China Musings

So I was in China for a few weeks for the holidays and this is an unorganized collection of my observations there and a few Chinese stock ideas. I grew up in China and view things there with a slightly different perspective from the traditional Western visitor so hopefully you will find this interesting. Also, I wrote this article two weeks ago but because WordPress is blocked in China, I have had to wait until I came back to Canada to get it posted so keep that in mind. Some things in here like stock prices and verb tense are consequently outdated.

General Observations

1. The average standard of living has markedly improved in the last five years. The best evidence for this is the dramatic reduction in bicycle use across major cities. Shanghai is so crowded with cars that the municipal government is charging new drivers RMB 73,500 (US$12,000) a pop for new license plates, the price equivalent of a small sedan.

2. Real estate in large cities is still booming. Prices are up something like 10 – 20% in Beijing and Shanghai in 2013. You wouldn’t believe the number of times I’ve been told that real estate prices in China can never fall.

The so-called “investment properties” in China are mostly left unoccupied after they are purchased because most people feel that the rent isn’t high enough to justify the hassles of having a tenant (imagine that!). The last time I checked, the value of an “investment” was defined as the future cash flows discounted back to present. Maybe the laws of economics don’t work in China, or perhaps “investment properties” is just another fancy label to mask uneconomic, speculative behavior in a seemingly invincible market.

I also find that financial illiteracy is quite widespread among high net-worth individuals, who often have extremely unrealistic returns expectations for their investments. Why bother learning about investing theory and capital markets when you can make an easy 30% buying “investment properties” in Beijing, an easy 35% buying art pieces, or when you really run out of options, park your money in “risk-free” 5-year municipal bonds at 11%?

And then there are stories like this http://www.theage.com.au/business/china/why-i-became-a-shadow-banker-in-china-20130709-2pnvi.html which just makes your brain bleed. Why shouldn’t I lend money to florists, restaurateurs, fish farmers, vegetable growers, roadside hawkers when I can make 24% a year doing it? The author asks. He would be well-advised to ponder over a better question: “Why should I make 24% a year doing the same thing that everyone else is doing?”, or “Why should my customers borrow at 24%? Can a florist, a restaurateur or a fish farm earn a higher return to justify a 24% cost of capital?” I think people have a good reason to be concerned whenever too much money is being made too easily, and China concerns me.

3. Weathermen use the word “smog” as if it were an actual weather condition in China. The air in Beijing smelled like jet fuel, even after I left the airport.

4. Inflation has been very high in consumables. In my experience food prices have tripled from what they were five years ago. Price levels of big-ticket items have, however, mostly stayed flat. This is a good thing because the affordability of durables is a main driver of improvements in the standard of living.

5. There is currently a very serious shortage of skilled labor in manufacturing. I spoke with a few business people there and was told that 1) university degrees are too easy to obtain and new graduates only want office jobs, even if they pay less than manufacturing jobs; 2) turnover is very high so the high costs associated with training unskilled labor frequently can’t be justified. A government push to increase the minimum wage by 13% per year is also not helping.

6. The local government built this giant seven-story mall (building on the left) a year and half a ago and it’s right next to where I’m staying (Tianjin, the 4th largest City in China with a GDP per capita on par with Beijing and Shanghai). Prada is a big tenant in there and I’ve visited that store about fifteen times, including on Saturday nights and the evening of January 1st.

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Other than myself, not a single time have I seen a customer in that Prada store (no one was even in there to inquire about the products).That was a little strange.

Shinzo Abe’s Yasukuni Shrine Visit

This is the dominant headline subject in China right now. Every time I turn on the TV there’s always a news anchor or “political analyst” blasting at this guy that I almost feel bad for him.

Just about the most unpopular man in the world at the moment, Shinzo Abe has been compared to a war criminal, a fascist, a Nazi sympathizer, a terrorist and a psychopath, among many other nasty things on the Chinese media. When Abe requested to meet with the Chinese and Korean leaders to reconcile, the official Chinese response was “the Chinese people do not welcome him”.[1]

An Internet poll on Weibo (think Twitter in China) shows that three quarters of the respondents would support a boycott of Japanese products in response to Abe’s political gesture. I bet Akio Toyoda will have second thoughts about getting this guy re-elected a few years down the road.

