TARIFF AND HELP TO BOOST EXPORTS


v The expectation on US interest rate hike will likely increase the capital outflow from China (tighter outflow control in China is in place) and creates stronger growth headwinds for China.

v Meanwhile, we believe that Beijing is very likely to choose a “neutral” monetary policy and relies primarily on the fiscal policy to stimulate the economy, such as reducing individual income tax, VAT, etc. On the monetary policy front, we deem a low possibility event of PBOC (People’s bank of China) raising benchmark interest rate, which generally puts pressure on RMB appreciation. On the other hand, PBOC also stands firmly on structural deleveraging and intensifies efforts of reducing overall systematic risks, which gives little possibility to or credit expansionary stimulus in short-to-medium term. On the rising US treasury rate and inflation expectation, it does not fundamentally support a stronger Chinese Yuan and also taking the Chinese government’s intention to shore up export into consideration.

v As a result of China’s effort to reduce the current account surplus, the balance of payment position was strengthened over a few quarters before its depreciation in 2H2018, which could give Beijing option to hold RMB relatively stable against USD or against the basket.

In summary, it is the historical and unique windows of opportunity for international investors who still believe in China growth story for medium and long term, to do acquisition in China

v The valuation benchmark that Chinese entrepreneurs commonly

make reference to – the capital market will rebound quickly if the negative external factors are lifted

v Selling of business to a strategic investor becomes a viable and good option to monetize in the short-term considering the increasing difficulties to obtain IPO approval in Chinese A-share market, long lock-up period ( up to 3 year post IPO), currently unattractive valuation and smaller IPO scale.

v Weakening RMB also lowers the transaction consideration since almost all inbound transactions in China are settled in Chinese Yuan and many of them are financed in other major currencies such as Euro and USD.

THE “SUPERMARKET” IN CHINA

OFFICIALLY OPENS, READY FOR

“SHOPPING” NOW

CHINESE YUAN IS LIKELY TO STAY WEAK GIVEN THE TRADE TENSION, CONSTRAINTS OF CCB MONETARY POLICY AND RISING US INTEREST RATE EXPECTATION


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