One of the top three players in the air-conditioning manufacturer market.
Business objective: “world’s biggest air-conditioners manufacturer within the next 5 years”
Company Overview Location Guangdong Founded in 1994 Ownership In 2005, Geeli was held by Li Zhigao,Chairman, more than 90% Products Household AC 91%, commercial AC 7% and other home appliances 2% of the company’s sales Output Capacity household AC 8 million and commercial AC 0.5 million units Markets 67% of products sell in domestic and 33% for export to 20 countries in USD The most valuable asset is its brand $350 million
Issues in the case
Rational for Expansion capacity
China Vs. US. market
What are the "Emerging Markets " ?
What are the "Emerging Markets" ? Regions Fully industrialized Emerging (rapidly) Developing nation 1. Europe Germany, UK, etc.. Russia, Poland, etc.. Bulgaria, Romania, etc.. 2. Asia Japan... China , etc.. Laos, etc.. 3. Americas USA , Canada... Mexico, Brazil, etc.. Paraguay, etc.. 4. SE. Asia n/a Indonesia, Thailand, etc.. n/a
The future leaders: BRIC's The report found that developing economies’ share of total global output had risen significantly in the past decade, as nations such as India and China had grown far faster than their richer counterparts. As a result, developing nations accounted for 41 per cent of $58,600bn (€37,000bn, £29,600bn) in total global economic output in 2006 – up from 36 per cent in 2000. BRIC's (Brazil, Russia, India, China)
The future leaders: BRIC's BRIC's (Brazil, Russia, India, China) Real GDP growth in Brazil, Russia, India and China: 2001-2007 Source: Deloitte’s Global Manufacturing Industry Group
Investors opportunities in Emerging Markets:
Most of the world populations
(over 80% of the world’s people live in emerging
Younger and increasingly educated workforces
Rising levels of individual wealth
Increasing domestic demand for products within emerging countries
High global demand for labor and raw materials
Strong flows of foreign direct investment
Investors threats in Emerging Markets:
Emerging markets can be highly volatile
and investing in them entails unique risks, including
but not limited to:
Economic risks, such as local currency depreciation or significant policy changes that dramatically impact market performance
Political uncertainty or upheaval, such as social instability within an emerging country or region
The underdeveloped financial markets and the institution for distribution of capital are not strong as in developed countries
Distance between Developed market and Emerging market
Debt or Equity ?
Geeli Expansion financing options
Source: Puzzle in Chinese Stock Market Option 1-Equity Share in Chinese Market
Requirement to be Listed Criteria Chinese Stock Market Hong Kong Stock Market Geeli( Yr 2004) Stockholders Equity US $ 6 Million US $ 12 Mil US$ 247.9 Mil Assets None Net Assets > US$ 40 Mil US$ 359.3 Mil Income from continuing operations None Las Years Profit after Tax Cannot be lower than US $ 7 US$ 95.6 Mil Publicly Held Shares No Market value of publicly held shares No Shareholders Operating History 3 Years Before 1994 Profitability 3 Years cumulative US$ 6 Mil(last yr. US$ 3M;Former 2 Yr combined US $4 Mil) 48 Mil(2003) 62.1 Mil(2004)
HK Market in comparison:
Financing Option 1- Contd: Fund Raised by the Chinese Markets & H-Shares of the Hong Kong market (US $ Bn) Source: Hong Kong: A prime centre for Chinese companies in the Primary IPO & Secondary market
Financing Option 2- US Market (NYSE & NASDAQ) Criteria NYSE NASDAQ Geeli( Yr 2004) Stockholders Equity US $ 15 Million US$ 247.9 Mil Assets Net Tangible Asset =US $ 40M None US$ 359.3 Mil Income from continuing operations Most recent fiscal yr>= US $ 4.5 Mil Last fiscal Year >= US $ 1 Mil US$ 95.6 Mil Publicly Held Shares 1.1 Million 1.1 Million None Market value of publicly held shares US $ 9 Mil Us $ 8 Mil None Shareholders 2000 holders of 100 shares or more 400 Operating History 3 Years None Before 1994 Profitability 3 Years None 48 Mil(2003) 62.1 Mil(2004)
AMERICAN DEPOSITARY RECEIPT Stock that trades in united states but represents the specified number of shares in a Foreign Corporation. They are bought and sold on American markets just like regular stocks and are issued/sponsored in the U.S by a bank or brokerage.
