Pay Attention or Pay the Consequences: Investing in China

posted by Marsha Vande Berg on August 7, 2017 - 10:21am

It doesn’t matter if the corporate governance is black or white, when it concerns Chinese companies – stated owned or privately-held -- investors’ due diligence is the only game worth playing.

Like listed companies worldwide, Chinese companies reflect the market economy in which they operate. In China’s case, it’s a social market economy that is subject to market forces, engages capitalists but run with the Chinese Communist Party’s interests paramount. The government’s hand can be heavy, non-transparent and a key influencer in the interplay between China’s brand of capitalism and governance matters like minority shareholder rights.

When it comes to shareholder protections, China’s corporate governance standards acknowledge the validity of such concerns, and the country’s legal system is supposed to guard them in principle. But at the end of the day, the tradeoff becomes the reconciliation of twin goals of maximizing shareholder value and advancing the economic interests of the state. 

What this means for investors who want to buy into the China miracle growth story is not to avoid Chinese companies but exercise appropriate due diligence into their governance structures and a company’s relationships with government before signing off on the investment.  China’s economy has made phenomenal strides, but it is still run more like a planned economy than not, and the government is still planner-in-chief. 

Consider possible implications for China’s e-commerce star, Alibaba, which listed in 2014 on the NYSE, of the four sprawling Chinese conglomerates now in the government’s cross hairs for building global empires and using state-bank debt and their key connections.  One of the three is traded – Fosun International on the Hong Kong exchange, but all four – like Alibaba – depend on the Chinese marketplace and their relationship with government.

China’s Communist Party’s newspaper describes companies like the four conglomerates as “gray rhinos” because they pose problems for the economy which go ignored until the start moving fast. Each of the four – Anbang Insurance, which is now under orders to sell the famed Waldorf Astoria which it bought for $2 billion during its acquisition spree, HNA Group, Dalian Wanda Group, a real estate consortium, and Fosun International, a financial and industrial operation, which is traded in Hong Kong – ramped up growth by acquisition using state bank loans and at the government’s urging to build China’s global presence. Their combined spending on acquisitions abroad was an estimated $41 billion at a minimum. 

But when the tide on Chinese debt began receding, the gray rhinos were exposed as part of the problem. The OECD reported recently that China’s debt levels internally had exceeded GDP by 250 percent, and of that, 170 percent was corporate debt. The Party’s bigger concern arguably was the potential for embarrassment during the upcoming Party congress, meeting in late fall to decide the future political leadership for the next five and possibly ten years.

Technology companies have been luckier.  They are considered part of the solution and central to China’s declared intentions to transition its behemoth economy from its productivity-challenged manufacturing base to one where technology-driven innovation is the centerpiece. Alibaba is one such technology company. 

Alibaba, which first tried listing in Hong Kong but was turned down but then succeeded with the NYSE, has a governance structure that in no small way reflects multiple western corporate governance constructs but with a unique twist. The holding company, Alibaba Group Holding, has a board of directors; the company reports transparently to the SEC quarterly; it reports earnings and will report the new fiscal year’s first quarter earnings in mid-August. But 90 percent or more of its business is in China, where Alibaba relies on its access to the internet which government controls and regulates.

The holding company is managed by the Alibaba Partnership, which was designed specifically to keep founder Jack Ma and his managers in control of the company and its strategic direction. It’s similar to having a dual class stock structure, like Google and Facebook, and which recently was dealt a blow when the S&P 500 ruled out the future inclusion of dual class shareholding companies on what is the world’s most widely followed market benchmark. The decision also affects two S&P sister composites.

At the time, Ma held 8.9 percent and the Partnership owned 89 percent – sufficient for virtually lock-tight control on the company’s direction.

Headquartered in Hangzhou, the company operates online and mobile marketplaces in retail and wholesale trade, as well as cloud computing and other technology and related services cod consumers, merchants and participants generally in its online ecosystem. It operates Taobao Marketplace, an online shopping destination; Tmall, a third-party platform for brands and retailers; Juhuasuan, a group-buying marketplace;, an online business to business marketplace;, an online wholesale marketplace; and AliExpress, a consumer marketplace.

Alipay, China’s largest Internet payment service, started by Alibaba Group and later spun off into an entity that evolved into Ma’s Ant Financial Services Group, which provides a bevy of financial services in including Alipay and Yu’E Bao, now the world’s largest money market fund.  Alipay, together with China’s other e-commerce behemoth, TenCent Holdings and its WeChat Pay, dominate 90-percent share of China’s mobile payment market.

This month, Alibaba stock is forecast to notch another 90-cents per share when it reports quarterly earnings come mid-August. With lead revenue streams still dependent on commissions and advertising, Alibaba has been engaging in dual strategies of broadening its international holdings and therefore its latitude for operations while retaining bread and butter linkages with its bread and butter client, the Chinese consumer.

Via Ant Financial, Ma is expanding into the United States, with the acquisition of First Data Corp, a payments processor and Dallas-based Moneygram International, pending regulatory approvals. Via Ant Financial and other affiliates, his buying spree reaches into Thailand and India among others. Having chalked up ten acquisitions between September 2013 and March 2017, Alibaba Pictures, a movie and TV content business controlled by Alibaba, bought Chennai-based TicketNew, making Alibaba the largest B2B operator in the world’s second largest population center.

Its corporate debt is three percent on an enterprise value of $390 billion, compared to the much larger Amazon with an enterprise value of $480 billion and six percent debt.

Duncan Clark, author of Alibaba: The House that Jack Ma Built, describes the relationship between Ma and the Chinese government as an interesting dance. The government recognizes the utility of people like Ma and its leverage is it regulates Alibaba’s lifeblood.

Meanwhile Alibaba fulfils the Chinese dream of economic expansion via the technology sector. It’s likewise an interesting dance between Beijing and all of China Inc., and understanding that tune can be devilishly difficult. The government does not disclose who controls what, and it can’t be inferred. Alibaba’s exception is transparency by force of the governance controls under its NYSE listing.