CDT Money: Earnings Season Marred by Cloud of Fraud

A preliminary measure of manufacturing activity painted a stabilizing picture of the Chinese factory sector this week, though concerns persist over potential export weakness as a trip by Wen Jiabao brought Europe back to the forefront. HSBC’s flash purchasing manager’s index (PMI) for April posted its best reading of the year, recovering from 48.3 to 49.1 and reversing March’s four-month low. While the number failed to eclipse the 50 level, which would have marked a movement into expansionary territory, the improvement strengthens the belief of some analysts that China’s economic growth has bottomed out and begun a modest recovery. The director of China’s State Information Center, for one, said last weekend that he expected China’s GDP growth rate to stabilize in the second quarter before rebounding to 8.5% for 2012.

Other economists believe China’s growth will rapidly pick up, including Tang Jianwei at the Bank of Communications:

“Growth will rebound in the second quarter. The chance for a hard landing is slim,” said Tang Jianwei, an analyst at the Bank of Communications.

“The economy will keep a reasonable growth rate as long as the government properly handles its macroeconomic control measures,” he said, forecasting growth of 8.6, 8.7 and 9 percent, respectively, for the next three quarters.

Tang said he expects export growth to recover in the second quarter, as export orders have increased amid an improved global economic outlook.

The Bank of Communications also published a report predicting that China’s inflation rate would ease in April to 3.3 percent, down from 3.6 percent in March on the back of slowing growth in food prices. Otherwise, focus turned to Chinese corporates. Many of China’s public companies reported their results for the first quarter, results which indicate that the Chinese economy may have not bottomed out yet after all.  More than 60 percent of the listed companies to release earnings by April 23 had reported either a drop in profits or a loss, with big manufacturers leading the decline.

Sluggish earnings may be the least of investors’ worries in China, however, as clouds of fraud have formed around several PRC companies in recent weeks. With the Sino-Forest scandal still lingering after the tree grower filed for bankruptcy protection in March, another Chinese timber company, Hong Kong-listed China Forestry Holdings, announced that it could only account for about 1 percent of its historical sales. The announcement caps a tumultous 15 months for the company – Former CEO Li Han Chun was detained by police in March 2011 for the alleged embezzlement of 30 million yuan, and the company also halted trading in its shares early last year so an independent committee could investigate account irregularities highlighted by the company’s auditor.

Elsewhere, the U.S. Securities and Exchange Commission (SEC) charged U.S.-listed Chinese oil field services firm SinoTech Energy and its two top executives with fraud last week, specifically for lying about the value of the company’s assets and misappopriating proceeds from its 2010 initial public offering. According to The Wall Street Journal, the company’s chairman allegely stole more than $40 million from the company’s bank account last summer.

In the world of rogue Chinese CEO’s, however, few can hold a candle to Ron Chan, the former chief executive of ChinaCast Education. ChinaCast revealed in an open letter earlier this month that Chan and several other executives had made off with key company property, including corporate chops (for affixing company seals to authorize its business operations), following a dispute with the board which saw him removed from his post in Shanghai.

In The New York Times’ DealBook, Steven M. Davidoff writes that the real problem facing Chinese companies in their battle to regain investor confidence goes well beyond missing chops:

One reason that ChinaCast is having a problem is that shareholders did not actually buy an interest in its operations. Instead, to avoid Chinese restrictions on foreign investment, ChinaCast’s shareholders invested in a United States company that has contractual arrangements with a Chinese company. But the Chinese company remains in the ownership of Chinese citizens.

The problem with this structure, known as a variable interest entity, is that it may be illegal under Chinese law and has been criticized by Chinese regulators. Even if it is legal, if the Chinese owners decide to go rogue, the United States-listed entity must sue and obtain a judgment from a Chinese court to enforce these dubious contracts. Good luck with that. Such a litigation can take a long time to resolve, if ever.

In ChinaCast’s case, it can’t do anything until it has control of the corporate seals, but under Chinese law it needs them to sue to recover them. In the meantime, the operators of the Chinese subsidiary can take full advantage of the situation.

As recent attempts by Chinese companies to list in the United States show, the improprieties of Ron Chan, SinoTech, Sino Forest and others have left the door firmly shut for others to access the U.S. market. China Auto Rental, the country’s top car rental provider, hit the brakes on its proposed U.S. IPO this week to “avoid possible bloodshed” after it failed to generate any meaningful interest in its stock offering. Bloomberg reported that only about half of the ~$140 million order book was covered by the time the company chose to scrap the deal.

So far this year, only one Chinese company has completed a public listing in the United States – Vipshop, a Guangzhou-based online discount retailer, which plummeted 33 percent in its first five days of trading after it already had to price the offering well below the marketed range. Vipshop became the first Chinese company to list in the U.S. in nearly eight months, and likely will be the last for some time. With an increasing number of Chinese companies waiting for the U.S. market to open for them again, and with little evidence that it will do so in the near future, they will likely need to pursue alternative funding avenues until the storm clears.

New IPO Guidelines

While Chinese firms face significant headwinds in their efforts to tap the U.S. equity markets, China’s securities regulator announced new guidelines meant to improve the country’s own IPO process:

The reform is aimed to make the pricing of new offerings better reflect the issuer’s fundamentals. China’s stock market has been plagued by abnormally high pricings of new offerings and the subsequent reverse in earnings growth of the issuer after the listing, as well as continuous weakness in newly-listed companies’ shares.

The guidelines on new rules comes as a growing list of state-run firms are eager to tap a slowly recovering domestic stock market. The benchmark Shanghai Composite Index has gained 9% so far this year, after dropping 22% in 2011.

Analysts said the stock market is unlikely to react too much to the reform.

“Potential impact from the reform is likely to be limited as it’s more focused on technical adjustments in the pricing procedures [instead of fundamental reform of the IPO system],” said Jiang Shiqing, an analyst with Industrial Securities.

Shifting Opportunities for Foreign Firms in China

The Wall Street Journal’s Bob Davis looks at the first-quarter results of several foreign companies and highlights evidence of the beginnings of a transformation for China’s economy:

Caterpillar, the Peoria, Ill., construction- and mining-equipment company, last week bragged about first-quarter growth in the U.S., which Chief Executive Doug Oberhelman said “more than offset slowing in China and Brazil.”

Ditto for Swiss engineering company ABB. Chinese sales are having “some difficulties,” said Chief Executive Joel Hogan, while demand is growing in North America for its power equipment.

Others reporting slowing China demand during the first quarter included miner Vale SA VALE -1.27%and United Technologies Corp., UTX +0.92%which said new Chinese orders fell 21% at its Otis Elevator unit.

Meanwhile, Apple reported that sales in greater China, which includes Hong Kong and Taiwan, more than tripled to $7.9 billion in the quarter ended March 31, driven in large part by Chinese consumers like Wang Hong. The 24-year-old saleswoman on Friday bought a new iPhone 4S from an Apple Store in Beijing for about 5,000 yuan, or nearly $800. That is about 1,000 yuan more than she makes in a month, but she said she wanted the phone to keep up with her friends—one of the marks of an increasingly consumer-oriented society. Her friends have iPhones, “so I think I should own one, too,” she said.

The numbers, Davis writes, may signal the early stages of an economic rebalancing toward a heavier reliance on consumer spending versus exports and investment.

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