American Depositary Receipt
ADR Level III Process
Advantage of Listing in American Exchange: Source: ADR for Listed & Chinese Companies: First Round to the U.S Equity Market
It is raising of capital via private rather than public placement.
Sale of a security by a brokerage firm not involving in a public offering to small number of investors.
Disclosure requirements are less and registration is not required and process is much speedier.
Conducive market scenario since it has reached $602 million on year 2005 expected to double by 2008.
When China joined the WTO in 2001, its banking sector was in a very weak state, troubled by a serious non-performing loans (NPLs) problem.
Numerous measures like a large sum of government funds (roughly 20% of China’s GDP in 2004) has been provided to resolve the NPLs problems.
In 2003, China Banking Regulatory Commission (CBRC) was established to strengthen bank regulation.
Improved performance due to foreign competitors, lower transaction cost & easy administrative procedure for obtaining the loan.
Central Bank -People’s bank of China (PBOC) Four major state owned Commercial banks 1. ICBC 2.CCB 3. ABC 4. BOC Other regional Banks Option 1: Domestic Banks
Debt Choices (Domestic Banks)
Government Policy dictated lending practice and most loan went to state owned enterprise
Though measures initiated but still a very high rate of Non performing Loans (Example: Industrial & Commercial Bank of China (ICBC) had bad debt ratio of 19.46% compared to 2% for world leading Banks)
NPLs accounted for 26% of China’s total bank loans in 2002
High Credit Officer’s risk (PBOC) due to individual accountability
Lending highly discouraged to SME and private sector
Debt Choices (Domestic Banks)
Chinese government’s over-protection of domestic banks lead to lack of competition.
The ‘‘Big Four” state-owned commercial banks were less profitable, less efficient, and have vey poor asset quality
Weak enforceability of the contract obligations
No clear body of laws ruling business disputes
Poor corporate governance contributed to bad lending practice and resulting in new NPLs, fraud for instance, in 2005, CBRC involved misused funds of US$ 93.7 billion. In connection to these funds, 13 exposed 1,272 criminal cases and disciplined 6,826 banking staff, including 325 senior managers.
Of bonds outstanding, around 60% accounts for the corporate bonds issued by both financial and non-financial institutions.
Many reforms were initiated like in February 2004, a special working group was set up to improve the regulatory framework and liquidity of the corporate bond market. Online issuance and underwriting were on its testing stage
Government imposed stringent issuance requirements and required bank guarantees
There was a lack of information disclosure to investors
Administrative allocation of quotas was often used as a relief measure for financially distressed enterprises.
Administrative pricing of corporate bonds and price controls failed to reflect risks, thereby preventing effective risk management by issuers and investors.
Debt Choice (Corporate bonds)
Effective market discipline was not established. Market forces can discipline both the issuance and trading of corporate bonds as investors exercise their judgment in the choice of products – thereby giving them the final say on issue conditions, prices and consequences of default.
The Bankruptcy Law did not provide investors with effective liquidation as a form of recourse in the event of default. The residual assets - and even the issuer - could often simply disappear without going through legal procedures. Priority was given to the unemployed people instead of the creditor.
The absence of a credit rating system made it impossible for investors to obtain a clear idea of risks.
Debt Choice (Contd.)
Option 3 : Foreign Banks
Foreign banks may provide additional benefits of financial advisory service, asset management and insurance
On average, their NPLs are lower than 3 %, have better corporate governance, better risk control, and good access to international markets
China’s banks hold more than $4 trillion in consumers’ household savings. The demand for financial services has increased significantly and thus accessing foreign banks to 1.3 billion potential customers in China
Year 2005 Number of foreign Banks in China 71 from 20 different countries Number of Branches 238 Total Assets $ 84.5
Debt Choice (Contd.)
Strong regulation binding the foreign banks by the Chinese acts
The total assets of foreign banks accounted for only 2% of the total banks assets of China’s banking Institution
Foreign exchange loans accounted for just 20% of total foreign exchange loans in china
Criteria Financing 0ptions Equity Availability Our Choice Remarks Chinese Domestic Market -Freezing of IPO from 2005 until August 2006 -Non tradable shares -Quota System Private Placement - Opportunistic behavior - Below the standard Hong Kong Stock Exchange -Expensive -Low Valuation ADR -Sound legal and regulatory framework. - Lower the costs of future capital -Access to high caliber institutional investors Debts Domestic Banks -Non performing Loans -Not well established banks -poor financial derivatives Corporate Bonds -State regulation of price -absence of credit rating -Lack of information disclosure Foreign Banks -Strict Banking Regulation -Less economics of scale
The expansion project valuation as a U.S. investor
Foreign investment’s cost of equity assumptions
The project funded by 100% equity
Risk premium = 5%
Risk free rate = 4.55%
Beta proxy = 0.77 (averaging beta of two peer companies, same revenue size as Geeli)
the peer companies have the same capital structure as Geeli
The biggest, most prestige and high liability one in the world.