My father’s Honda lost a front wheel to sabotage the other day. Hm, why wasn’t I surprised?

CNR Mall

CNR Mall (CNRS) is the Chinese home shopping JV that I mentioned in the LINTA article. I’ve watched almost 30 hours of this stuff and talked to a few people who buy things from them regularly. Here are my observations:

1. There are five sizable competitors in the space. I watched all of their programs and found CNRS to be the most QVC-like. The biggest of them all I believe is a channel run by the state TV monopoly CCTV so I was wrong about CNRS being the only brand with a state-media affiliation –  there are two of them (CNRS is owned by QVC and the state radio monopoly). The other home shopping channels are operated by provincial network companies but are usually available in multiple provinces.

Home shopping in China accounts for a much smaller % of total retail sales than in the U.S. and the industry is growing at solid double digit rates. Another factor that makes China an interesting market which nobody has mentioned is the fact that women in China retire at the age of 50. They receive reasonably generous pension payments from the state and there is nothing that says they can’t just stay home and watch this stuff all day long.

Already a multi-billion dollar industry, I would not be surprised if the Chinese home shopping industry exceeds the size of the US market in ten years.

2. At least where I was, the local cable system gave CNRS the best channel placement, even better than the CCTV network.

3. Shipping for any order above RMB180 ($30) is free and the service is very good. My mother regularly buys things from them and they usually arrive in two days.

4. The home shopping channels provide real savings to consumers. My observation has been that the channels generally price 15 – 30% cheaper than Taobao (Alibaba’s retail site) for identical products.

Even foreign vendors wishing to make a marketing push in China are attracted to the home shopping model. I had a conversation with a family friend who runs the Chinese subsidiary of a reputable travelbag brand. He told me that companies willingly offer large discounts to the home shopping networks because the free marketing provided is extremely valuable (perhaps more so in China than in other markets – keep in mind that these networks can reach something like a billion people which is more than the rest of QVC’s markets combined).

5. There doesn’t seem to be much differentiation between the five networks and I was very disappointed about that. CNRS is more upscale and sells slightly more expensive things, but most of their products are the same Chinese brands that everybody else is selling. I think the strategy that QVC communicated about bringing CNRS more US brands is key for them to take market share from their competitors.

On a side note, the vast majority of high quality content in China is still produced by the state monopoly CCTV (through 31 public broadcast channels and 12 pay TV networks) so cord-cutting is not a very significant threat in that market.

Chinese Stocks

Since this is a stock blog, it would be boring to make a China post without some comments on Chinese stocks. In the West, the Chinese stock exchanges are often portrayed as casinos where insiders and promoters rip off retail investors. That’s quite close to the consensus within China, where a lot of people have lost their savings speculating in the 2007 stock market bubble and have developed a bit of a Depression mentality with respect to investing in equities (The Shanghai Index wiped out almost three quarters of its value during the collapse in 2008; miraculously China’s economy grew 10% real that year).

But things can’t be that bad; after all, something has to be legitimate for an $8 trillion economy to function. Chinese stocks have done basically nothing in the last five years and are on average trading at 40% above book value. Reportedly, Howard Marks is finding bargains on the Chinese exchanges so it will be interesting to see how things will develop from this point.

Anyway, I am more interested in the Chinese stocks listed here. While there is no doubt that many of the Chinese companies listed on North American exchanges are frauds, many are also legitimate businesses. With many of these companies selling for single digit multiples of reported earnings, finding an honest one to invest in can be enormously rewarding.

My opinion on analyzing Chinese companies is that they should be assumed guilty until proven innocent. Using a checklist might help and a reasonably conservative checklist could include the following:

1. Not a reverse merger; went IPO with a legitimate underwriter. Some IPOs may be fraudulent too, but most aren’t.

2. Presence and condition of operating assets can be easily examined and verified. Internet companies tend to fit this bill quite well.

3. Management demonstrates a high willingness to avoid conflicts of interest (12 pages of SEC filings on related party transactions is always a bad sign).

