Jiangnan Group 1366.HK – 68% annualised returns on possible privatisation offer

Jiangnan Group (JG) is engaged in the manufacture of and trading in wires and cables.

JG IPOed in 2012, placing 338m shares at HKD 1.42 and raising HKD 448m. In 2012, it had 3.07b shares outstanding, of which 2.2b shares (71%) were owned by the Power Heritage Group (PH). PH was 83% owned by Rui Fubin (father) and 17% owned by Rui Yiping (son).

I came across this company as I was screening for companies that traded on a “net-net” basis. Buying net-net shares is an idea pioneered by Benjamin Graham. The idea is to buy shares at two-thirds of their NNWC (net net working captial, current assets less total liabilities) and sell them when the price reverts to their NNWC. In other words, buy “very cheap” and sell “cheap”. Graham had much success in following this purely quantitative strategy over long periods of time. Note that the qualitative aspects of the company are totally ignored. I typically hold a 1-2% position in each NNWC share in my portfolio

NNWC shares are companies which I categorise as tier 3 companies, and such companies have poor and/or declining businesses, which is why they trade at a significant discount. That is the reason why you do not want to hold their shares for the long term, as your returns will tend to be the same as the returns of the underlying business, which will inevitably be poor.

I monitor a list of shares which trade near or below their NNWC. Though JG trades above their NNWC, to my surprise, JG’s revenues and profits have increased from RMB 5.3b & RMB 376m in FY12 to RMB 9.1b & RMB 703m in FY15. They have also been operating cash flow positive in FY12-FY15, and have been paying 25% of earnings as dividends from FY12-FY15. This is not the typical profile of a NNWC share, which warrants further investigation.

In my experience, there are some plausible reasons for a company with a decently profitable business to be trading at such a significant discount.

1.The market could be pessimistic in general and apply discounted valuations to most companies.

2. The majority owner may have engaged in minority shareholder unfriendly practices such as hoarding cash, not paying dividends and treating the company as a personal piggy bank. Such abuses seem to be more common in Asian listed companies compared to their US peers.

Companies like China Star Entertainment 0326.HK and Neway Group 0055.HK have repeatedly raised capital via rights issues or private placements, often at prices heavily discounted to their book value, only to hoard the cash or plowing it into unprofitable ventures that may be linked to their privately owned entities.

And then there are other companies whose business is typically investment holding, has complicated ownership structures, pays little to no dividends, yet holds excessive amounts of cash which earn very poor returns. Examples are Asia Standard 0129.HK and Lai Sun 0191.HK. They may trade as “cheap” as 0.2x book, but will typically remain “cheap” as long as the majority owner continues their practice.

3. The market thinks that this company is likely to be fraudulent and is therefore worth much less than what their financial statements suggest.

Looking at the current list of NNWC shares and their valuation, I rule out general market pessimism. Given the short listing history of JG, it is worthwhile to examine if the latter reasons are true.

As mentioned before, the company has been profitable, cash flow positive and distributed 25% of earnings as dividends. The total directors’ remuneration has been around RMB 3m annually, which is a reasonable amount for a company of this size. There were also no share options, and no major related party transactions. At least in their short operating history, the majority owners did not do anything to suggest abuse of the minority shareholders. Although one negative point of note is that the company did not pay an interim dividend 2016 while they have done so every year since listing.

Apart from looking at the financial statements and the behavior of the owners, good short sellers go to the extent of doing ground visits and conducting interviews with suppliers and customers to determine fraud. This is something which I do not have the time and resources for, so I will try reach a conclusion based on publicly available information filed by the company.

There are two important points which I examine, which are by no means exhaustive in proving or disproving fraud. The first is to look at what the majority owner did with their shares since listing. The second is to examine if the cash paid out by the company is more than the sum of the cash raised by the company during the IPO and any subsequent fund raising. The idea is that if the company paid out more than it raised, then the business is legitimate because cash paid out cannot be faked.

Firstly, lets take a look at the how the majority owner behaved with their shares since listing. In the typical simple fraud case, the fraudster inflates the company’s financial statements and sells their highly overvalued shares into the market, pocketing a fortune in the process.

Year	Shares of the company (b)	Shares owned by PH (b)	% owned by PH
2012	3.07	2.2	71.66%
2013	3.07	2.2	71.66%
2014	3.38	1.7	50.30%
2015	4.08	1.7	41.67%

Apr 2014: PG sold 510m shares to Chu Hui (Rui Fubin’s son-in-law) & 3 other employees at HKD 0.70 when the stock was trading at around HKD 1.40.

23 Apr 2014: Company issued 150m warrants to 3rd parties at HKD 0.01 per warrant, exercise price HKD 1.70, 2 years expiry. 30m warrants were exercised as of 31 Dec 2015.

7 Jul 2014: Chu Hui was appointed CEO, replacing Rui Fubin.

11 Sep 2014: Company placed 318m shares to 3^rd parties at HKD 1.95 per share, raising about HKD 620m

31 Dec 2014: Chu Hui has a personal stake of 167m shares as shown in the annual report FY14

29 Apr 2015: Issued 296m shares at HKD 1.97 per share as partial consideration in 2 acquisitions to independent 3rd parties. Both are companies that deal with wire and cables

24 Jul 2015: Company placed 370m shares to 3rd parties at HKD 1.95 per share, raising about HKD 721m.

27 Jan 2016: Rui Fubin & Rui Yiping transferred all of their shares in PG to Chu Hui at nil consideration. PG transferred 448m shares to Rui Yiping at nil consideration.

