Will Leveraged Buy Outs (LBO) Lead to PE Expansion for ChinaHybrid Stocks?

ChinaHybrids^TM and short-sellers have been in a heated battle throughout most of 2010. We can all agree that the shorts, with a little help from a fear driven market, won round one. Who will win round two? On November 2, 2010 I mentioned that,

“recent events have led investors and investment banks to perform deeper due diligence, resulting in aggressive funds flow across the board, a short-term dagger thrust into the portfolios of many pessimists.” (Limit Risk While You Invest in ChinaHybrids)

In addition to share buy-backs as well as attempts by firms to improve internal controls and 2011 EPS outlooks, the possibility of going private transactions could shove this dagger even deeper into the portfolios of blood thirsty short-investors.

Two companies have recently announced intent to possibly take their companies private.

Harbin Electric (NASDAQ:HRBN)

The company announced that its Board of Directors has received a proposal letter from its Chairman and Chief Executive Officer, Mr. Tianfu Yang and Baring Private Equity Asia Group Limited for Mr. Yang and an investment fund advised by Baring to acquire all of the outstanding shares of Common Stock of Harbin not currently owned by Mr. Yang and his affiliates in a going private transaction for $24.00 per share in cash, subject to certain conditions.

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Fushi Copperweld (NASDAQ:FSIN)

Fushi Copperweld, Inc. today announced that its Board of Directors has received a proposal letter from its Chairman and Chief Executive Officer, Mr. Li Fu ("Mr. Fu") and Abax Global Capital (Hong Kong) Limited on behalf of funds managed by it and its affiliates ("Abax") for Mr. Fu and Abax to acquire all of the outstanding shares of Common Stock of Fushi not currently owned by Mr. Fu and his affiliates in a going private transaction for $11.50 per share in cash, subject to certain conditions.

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A third company, Bmp Sunstone (NASDAQ:BJGP), announced that it actually received a takeover offer.

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If these transactions materialize, round two becomes very intriguing. The shorts could get slaughtered in what could become an irrational surge in ChinaHybrid stocks as investors speculate which company will be next to go private. This scenario becomes more venomous if stocks that the shorts have actually accused of being fraudulent go private. Their “rationale” will undoubtedly include, "well this does not prove anything since companies have already fooled investors and received the cash from equity offerings. They still lied and are frauds. "

But in a game of speculation does this really matter? Even if these firms are smaller than SEC filings indicated, current P/E multiples may make going private an attractive option. For example, if a company's P/E should be 10 as opposed to a 3 multiple based on SEC reported EPS, it could still attract suitors. Worse yet for the shorts, if tax fraud is the main elephant in the room then the probability of private buyouts heightens until P/E multiples rise.

Can we blame under loved companies for choosing this route and avoiding the legal hassle of being a U.S. listed company? Legitimate firms, whether or not supported by SEC flings, can at some point in their lifespan go private and re-IPO at higher multiples in China, where income tax fraud and “facilitation” fees are cultural. If equity growth capital has already been raised, the incentive to go private increases.

Although rising tides lifts all ships, investors who want to play this angle should look for the companies:

1. where investment banks have completed updated due diligence procedures
2. that have allowed investment banks to independently view bank statements
3. that are buying back stock
4. with healthy cash balances
5. with strong operating cash flow
6. that have already raised money sufficient for growth plans
7. with a positive cash ratio
8. with a positive current ratio
9. battling fraud allegations or financial statement problems
10. with high short interests

Before we get too excited, keep in mind that the HRBN and FSIN transactions still need to materialize. In fact some investors have already expressed doubts about the consummation of an HRBN transaction.  It will be interesting to observe if more firms consider going private before 2010 year end audits are completed.

Global Hunter agrees:

"On a more macro scale, we would expect to see more LBOs/MBOs in the US listed China space in the near future, as more of the companies’ management teams get discouraged with public market valuations and private equity firms realize the potential value in these names."

Disclosure: Long HRBN

We will still continue our due diligence into the SAIC/SAT vs.SEC filings issue.  Many questions still remain open, but we intend to profit from the change in market sentiment for as long as we can.

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