4. Management demonstrates that it is not motivated to benefit at the expense of investors. There are only so many ways fraudsters can make money off of capital markets. They can raise cash and embezzle it. They can inflate the stock price and sell their personal stakes to the public. They can shift assets back and forth between the public company and their personal investment vehicles. Or they can just pay themselves an awful lot more money than they deserve. An absence of financing & related party activities, aggressive insider buying, management lock-in agreements, and a low salary are generally good signs that one should look for.

5. Uses a reputable auditor – while one may argue that even the Big Four have been repeat offenders in Chinese reverse merger cases, “boutique” auditors fare far worse. In fact, many of such entities were deliberately set up to service reverse merger frauds in China, while the Big Four at least have some incentive to defend their reputation.

Also, suppose you are the CFO of a legitimate Chinese company trying to get your company listed on the NASDAQ. If you have done any research at all, you should know as well as anyone that simply by virtue of your company being Chinese it will highly likely be suspected as a fraud in the United States. So if your goal is to instill investor confidence in the veracity of your public reporting, would you in your right mind hire “Albert Wong & Co” instead of KPMG just to save $300k a year in audit fees? Getting a Big Four brand name on your audit statement is the LEAST you can do to reinforce your legitimacy. To my knowledge, in the world of Chinese audit firms, the best track record belongs to PWC Zhong Tian, which has had relatively few frauds as clients and has been fired multiple times for refusing to sign off on auditing statements.

6. Has a history of returning capital to shareholders. This is a necessary requirement because you never know if the cash is “there” unless a lot of it has been internally generated and paid out to shareholders in the past.

7. A catalyst on the horizon to unlock more value, usually in the form of a spin-off, a special dividend, or a large repurchase program. This is very important because many of these “cheap” Chinese companies end up staying “cheap” for longer than you want them to be. Requiring a catalyst is the best way to avoid that problem.

8. Obviously, accounting irregularities are an automatic no.

While this is a rigorous process and would eliminate many good investment opportunities, there are always over-achievers that pass the whole smell test. I usually combine this checklist with a screen for companies trading below 2.5 times net cash, and have found reasonable success with it.

SOHU.COM (NASDAQ: SOHU)

Date: 01/02/2014 / Ticker: SOHU / Price: $73.28 / Market Cap: $2,798 million / Idea Type: I don’t know

One opportunity that checked off on all of the above items was Sohu.com (NASDAQ: SOHU). I found that thing in late 2012. Back then it was such a steal that I seriously considered giving the chairman a phone pitch on the merit of a potential going-private transaction (just couldn’t find his phone number).

The math worked like this: the stock was $38. SOHU had $15 a share in corporate level cash, no debt and a 68% stake in a NASDAQ-listed subsidiary (NASDAQ: CYOU) valued at $23 a share in the market. The rest of the business consisted of the second largest internet portal business, the third largest search engine, the second largest online video business in China and a whole bunch of other things (such as half a $ billion worth of headquarter buildings) – fast growing, extremely valuable assets that you could buy essentially for nothing.

The company was founded in 1996 and was a pioneer in the Chinese internet space. In 2000, it became the second Chinese internet company to go IPO on the NASDAQ. SOHU is a household name and was at one point was the biggest Internet company in China.

The chairman (20% owner) was MIT-educated with a Ph.D in experimental physics and founded the company with seed money from a Sloan professor who remains a director and a significant shareholder today. PWC Zhong Tian has been the auditor and the company has had a flawless compliance track record as a public company for over a decade. The corporate governance is so good that SOHU received what I believe to be the highest recognition that any Chinese public company could possibly receive in North America – it was recommended by Citron as a long.

Management shows no motivation to screw shareholders. After SOHU’s IPO in 2000, they basically never raised money again and funded all of their growth with internally generated cash. They spun out their game subsidiary in 2009 and paid a big special dividend. They have also been buying back their own stock. The company has minimal IR efforts and the chairman despises Wall Street’s focus on quarterly earnings.

