Are China Stocks Ready to Pop?

This past Monday was a throwaway day for most investors (the S&P 500 was flat), but potentially a very significant one for investors who have put money to work in China. That's because Harbin Electric (Nasdaq: HRBN  ) , a small Chinese maker of electric motors, announced that it had received a going-private proposal at $24 per share from CEO Tianfu Yang and private equity group Baring. This news had a significant effect on Harbin Electric's stock price, with the issue popping from $20 to $25, but it also had knock-on effects across the entire universe of small, U.S.-listed Chinese companies, with more than 100 of them up 3% or more.

The reason for this is that Harbin's CEO, in showing that he won't stand for what he considers an inadequate valuation of his company, may be setting an example for the CEOs of other small, U.S.-listed Chinese companies to follow.

Follow the leader
Harbin Electric, like many of its small-cap Chinese peers, is a stock over which U.S. investors had growing skepticism. The company employed two little-known auditors, Frazer Frost and Kabani & Co., during its history as a public company, was heavily shorted, and had been sold down from $24 to $16 from April to July as several high-profile media outlets, including Barron's, raised concerns about the quality of company in this space.

Yet Harbin, provided you believed its financials, was ostensibly worth much more than its market valuation. At $20 per share, the company was being valued at just six times EBITDA despite growing sales and income at better than 150% and 260%, respectively, over the trailing-12-month period. Admittedly, Harbin suffered from some of the same financial maladies that plague many Chinese companies, including a long cash conversion cycle and lumpy receivables cycle, but that growth at that price, all else being equal, looked like a steal.

Concerned U.S. investors, however, were skeptical of Harbin Electric's financials just as they remain skeptical of many of the other small U.S.-listed Chinese companies. In fact, Harbin is hardly alone in this space in looking like a bargain. According to data from Capital IQ, small U.S.-listed Chinese companies trade for an average of 1.3 times sales and 5.4 times EBITDA. That compares to 3.2 times sales and 11.8 times EBITDA for large U.S.-listed Chinese companies such as Baidu (Nasdaq: BIDU  ) and PetroChina (NYSE: PTR  ) that no one doubts as going concerns and that are popular picks among China investors; and two times sales and 11.7 times EBITDA for Chinese companies listed in Hong Kong, where investors are much more familiar with Chinese business practices and thanks to proximity, more able to check in on the health of their investments.

Small U.S.-listed Chinese companies, however, have struggled to be awarded the same valuations as their larger or Hong Kong-listed peers. Risk-averse U.S. investors scoff at explanations of cultural difference, are uncomfortable with the language barrier, and are now demanding that small Chinese companies hire so-called Big Four auditors even if it's neither economical nor worthwhile to do so (Big Four auditors are expensive and less likely to spend time with small clients). And while many of these Chinese companies have promised to improve their communications with investors and have initiated processes to hire bigger auditing firms, Harbin's CEO, Mr. Yang, who already owned more than 30% of the company, has apparently decided to heck with all that.

The first, but not the last
And Yang won't be the last Chinese CEO to figure out that it's easier to find a private equity partner to take a company private than it is to assuage the concerns of U.S. retail investors. Remember that interest rates around the world are extraordinarily low and cash is flooding into emerging markets, making it easier than ever to find a partner to buy out a fast-growing Chinese business. Further, remember that the reason these companies came public in the U.S. in the first place was because they were having trouble gaining government approvals for Chinese bank loans or Chinese listings from 2005 to 2007 as the government sought to encourage consolidation in the economy and prop up larger state-owned enterprises. The government has since made it easier for small- and medium-sized enterprises in the country to access financing both from banks and via the new Growth Enterprise Market, making a U.S. listing no longer necessary (not that it does much good to raise money at such low valuations anyway).

Indeed, Matt Hayden, president of IR firm HC International that represents a number of small Chinese companies, declared this "a watershed event for the space" and predicts more mergers, acquisitions, and leveraged buyouts for Chinese companies over the next year. Candidates could include Winner Medical (Nasdaq: WWIN  ) , China Marine Food (Nasdaq: CMFO  ) , and Fushi Copperweld (Nasdaq: FSIN  ) -- three companies that are significantly owned by their CEOs, virtually debt free, and trading at depressed multiples.

The takeaway for investors
One of the sentiments we heard over and over again during our most recent Motley Fool Global Gains research trip to China was that companies there were upset with the valuations they were being awarded by U.S. investors. As a result, I suspect many have taken notice of what Mr. Yang is doing at Harbin and are contemplating doing similar deals themselves.

This is not an excuse to speculate in Chinese small-cap stocks; there are a number of dicey public companies in the space that won't be able to attract private equity interest. That said, the prospect for additional leveraged buyouts in this space should prove to be a positive near-term catalyst for investors who have already built positions in a diverse collection of Chinese companies.

Of course, there's also a downside. Valuations in this space are so low that investors likely won't get fair value for their holdings even if they're bought out at a substantial premium. The Harbin deal, after all, proposes to take the company private for a little more than two times sales and seven times EBITDA -- still a discount to the multiples that larger or Hong Kong-listed companies are fetching from investors. To wit, class action lawyers have already announced investigations into whether Harbin's board is doing its duty to get fair value for investors. Further, remember that if the most promising small Chinese companies are taken private, then investors are ceding long-term exposure to China's promising growth story -- a significant sacrifice that should not be lost sight of amid the enjoyment of short-term gains.

Interested in what The Motley Fool thinks is the No. 1 China stock? Click here for a free five-page report!

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Tim Hanson is co-advisor of Motley Fool Global Gains. He does not own shares of any company mentioned. Baidu is a Motley Fool Rule Breakers recommendation. Winner Medical Group is a Motley Fool Global Gains selection. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (16)

Comments from our Foolish Readers

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  • Report this Comment On October 14, 2010, at 12:38 PM, ETFsRule wrote:

    It looks that way to me... HOGS has been on fire... AOB has shown signs of being ready to pop... and now CRTP is going crazy. Get in before it's too late!

  • Report this Comment On October 18, 2010, at 9:23 PM, whomonkyoulus wrote:

    Good job!

    CMFO is one of my favorites.

  • Report this Comment On October 20, 2010, at 10:12 AM, jonheyen wrote:

    I would like to advertise but Tamara Ragin or anyone from the Motley Fool will not return my call. Can anyone out there tell me how to advertise with the Motley Fool or tell me who to call. Please email your response to jonathanheyen@gmail.com. Thank you.

  • Report this Comment On October 20, 2010, at 10:58 AM, MikeStevens1968 wrote:

    My favorite stock to watch is the unusual happenings with Manganese. Check APIT. Its worth putting on the list to watch.

  • Report this Comment On November 21, 2010, at 12:02 PM, TheSecretHistory wrote:

    Harbin Electric was a major player during the fifties and sixties because of Harbins close proximity to the Soviet Union, which helped facilitate technology exchanges between the two Communist countries. Its a government-owned corporation, which means that up until now it has never had to turn a profit. Its specialization is the construction of coal-powered plants, seeing as the Chinese government is looking to reduce dependence on coal use, there could be some problems in the future. The fact that they're going private might just mean that the company has lost favor with Beijing, or the local government no longer has the resources to subsidize them. Heiilongjiang is notoriously mismanaged and corrupt.

    One other thing to watch out for is that its overseas customers have locked them into long term payment plans in dollars, which means that any appreciation of the yuan against the dollar affects their bottom-line.

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