30 May 2016: Rui Fubin retires and appoints Chu Hui as Chairman

As of today, Chu Hui owns a personal stake of 167m shares and 1.25b shares via PG. This amounts to about 35% of the total number of shares in the company. Rui Yiping holds 448m shares, around 10.9% of the company.

As seen above, PH did not sell their shares except to insiders. On the surface, given their behaviour so far, we can rule out that they are trying to make a quick fortune by selling overvalued shares in a fraudulent company. However, they may engage in more sophisticated measures such as off balance sheet transactions such as pledging their shares for a loan. Unfortunately, this is something we cannot rule out.

There has also been no changes in their auditors or resignation of any key directors. Sometimes this is a hint of fraudulent activity in the company.

Now we examine the cash raised by the company. JG raised HKD 448m in the IPO, and further raised more than HKD 1.3b through placement of shares in 2014 & 2015, at a multiple of around 10x earnings.

Since 2012, JG has paid out cumulative dividends of about 22c per share. JG’s share count has varied from year to year but for simplicity’s sake, we just take the most recent share count of 4b*22c = HKD 880m. This is an overestimate because JG’s share count was lesser in the prior years but even then, the amount paid out is still significantly less than the amount raised through the IPO and placements. Hence, based on this point alone, we are unable to prove that JG is not a fraud.

When examining the cash paid out for other companies, it is important to note that you should look at total cash paid out to minority shareholders and not total cash paid out to all shareholders. This is because cash paid out to the majority owner may be placed back into the company via hidden transactions to be recycled. Hence, even though total cash paid may be more than total cash raised, we are unable to conclude that the cash and business is real.

Even if the accounting is not fraudulent, the company’s cash may be still be misappropriated by insiders, as was the case with CECEP Costin 2228.HK in 2016. About RMB 1b of cash was suddenly unaccounted for as the company could not pay interest on borrowings that fell due. The case is still unraveling to this date. Again, this is a risk which we cannot completely mitigate.

On 17 Oct 2016, JG received notice from its substantial shareholder, PH, that it is considering the feasibility of a proposal to privatise the company via a scheme of arrangement. PH currently holds 1.25b shares (30.62% of the company) and is wholly owned by Chu Hui, the Chairman and CEO of the company.

Surprisingly, the price was roughly unchanged compared to the previous day, at about HKD 1.45. It continued to drift downwards in the next two months to around HKD 1.10. The market is clearly not giving any credit at all for the takeover offer to materialise.

In 2016 we had another HK listed company, Peak Sports 1968.HK who went through a similar privatisation process. Below was the timeline of events:

http://ir.peaksport.com/html/announcements.php

24 May 2016: Announcement of POSSIBLE takeover by scheme of arrangement

26 Jul 2016: Formal notice of offer

23 Sep 2016: Despatch of scheme document

1 Nov 2016: Completion of scheme of arrangement, successful privatisation

Peak Sports 1968.HK was trading at a cheap price for a few years. The insiders, who knew that the company was legitimate, took advantage of it by taking the company private at a cheap price of a low single digit price earnings multiple, after taking into account the excess cash held by the company.

Conclusion

After weighing the facts of the matter, I conclude that it is more likely that JG is not fraudulent. After the change in control of the company from Rui Fubin to his son-in-law Chu Hui, Chu Hui is likely trying to take the company private at a cheap price, as was the case with Peak Sports 1968.HK this year.

Although it is likely to be more, I conservatively estimate that the offer price will be at least HKD 1.45, which was the price on the day the announcement was made about the possible privatisation. This price represents a P/E ratio of 7.7 on 2015’s earnings. Assuming an offer price of HKD 1.45, and a similar time to completion like Peak Sports’ privatisation of about 3-6 months, at the current price of HKD 1.08, this represents an annualised return of 68-136%.

Such a high spread is unusual and reminds me of Fairfax’s takeover offer of Blackberry in 2013. Fairfax is led by value investor Prem Watsa, who has a good reputation and respectable long term record. At the time, I remember that after the offer was announced, the spread was much higher than normal for a takeover offer. The only thing required for the bid was financing and in the end, the market was proven correct and the bid did not materialise. By comparison, after Peak Sports 1968.HK announced the possible bid, their share price went up by 10% and continued going up until the formal bid was announced. The market action by JG suggests that I may totally wrong in my judgement of the matter, but I will still stick to it and regard it as a lesson learnt for the future.

Note that the company issued shares at HKD 1.95 in 2014 and HKD 1.97 in 2015. The total number of shares issued was around 670m, representing around 25% of the total number of shares held outside of Chu Hui/PH. If we assume that these shares are still held by the respective third parties, and given that a scheme of arrangement requires 75% of the votes in value and 50% of the votes in number to go through, it is quite likely that the offer price will be higher than HKD 1.45.

An interesting point to note is that in p52 of the Annual Report in 2015, Extra Fame, a wholly owned subsidiary of JG, owns 297m shares of JG. The effect of such as cross holding structure is that it effectively reduces the total number of shares outstanding by 297m. Even though the stated amount is 4.08b, whoever owns 3.7b shares of JG controls the whole company. The effect of this is that it makes it slightly cheaper for PH to privatise the company and hence they may offer a higher price.

Given the risks and rewards of the trade, I think a medium sized position is appropriate. If we could be more certain that the company is not fraudulent, or if we know more about their business, or if we can be more certain that the offer will materialise, this could be a much bigger sized position.

If the takeover offer does not materialise, we end up holding shares of a company which is unlikely to be fraudulent, and trading at a statistically cheap level. Because we do not know anything about the company’s business, we have to cut down our position accordingly.