What would ultimately make the thesis work so well was the fact that management already had plans to unlock value from the “hidden” assets. They communicated at the conference calls that they would spin off the video business from SOHU and a web game segment from CYOU in a few years. In September they also sold a stake in their search engine business to Tencent, which valued that business alone at close to $1.2 billion ($32 a share). All of that was readily available information but just a little over a year ago the stock traded as if all of the operating assets of the business were completely worthless.

In half a year SOHU more than doubled and it turned out to be one of the highest IRR investments I have ever made. I sold my shares and it has slipped to the 70s. However, considering the significant growth in the business in 2013, I think a reasonable sum-of-parts analysis today could still easily get you more than $100 a share.

I find the stock somewhat attractive today and will re-open a position if it dips back to the 60s.

Nam Tai Electronics (NYSE: NTE)

Date: 12/27/2013 / Ticker: NTE / Price: $6.99 / Market Cap: $315 million / Idea Type: Special Situation

For almost forty years, Nam Tai has been an outsourcing partner to consumer electronics companies manufacturing components for electronic devices (mainly liquid crystal display modules or LCMs, the kind that is used on smartphones and tablets). This is a hyper-competitive industry characterized by single-digit gross margins, low returns on capital and little bargaining power over customers but NTE has managed to squeeze a decent amount of cash out of it.

In a strange turn of events, just as it was having a record year in revenue and profits, the company announced in April plans to shutter its core business and redevelop its main facilities in Shenzhen into a high-end commercial district. Its other facility in Wuxi, which had been idled by Q2 2013, would also be sold. To borrow NTE’s own words, the company is now “an electronics manufacturing and design services provider in the midst of transforming [themselves] to a real estate development company”[2]. The company also cut next year’s dividends from 60 cents to 8 cents. Unsurprisingly, the stock fell by half on the news.

The decision was made because NTE’s main customer decided to switch to a lower cost contractor for components and management felt that NTE would be unable to make money should it match the competing rate. NTE’s Shenzhen facility, however, is currently sitting on very valuable land that the company acquired for close to nothing in the early 1990s. The land is situated at a really nice spot, just six miles south of the Shenzhen Bao’an International Airport and ten miles north of the Qianhai Bay Special Economic Zone. The Shenzhen government is currently converting this whole area from an industrial zone into a commercial district and actively encouraging redevelopment projects such as NTE’s with extensive tax and financial incentives.

I know nothing about the business of sub-assembling iPhone screens but now that the stock has been conveniently reshaped into an asset story, things have just become a lot more interesting.

Valuation

The company had $238 million in cash and no debt as of Q3 2013. Excluding cash, net working capital was basically zero and I expect this to still be the case once the core business winds down. NTE’s contract was extended to Q4 2013 so it should generate cash for another quarter. To make things simple let’s call the cash pile $250 million, or $5.5 per share. The stock is trading at $7 so that means the rest of the business ex-cash is valued at only $1.5 a share.

NTE has put its Wuxi facilities and land on sale. The carrying value of that asset as of Q3 was $44.6 million or roughly $1 per share. The company also has 1.27 million sq ft of land in Guangming, which is a new high-tech industrial park in Shenzhen. Realistically I think the company can easily get $1.5 a share out of those two properties but to be conservative let’s say both of these assets are worth nothing.

The most important asset is the company’s land in Shenzhen which it acquired in the early 1990s and is being redeveloped into a commercial property. The land is 566,100 sq ft or roughly 52,600 m2. If you read Chinese, you can find a list of precedent transactions on the local government website here: http://www.sz68.com/land/?s=1. I made it easy for you and organized all of the recent relevant transactions on a table:

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Commercial land in the nearby Qianhai Special Economic Zone sold for between $17.5k and $63.7k per m2 in 2013. NTE’s land is not in the special economic zone so it’s not worth as much, but it’s nearby enough (less than 10 min drive) that it wouldn’t be worth that much less.

To get a sense of perspective, let’s assume that NTE’s land is worth only $3.5k per m2, or just 20% of the lowest price paid on the transaction list. NTE’s 52,600 m2 is thus worth $184 million, or over $4 a share. If the land is worth $8k per m2 then the whole lot becomes $420 million, or over $9 a share.

