China
to drive value ... but at what price?
With China one
of the only growing economies in the world, coupled with the array
of corporate meltdown's currently taking place in the United States,
many companies are looking to China to diversify revenue flows, expand
market share and, most importantly, drive
future sales growth. Whether it is Japanese manufacturers
such as Seiko looking to cut labor costs or American I.T companies
such as Oracle or Agilent looking to jump on board the Chinese juggernaut,
multinationals from all nations are re-thinking their global strategy
and China has surfaced as the last frontier.
Conveniently,
at present there is also a glut of factories and operations for sale
in the market, as the Chinese government continues to sell
off State Owned Enterprises (SOE) and many multinationals
rationalize their non-core and non-profitable investments in the mainland.
However, with all this market movement and Foreign Direct Investment
flowing in and out of the country, multinationals need to even more
carefully evaluate their investment options
and analyze growth opportunities.
In the 1990's
many multinationals threw endless dollars into the 'China pit' with
the idea that China was, without a doubt, the great big market of
the future. Whilst many would argue that this claim certainly still
rings true, CFO's no longer have endless budgets to blow on over-priced
Chinese investments, and CEO's realize that their heads are on the
chopping boards if investments prove not to be in the best interest
of shareholders. On the flip-side, as multinationals begin to re-structure
their existing operations within China itself, including divesting
assets and re-negotiating join venture terms, shareholders
are demanding greater financial scrutiny and market understanding.
In light of this,
comprehensive and diligent valuation of factories and businesses in
China is becoming the most integral aspect of investment decisions.
Gone are the days of companies claiming that they need to be in China
'regardless of the cost'. Understanding the intricacies of all the
risks and future returns is now on top of the CFO's agenda.
All corporate
finance books will warn that valuations must be viewed with caution,
citing reasons such as "There is no such thing as absolute value,
"All value is relative", that "cash-flows are uncertain", and
that "value is subjective". However, in China, there are many
more factors that play vital roles when estimating value.
Whether it be
trying to calculate the value of a joint venture asset, valuing injected
registered capital, assessing intangible assets, or even an entire
business operation, financial advisors and management must consider
a multitude of China-specific factors. Unless this deep understanding
of the China market is grasped, multinationals may just as well write
out 'open cheques' and have their CEO's seek the aid of career-transition
consultants which are seemingly over-inundated at present.
In China valuations
prove even more difficult for the following reasons:
Quality information:
The quality of a valuation is heavily dependent upon the quality of
the information on which it is based. In more developed nations, valuers
rely on industry seminars, published studies, market research papers,
broker's reports, annual company reports and other publicly available
information to understand the company, industry
and market conditions.
However, in China the lack of public information and immaturity of
supporting industries (such as the financial services industry) means
that there is a void of reliable, 'independent', quality information.
As such valuers are forced to rely on information provided to it by
the valuation target itself, existing 'in-house' research and analysis,
and market information from external overseas sources.
Indicators
and benchmarks: Once a valuation has been completed, analysts
generally evaluate their conclusions against past comparable
company valuations, industry benchmarks (e.g. price/earnings
ratios) and market indicators
(e.g. market share and size). In China at present, however, with the
amount of investor speculation in the stock-market, lack of transparency
in financial information, and limited scope/number of listed companies,
it is difficult for valuations to be 'sanity' checked against market
price.
Though the growing number of mergers, acquisitions
and divestitures in China is proving a valuable source
for such comparisons, the 'database' of such information is still
very limited. Similarly, with the rate of growth and change in the
China market across all industries, the applicability of these indicators
is somewhat questionable.
Accounting
practices: The current world-wide scrutiny of accounting practices
and lack of confidence in financial statements is causing investors
to question the degree of 'creativity' which is built into many company
accounts. Such 'creativity' is the bane of
all valuations - predicting cash flows and earnings (two
commonly-used methodologies for valuing assets) is only feasible when
viewed in light of historic data. In essence - Garbage in, Garbage
out!
In China moreover, the lack of accounting practices and under-developed
accounting system means that reviewing a company's accounts may not
necessarily truly reflect the financial performance of the company.
Furthermore, the difference between Chinese Generally Accepted Accounting
Principles and International Accounting Standards requires that valuers
fully understand both sets of principles.
As such, conducting business due diligence and audits (under international
standards) is integral before any corporate valuation is undertaken
in China.
Legislation:
Whilst listing rules and corporate legislation in many other countries
ensure expert 'independent' valuations are conducted and due processes
are followed in valuations, the regulatory
environment in China is very under-developed.
The "Ministry of Finance" maintains responsibility for regulating
valuations (previously it was the "State Asset and Administration
Bureau" (SAAB)). However, current valuation legislation is only applicable
where "there is an asset transfer from a State Owned Entity". In these
cases a PRC approved valuer is appointed and a valuation report is
submitted to the Ministry. This ensures consistency in valuations,
although it has been argued that it also gives rise to inaccurate
and biased valuations.
For example, the government has only approved three
valuation methodologies for tangible assets, sparking many
financial analysts to argue that such limitations do not necessarily
give enough scope for valuers to incorporate all factors into their
analysis. Western financial analysts use tools such as the Porter
Model to impound a range of internal and external 'business factors'
into valuations. In China many valuations have not yet reached such
a level of sophistication.
As such, multinationals must be careful in ensuring an independent
valuer is engaged to "cross" check PRC valuations
when required, and also to guarantee proper due process is adhered
to in private valuations.
Other Factors:
Some other considerations that need to be taken into account inlcude:
- Valuation
of intangible assets - a difficult process in any valuation, but
even more so in China where there are many issues associated with
Intellectual Property. Just
as important is the fact that under Chinese accounting standards
goodwill must expensed and not capitalized as an asset. ¡T
- There
is a lack of public/media scrutiny surrounding takeover bids. In
the west such media attention plays an important role in ensuring
greater clarity and fairness in corporate transactions and provides
for greater management accountability
in "friendly" takeovers. ¡ì The lack of corporate transparency in
the operations of many local companies including fraudulent activities
and operating structures. ¡L
- Lack of regulatory
boards to oversee corporate transactions.
- The technological
deficiencies of many of the run-down state-owned enterprises and
private factories in China. ¡T
- The overwhelming
bureaucracy of conducting business in China, including
the multitude of government departments and bodies involved with
foreign investments.
Once these aspects
are comprehended, investors are able to better understand the difference
between price and value in China! With many companies
paying exorbitant prices to purchase assets in China throughout
the 1990's, companies are now slowly realizing that the future cash
flows (returns) from their investments are, as a result of the above
problems, not even in the same ball park as they initially anticipated.
The
End Game
Valuations are
unquestionably going to play an integral role in shaping the corporate
face of China for years to come. Just as multinationals are unraveling
joint ventures gone wrong and selling-off unproductive factories,
a new wave of corporations are looking to China
to shape their corporate future. Thus, it is in the interest
of both China and multinationals to ensure valuations represent sound
commercial dealings and return on investments promotes long-term outlooks
for all parties involved.
Valuations in
the west are conducted in an arguably transparent and independent
environment. The China market, on the other hand, certainly adds more
dimensions to a valuation than just a fancy spreadsheet. Though many
foreigners are now understanding the true price of goods in China's
famous shopping markets, it would appear that when it comes to business
deals many multinationals are still buying
the rotten onions at high prices and selling the good ones cheaply.
Cameron
Hume , LehmanBrown - Beijing.
