Equity Raises Killing Sentiment in U.S. Listed China Sector

Over the past several weeks, momentum of Chinese stocks has stalled. Off-hand four culprits can be identified

1. The sector had exploded onto the scene in 2009 with meteoric rises in many names, so a pull back is logical and healthy.
2. The Chinese New Year occurs in the first quarter resulting in irrational psychological fears.
3. The European debt crisis.
4. The fundraising activities over the last 12 months have finally caught up to the sector, instilling dilution fears.

My thoughts on investing in ChinaHybrids have been well documented over the course of the last two years and I have even said that there is an outside chance that the sector can experience a dot com type of experience. I also mentioned a caveat that could derail the viability of the China Hybrid space is the reckless equity raises that are taking place in the sector, a factor that we as investors have no control over. We continue to get blindsided with equity raises that will result in a suppression of near-term EPS growth and P/E multiples.

So is this dilemma navigable? To answer the question we must understand the nature of the China Hybrid universe and its natural progression as it relates to funding cycles.

We have to remember that these firms are here for one reason: to gain access to U.S. capital. I have carved out five phases of the fund raising cycle.

The Fund Raising Cycle

• Phase I: A company enters the U.S. financial market by merging with a non-operating stock (shell), a reporting but non trading Form 10 shell, or a Special Purpose Acquisition company, aka SPAC. In the first quarter of 2010, there were about 20 such transactions. This process is typically referred to as a reverse merger or share exchange.
• Phase II: A company (sometimes in conjunction with phase I raises money in a round of financing. The money raised is typically less than what is raised in a traditional IPO process. Thus, there is a good possibility that at some point down the line more money will be needed.
• Phase III: The company puts its initial funds to use and works through dilution from fundraising activities to deliver solid EPS growth.
• Phase IV: The company taps the capital markets again.
• Phase V: The Company puts further round of financing activities to use and works through dilution from fundraising activities to deliver solid EPS growth again.

Phase IV and V will continue to occur for seasoned companies.

As it turns out there are numerous companies entering phases II and seasoned companies that have completed phase IV about embark on phase V.

The key to being opportunistic in this cycle is to identify companies that have fueled up and are about to enter phases III or V. For the great companies, this can happen anywhere between 6 months to 18 months from the time when funds are raised. In 2009 we saw companies drive EPS growth through fund raising activities and an improving global environment.

I am of the opinion that the seasoned companies are selling themselves short and could attain much more favorable financing terms. It doesn’t seem rational for a company doubling its EPS to raise money at 5 times earnings. The reality of the situation is that a lack of participants in this market sector coupled with perceived risks of investing in China influences this inefficiency.

Because this phenomenon is currently unavoidable, I have put together a checklist to help investors tread through the China Hybrid space.

Reasons the Company May Need Financing

1. Has the company raised money since entering the U.S.? If no, then the risk of dilution is real?
2. Capacity. If a firm is near full capacity then the need to raise money is real.
3. Understand expansion plans.
4. Debt level. With less debt the company could utilize less equity to grow, but we rarely see  China Hybrids raise money via debt.
5. Net-working capital position and share holder equity. If negative we could see a raise.
6. Equipment upgrade requirements due to age or required certifications.
7. Contract backlog and the ability to meet such demands via current operations.
8. Firms that go public via a  SPAC transaction are prone to equity raises due to the need for the companies to sometimes buy back shares from investors who plan to vote against the approval of a business combination.
9. AR collection below standards.

Does The Equity Raise Make Sense?

1. Has the company provided specifics on the use of funds in its offering documents? Will the proceeds be used for  general working capital or growth initiatives?
   • Is dilution less than capacity expansion? If yes, then EPS accretion may be in the cards. China Green Material Tech (OTC BB:CAGM) may fall into this category.
   • If capacity can be added quickly then accretion can occur rapidly.
   • Plans to make immediately accretive acquisitions. Soko Fitness & Spa Group (OTC BB:SOKF) and China Valves Tech Inc (NASDAQ:CVVT) may fall into this category.
   • Are there new products lines and distribution channels in the works (can take time to develop)
2. What were terms and how dilutive were they? Example
   • How many warrants are associated with the raise?
   • Is there convertible debt?
   • How much of a discount to the current stock price did the raise occur at? Did the raise occur below book value per share. This can provide insight into the perceived risk of the company's operations and management's vision to enhance shareholder value. Winner Medical Group Inc (NASDAQ:WWIN) actually just priced a raise above current prices.
3. Is there management insight into earnings growth potential?
   • Are there any make-good provisions or incentive targets associated with the money raise?
   • Has the company given EPS guidance or just net income guidance? If only net income guidance is provided then dilution is still a risk. New Energy Systems Group (OTC BB:NEWN) is a rare example of a Chinese Hybrid firm that has issued EPS guidance. China Green Agriculture (NYSE:CGA) also has a history of of issuing EPS guidance
4. Has the company had a good track record of working through dilution? L&L Energy (NASDAQ:LLEN) has worked through dilution and delivered immediate positive results.
5. Who is involved in the raise and what has been their track record in the this space?  This includes investment banks, investors and IR firms.

The good news is that many of the China Hybrid firms are in ultra growth modes and dilution will eventually work itself out. In rare occurrences the money raise will be immediately accretive, especially for seasoned firms.

The bad news is that we currently have a mine field of irrational equity raises, imparting more risk in China Hybrid names, especially in those that have experienced sharp increases in share price. Everywhere you turn these actions are killing the sentiment in this sector. To ensure P/E expansions, the "savvy" CFO's need to think twice before giving away stock in the secondary market.

In general, we are still bullish on ChinaHybrid  prospects and welcome the pullbacks. Because the ChinaHybrid sector has been demolished in recent weeks, a short term bounce should be expected. Many stocks in the sector are now priced to fail and therefore need an adjustment. The fourth quarter of 2010 and first quarter of 2011 should offer improved EPS growth, precipitating the resumption of sustained share price increases. For example, analysts estimate that Shengkai Innovations Inc (NYSE AMEX:SHE) and Lihua Intl (NASDAQ:LIWA) earnings per share will increase sharply in 2011. Ultimately, the sector's performance will depend on China's ability to engineer a soft landing of its economy and the ability of companies to maintain financial integrity.

We will continue to invest in companies that:

1. Have no need to raise money,
2. Were left behind in the recent market climb,
3. Will begin to see EPS accretion from past fund raising activities,
4. New reverse mergers that make sense. 
5. Are in the process of closing equity raises that will not seriously jeopardize EPS growth.

Also, remember that the Shanghai Stock Exchange, currently down approximately 18% in 2010, is a good leading indicator for our stock market. In 2008 it fell before the U.S. market collapse. In 2009 it preceded our market recovery. China has continually stressed that it will do what it takes to maintain healthy growth rates. In fact, this weekend Government officials hinted that the measures they take to slow economic growth will be less stringent.

Disclosure

Positions: Long NEWN, CVVT, SOKF, CAGM at time of this article.

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