With these assumptions (without getting into taxes), if management simply sold the land and liquidated the whole business, you are looking at something like $10 to $15 a share in liquidation value.

But that’s not what management has decided to do. Selling the land may involve tax and regulatory issues and the company’s plan going forward is to basically liquidate most of its “non-core” properties and use the cash to develop a high-end commercial property on its Bao’an land, housing over 3 million sq ft of office space, malls and hotel rooms. Now that makes things tricky because real estate development exposes the shareholders to a host of risks (and also benefits) that a land owner is not exposed to. The company has hired three reputable consulting firms to conduct feasibility studies on the project and you can find their presentations here: http://www.namtai.com/investors#investors/news

The independent feasibility studies all show nice double digit projected IRR but I wouldn’t put that much faith in their DCF models. The chairman said on the last conference call that the company will likely first develop one building on a quarter of the land with a floor plan of 700,000 sq ft (65,000 m2). Management’s projection is that the first building will cost approximately $2,500 per m2 so the total cost will be $160 million, with expected rental income of $40 million per year. On a 50% cash flow margin and 7% cap rate, that’s worth $285 million or $6.3 a share. That’s just a quarter of the project! You are still left with $90 million and three quarters of the land to play with. Putting a number on the future value of the whole project is impossible, since the whole thing is still in planning stage, but I think this illustrates pretty well that the property will be worth more than $7 (a LOT more if you think the project is worth more than the cash and the land value combined) once its fully developed.

Is It a Fraud?

I believe it is extremely unlikely that NTE is a fraud.

NTE was founded in 1975, went IPO on the NASDAQ in 1988, and transferred to the NYSE in 2003. It was not a reverse merger and has had a long history of SEC compliance. By “long”, I mean longer than any other Mainland company on a US exchange!

The company also has a long history of paying dividends, having paid out a total of $9 in the last fifteen years:

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That’s a lot of dividends, especially considering that the stock is only trading for $7 a share today!

How do you know if the assets are real? Well, you can find their X million sq. ft of facilities right on Google Earth. In fact this company has had such a long-term influence on the local economy that the government literally named the two streets right next to them after the company. You can’t lie about that!

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(Nantai Road = Nam Tai Road – just translation difference)

On a side note, NTE discloses the names of its two largest suppliers, which accounted for 95% of its revenue in 2012 so you can always call up Japan Display (formerly Toshiba Mobile Display and Sony Mobile Display) and Sharp for an enquiry.

The auditor is Moore Stephens, not a Big Four but nonetheless a multi-billion dollar global audit firm.

In terms of management, NTE is controlled by its chairman and CFO, Ming Kown Koo. Peter Kellogg, an American billionaire, has been a long-term director of the company and owns 27.3% of the company. Mr. Koo owns 11.7%.

Mr. Koo founded the company in 1975 with just a few thousand dollars, selling calculators in Hong Kong. He transitioned the business into an outsourcing operation in the early 1980s, relocating its operations to Shenzhen. Thanks to Mr. Koo’s vision, NTE was among the very first companies to invest in the Shenzhen Special Economic Zone after it was established by the Chinese Communist Party.

I’ve read quite a bit about Mr. Koo and have actually come to really admire this guy. What got me really interested in his story was this part of last year’s annual report:

“In connection with the appointment of Mr. Koo as Nam Tai’s Chief Financial Officer in March 2009, Nam Tai and Mr. Koo agreed to the following compensation arrangements: (1) a salary of $1.00 per month; (2) employment benefits comparable to those provided to other members of senior management, including insurance coverage, annual physical examination, golf club membership fees, and housing allowance for his apartment in Hong Kong of up to $0.02 million per month, plus all miscellaneous fees; and (3) compensation in the amount of $3.0 million after completion of three years’ service with Nam Tai as Chief Financial Officer.