Large amount of available capital from big investors.
High ability of debt raising because of there are many big investors.
Image of listed companies in this market are improve internationally and domestically.
The stringent regulations and detail financial report and information requirements helps investors lower risks of asymmetric information and from that can reduce cost of capital.
The U.S law system pays special concern about protecting investor’s interests.
Regulations of SEC and developed mass media means contribute to the equality, limiting interest contradiction between minority investors and controlling shareholders. Therefore, minority investors will bear less risk and accept lower interest. As a result, company cost of capital will be decreased
As a result, for raising fund in U.S. ,Geeli can have more funding choices and lower cost of capital compared to raising fund in China
Debt is obviously the cheaper sources of funds however, in emerging markets such as Geeli in China ,debt is not available easily due to poor banking facility specifically during that period.
Therefore, the companies in emerging markets tend to rely on the well-regulated environment business and abundant sources of funds in developed market which results in lower cost of funds. In this case, Geeli should raise funds from US. Market through ADRs.
However, to ensure the financing plan is viable, the positive NPV is a must. For example, Geeli ‘s NPV is $887million in investor’s point of view.
Capital Markets. The capital and financial markets in developing countries are remarkable for their lack of sophistication. Apart from a few stock exchanges and government-appointed regulators, there aren't many reliable intermediaries like credit-rating agencies, investment analysts, merchant bankers, or venture capital firms. Multinationals can't count on raising debt or equity capital locally to finance their operations. Like investors, creditors don't have access to accurate information on companies. Businesses can't easily assess the creditworthiness of other firms or collect receivables after they have extended credit to customers. Corporate governance is also notoriously poor in emerging markets. Transnational companies, therefore, can't trust their partners to adhere to local laws and joint venture agreements. In fact, since crony capitalism thrives in developing countries, multinationals can't assume that the profit motive alone is what's driving local firms.
Several CEOs have asked us why we emphasize the role of institutional intermediaries and ignore industry factors. They argue that industry structure, such as the degree of competition, should also influence companies' strategies. But when Harvard Business School professor Jan Rivkin and one of the authors of this article ranked industries by profitability, they found that the correlation of industry rankings across pairs of countries was close to zero, which means that the attractiveness of an industry varied widely from country to country. So although factors like scale economies, entry barriers, and the ability to differentiate products matter in every industry, the weight of their importance varies from place to place. An attractive industry in your home market may turn out to be unattractive in another country. Companies should analyze industry structures—always a useful exercise—only after they understand a country's institutional context
"It's a question of risk versus reward. The potential reward for investing in mature markets has improved significantly over the last couple of years, whereas the risk has if anything reduced. ''On the other hand, emerging markets, whilst they still represent good reward, their risk element - transparency, regulation - is still a concern. Therefore funds that would normally have been earmarked for emerging markets are now finding their way into the more mature real estate," he said.
Identify Market Imperfections Items In the U.S In Geeli case Transaction Costs - Lack of infrastructure in Chinese capital market Taxes and Regulations Not require SEC registration for private placement
- Allocation quota and select, approve of listing candidates.
- IPO freeze and non-tradeable state share reform.
Tax on share trading
No clear body of laws and precedent-setting rulings governing business disputes.
Private placement was under legislated.
Require CSRC and other ministry appoval for public offerings.
Lack of wel-establised bankruptcy procedures.
Foreign exchange control over foreign banks, limiting the Chiniese corporate customers to access.
Non-traded assets 70% of total capital hold by the state, reducing float of shares. Agency and Information Problems.
China banking system still influenced by its history. Most loans went to the state-owned enterprises even though many of them performed poorly.
Lack of credit officer experience at making loans to private SMEs, credit officers reluctant to lend to the private sector, viewing it as much riskier than the state-owned enterprises.
SME corporate bond issuance requirement very stringent, need both government and state-owned band guarantee. A as result, all of the issuers are state-owned entities.