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Domain Drag - Whatever is motivating Chinese firms’ current buying spree, it isn’t value

28/04/2016

Andrew Williams

Andrew Williams

Investment Specialist, Equity Value

Ask any investor what they currently see as the biggest threats to their portfolio and, chances are, China will feature near the top of the list. More often than not, however, it will be the country’s economic health that is the cause for concern rather than its state-owned enterprises – even though a number of these companies have been behaving like a teenager who has just found the parental credit card. 

As we will see, that metaphor is even more apt than you might think but let’s first zero in on the case of ChemChina, which earlier this year bid $44bn (£30.6bn) for Swiss agribusiness giant Syngenta. Clearly that is quite a price tag to put on any business – and even more so when you consider it is approaching half the $110bn total of Chinese outbound investment made in 2015, which was itself a record. 

That said, it is not a bid’s absolute size so much as its inherent value that matters – certainly as far as The Value Perspective is concerned – yet, to our eyes, the ChemChina bid appears to fail on almost any measure. Not only does it represent a 40% premium on Syngenta’s average share price over the course of 2015, it equates to multiples of 25x profits before tax and 35x net profits. 

Still, if that is not enough to convince you the deal is expensive, try inverting that 35x multiple and, yes, this is a company that is effectively paying $44bn for a 3% yield. That realisation becomes even more remarkable when you consider that, in common with many of these sorts of deals, ChemChina is taking on significant amounts of debt to help finance it. 

Interestingly, as a state-owned business, ChemChina has a number of bonds in issue at present – and all of the ones that mature after 2017 yield more than 3.5%. In other words, bond investors are currently demanding more from the company than it is set to receive from the Syngenta deal so this is not even a case of a buyer gearing up to make a return. Nowhere here does the maths seem to make sense. 

And certainly not when it comes to ChemChina’s ratio of total debt to EBITDA  (earnings before interest, taxes, depreciation and amortisation), which, according to an excellent analysis piece in the Financial Times, China’s world of debt, stands at 9.5x – somewhat higher than the 2x to 2.5x level at which we start to feel a bit uneasy here on The Value Perspective. 

High debt levels 

As suggested earlier, however, high levels of debt have become something of a trend among Chinese companies investing abroad. So, sure, 9.5x is at the top end of the scale and yet, according to that FT article, it is a scale where the median debt multiple racked up by the 54 Chinese companies that publish financial figures and did overseas deals in 2015 stands at an uncomfortable 5.4x. 

Clearly this is a very heavily leveraged sector indeed but how has it come to this? To return to our metaphor at the start, the reason these particular teenagers are able to wield the parental credit card with such abandon is that their parents – as in the powers that be in Beijing – are actively encouraging them to do so. 

We mentioned earlier that outbound investment by Chinese companies passed $100bn for the first time last year and yet China’s premier Xi Jinping is on record as saying he expects Chinese companies will do around $1 trillion of outbound investment between 2016 and 2020 – in other words, twice as much as they achieved last year in each of the coming five years. 

So the story so far is that China is on a buying spree and looking to double last year’s annual record of outbound investment from this point on and most of the companies pushing shopping trolleys are already leveraged to the hilt. Would you be surprised to learn our view on all this is that using a lot of debt to buy overvalued assets – yes, such as Syngenta – is rarely a recipe for a happy ending? 

And yet ChemChina’s planned acquisition of Syngenta is not an isolated case but the standard-bearer – for now anyway – in a growing trend. So who should be worried? Well, two groups immediately spring to mind – anyone who owns any debt in these acquiring companies and anyone who owns any equity. After all, to put it mildly, such deals seem an odd way to go about creating shareholder value.                         

Which begs an interesting question – if the creation of shareholder value is not the overriding ambition here, what is? And for many Chinese businesses – and especially those that are state-owned – the answer is the size of their domain. What they really want is influence – and specifically the ear of the nine-man council that effectively governs China. 

State-backed asset grabs 

As the FT article points out, if these acquisitions were being undertaken purely as commercial enterprises, there is not a chance the companies would receive this sort of debt-financing. But these deals are effectively state-backed asset grabs and those involved are being rewarded for doing the grabbing irrespective of whether any shareholder value is being created. That has to be a concern. 

A third group of people who should be worried are those who own equity in a business being targeted for acquisition. Here the concern is not so much the prices being paid – presumably, for example, most Syngenta shareholders would be more than happy to receive a 40% uplift on their shares – as the chances of the deal actually being completed. 

That such concerns are real is illustrated by how, while ChemChina’s current – and apparently funded – offer is worth 491 Swiss francs (£355) a share, Syngenta shares have only been trading around the 400 Swiss franc mark. You could, in other words, make some 20% just by assuming the deal goes ahead on its current terms. The discount exists, of course, because the market is not convinced it will. 

The key issue here is whether the Syngenta deal will receive approval from the Swiss authorities, with those who worry that it will not able to point to a growing list of regulatory concerns that have ended multi-billion-dollar Chinese interest in the likes of a US lighting business owned by Dutch conglomerate Philips, and chipmaker Micron, again in the US. 

Investors need to recognise these deals are not operating in a vacuum and the more debt that is involved in an acquisition, the more likely it is to be rejected by the powers that be. Nor is this merely a result of regulatory caprice or even – necessarily – protectionism. The points is that, the more debt there is in a company take-over, the greater the pressure later to cut jobs and scale back investment. 

In short, depending on which side of this new generation of state-backed, highly-leveraged, value-indifferent acquisitions stakeholders find themselves, there are some very significant risks to take into consideration – whether the deals ever go ahead in the first place or, if they do, whether they should have gone ahead at all. 

Author

Andrew Williams

Andrew Williams

Investment Specialist, Equity Value

I joined Schroders in 2010 as part of the Investment Communications team focusing on UK equities. In 2014 I moved across to the Value Investment team. Prior to joining Schroders I was an analyst at an independent capital markets research firm. 

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