The compensation payable to Mr. Koo for his three-years’ of service was not payable if Nam Tai replaced Mr. Koo with a suitable candidate within the three-year period ending February 28, 2012. In October 2010, Nam Tai appointed Joseph Li as Chief Financial Officer. In November 2010, as a consequence of his wife’s health, Mr. Li resigned as Nam Tai’s Chief Financial Officer and Mr. Koo again resumed in that position. However, despite his short tenure, Mr. Li’s appointment as Nam Tai’s Chief Financial Officer within the three-year period terminated the Company’s obligation to pay Mr. Koo at the end of the three years. Accordingly, the approximately $1.6 million we accrued since March 2009 for the potential payment to Mr. Koo at the end of his three years of service as the Chief Financial Officer was added to the Company’s additional paid-in capital on Nam Tai’s balance sheet at December 31, 2010 in accordance with the guidance under SAB Topics 1B.1 and 5T, and FASB ASC 718-10-15-4.”

So Mr. Koo’s tenure as CFO was only interrupted for one month and he let the company claw back his entire accrued salary for the previous 20 months! That’s a level of corporate governance rare among even U.S. companies.

Koo has run the company very conservatively for forty years, never used debt and never hesitated to idle a plant if it couldn’t secure a profitable contract. Never eager to please Wall Street, Koo implemented a policy of resetting dividends every year based on business requirements, hence the volatility in the annual payout.

In 2004, Koo donated HK$100 million (US$12.8 million and a significant portion of his net worth at the time) to the Hong Kong Baptist University in the largest single donation ever given to a Hong Kong university. I found this rare piece on Mr. Koo on the university’s website which I think everyone should read even as a business case: http://www.cityu.edu.hk/cityu/about/honorary/2013-hondr/en_koo.pdf

Here is an excerpt: “In 1985, as a result of a shortage of foreign exchange in China and the cancellation of a lot of orders due to the rapid change of the market, the business of the Nam Tai Group suffered, and the company was burdened with losses for three consecutive years. Orders for products fell, affecting even the business of the Japanese raw material suppliers. Even when the suppliers offered to release Mr Koo from the contract and lower the price, just as they had offered to other customers, so as to cut down on his losses, Mr Koo insisted that he would fulfill the terms of the contract. He would rather shoulder the loss than break his promise. Later, the Japanese partner helped him broaden his business on LCD monitors processing and referred him to new clients, which brought to the Nam Tai Group new opportunities.”

I can see why Peter Kellogg is staying around.

Optionality

1. Potential sale of the building after its completion

2. Potential liquidation of the company

3. Management raises the dividend once the property starts paying rent

4. NTE gets a good price for its Wuxi and Guangming properties

5. Demand for LCMs explode and NTE gets a new contract

Risks

1. Everyone and their uncle (except some people in China) think that real estate in China is in a bubble. The good thing is that the company seems more interested in renting its buildings out. The rental income is far safer than the real estate value.

2. Potential trouble from the local government – tax issues, building permits, and so on.

3. This is the biggest risk. NTE’s cash balance seems only enough for it to complete one building or one quarter of the project. If NTE’s management ever decides to borrow money to finish the whole project and real estate suddenly collapses in China, the shareholders are in big trouble. But given how conservative Mr. Koo is as a businessman I think it is unlikely he will allow the company to use leverage. In the more likely scenario, I think Mr. Koo will sell the first building once it’s completed and use the proceeds to complete the rest of the project.

Pattern Seeking

Interestingly enough, there are striking similarities between NTE and Automodular, a Canadian micro-cap I wrote up a while ago (https://oraclefromomaha.wordpress.com/2013/06/).

1. Both companies are subassembly businesses on run-off mode.

2. Both stocks got halved when the companies lost their contracts.

3. Both are run by shareholder friendly managements with a track record of paying out excess cash.

4. Both have a ton of cash and no debt.

5. And lastly, both companies fit into my favorite investment category – stocks with HUGE optionality trading below liquidation value.

Disclosure

The author of this write-up owns no shares in the company mentioned (NASDAQ: SOHU, NYSE: NTE) and may purchase or sell shares without notice. This write-up represents only the author’s personal opinions and is not a recommendation to buy or sell a security. No information presented in the write-up is designed to be timely and accurate and should be used only for informational purposes. Readers of the write-up should perform their own due diligence before making investment decisions.


[1] Foreign Ministry Spokesman Qin Gang

[2] NTE 6-K, Oct 30th 2013

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