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Asia-PacificSeptember 3 2006

China’s M&A misfortunes

In their first major mergers and acquisitions forays overseas, Chinese companies are being buffeted by Sinophobia and their own lack of nous. Sophie Roell looks at recent deals.
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Chinese corporations are on a steep M&A learning curve and are learning many of their lessons the hard way. Armed with deep pockets of foreign exchange, a thirst for technology and natural resources, and a determination to join the ranks of top-tier multinationals, Chinese companies are buying up foreign assets like never before. But they are running into all the classic problems of an emerging market in its first forays overseas: snapping up assets that lose their shine after the deal is done and discovering that turning around acquired companies can be a long and costly business.

That is if the deal gets done at all. Sinophobia in the US prevented Chinese companies from acquiring oil company Unocal and consumer appliance maker Maytag. Even when Chinese companies break through this barrier, the opposition could still harm their business. In the most high-profile deal to date, computer-maker Lenovo bought IBM’s struggling PC division for $1.75bn last year but encountered difficulties with a contract to supply computers to the US State Department because US politicians feared that the Chinese could use the computers for spying.

Attitude problem

This kind of furore over Chinese companies buying overseas is reminiscent of the fuss that accompanied Japan’s first major foreign purchase in the 1980s (see below). These days, Japanese companies are still on the international mergers and acquisitions (M&A) scene but the hysteria has dwindled. Presumably, the same blasé attitude will eventually accompany Chinese acquisitions. In the meantime, their executives will be forced to take the heat, especially when well-known brand names go on the block.

Apart from Lenovo/IBM, the other deal that attracted attention was the purchase of British automaker MG Rover by Nanjing Automobile, a second-tier Chinese car manufacturer, last year. The fact that MG Rover was bankrupt, and its plants would otherwise have had to close, certainly helped to rally support for a deal that might otherwise have been more controversial.

Less high-profile brands are also vulnerable. These days, a Chinese company cashes in when a US consumer buys an RCA television and when a Frenchman makes a call on his an Alcatel mobile handset, and even when a South Korean housewife jumps into her Rexton SUV.

Chinese oil giants have been making efforts to secure energy resources anywhere from Australia to Yemen. China National Offshore Oil Corporation (CNOOC) acquired Repsol YPF’s Indonesian oil and gas assets in 2002, a $585m deal that at the time was one the biggest overseas investments ever made by a Chinese corporate. That looks almost trifling compared with some of the mega deals that are being proposed by Chinese companies in the oil and gas sector now.

“In the past two years, there has been a kind of tipping point – in the sense that the Chinese government has taken an active stance in encouraging Chinese companies to invest overseas, and putting in place measures to make that happen,” says Patrick Horgan, managing director of global consulting firm APCO, in Beijing.

Chinese state-owned enterprises (SOEs) were dogged for a long time by losses and hampered by the difficulties of getting foreign currency in a country where access to it was traditionally limited. Now they are, in some ways at least, ready to go global.

“The government has been pushing companies to grow, to expand their overseas presence, and to join the ranks of the Fortune 500,” says Jeffrey Wang, director of BDA in Shanghai, an advisory firm that specialises in Asian M&A. “There have been no specific targets set as such, but the impression I get from SOE officials is that if they complete an acquisition overseas and it’s successful, they have a good chance of being promoted to a higher position.” (In a reminder of just how different China’s economic system is from US-style capitalism, Chinese CEOs still tend to be rewarded not with bonuses and stock options, but rather with promotion in the Communist Party hierarchy.)

The problem is that not everyone is pleased to see Chinese companies. Many US politicians are terrified. Entire US industries are already being hollowed out and thousands of jobs lost to China’s cheap manufacturing base, even without Chinese companies taking over corporates on US turf. US politicians are also unhappy about Chinese energy giants snapping up oil and gas assets, just when energy prices hit all-time highs and worries about energy security loom large.

“There’s a real fear of China and a hypersensitivity in Washington to Chinese investment,” says Rhian Chilcott, head of the Washington DC office of the Confederation of British Industry. “Sinophobia is rampant in this city.”

The most high-profile victim to date has been the Chinese company that has been the most active overseas: CNOOC. “Chinese enterprises do not behave as normal commercial entities on the international market,” argued Duncan Hunter, chairman of the House Armed Services Committee, as he fended off CNOOC’s bid to buy Unocal last year. “Instead, they obey the political directions of China’s communist government.”

Unocal’s assets include pipelines in Georgia, Azerbaijan and Turkey, which Mr Hunter says are sensitive because they are key US allies in the global war on terror and the deal might dramatically increase China’s leverage over them. His arguments were apparently persuasive to his fellow congressmen. After they proposed a further review of the deal, CNOOC abandoned the $18.5bn offer. Homegrown oil giant Chevron was the main beneficiary, buying Unocal at the bargain price of $16.3bn.

The Unocal deal was not the only one that had to be abandoned for political reasons. Also last year, Haier, China’s largest domestic appliance maker, withdrew its $1.3bn bid for US appliance maker Maytag. Haier has already made a name for itself in the US for its small fridges and washing machines, and opened a plant in South Carolina in 2003. Nevertheless, Congress again made discouraging noises and Maytag was eventually bought by Whirlpool, a much more acceptable US bidder, for $1.7bn in March.

Moves make sense

As these examples suggest, for every major Chinese deal that has gone ahead, there have been many others that have failed. And yet, commercially, Chinese takeovers make a lot of sense, particularly when many US and European companies are being forced to move their manufacturing operations to China anyway.

For example, as US automakers and their suppliers teeter on the brink of insolvency, weighed down by high costs, there is a strong logic for Chinese companies, which can make components at a fraction of the price, stepping in to pick up some of the pieces. Some have already done so, such as auto parts maker Wanxiang America Corp, which sports a gleaming 51,000 square metre US headquarters just outside Chicago. The company has already made a number of acquisitions of US car part suppliers and hopes to pick up more as parts of bankrupt US auto parts maker Delphi are sold off, according to BDA’s Mr Wang.

For the Chinese companies, too, there is a logic to going overseas: many of the larger SOEs already have huge market share at home and competition in certain industries in the Chinese market is cut-throat – for example, in consumer electronics and domestic appliances. Why not go to other markets where margins might be more generous?

According to Angus Barker, head of Asian M&A at UBS in Hong Kong, obvious targets for Chinese companies are those with “good distribution and brand” but “not necessarily a manufacturing base where it rightfully belongs nowadays”.

And yet he does not believe a flood of Chinese overseas deals is imminent. “This is not Japan in the 1980s, with companies buying things left right and centre and everyone asking what’s next,” he says.

It is not just vociferous US politicians that are stemming the tide. Despite the stereotype of Chinese companies as giants bankrolled by the government for whom money is no object, most have been remarkably restrained to date. The most recent big deal to fail, for example, was a bid by China’s dominant mobile phone operator, China Mobile, for Luxembourg-based Millicom International Cellular, which has mobile operations in 16 emerging markets. Despite the huge amount of cash on the Chinese carrier’s balance sheet and its oft-stated desire to do a deal overseas, the price tag, $5.3bn, was viewed as too high and China Mobile withdrew its bid at the 11th hour.

That was not the first time that China Mobile had been put off by price. “Pakistan Telecom was the first investment it looked at, and it was outbid by a Middle Eastern operator, who probably paid too much for it,” says Francis Cheung, head of telecom research at CLSA in Hong Kong. “So it showed some restraint there, in terms of not paying too much money. Millicom was the same – there was an issue over price and the deal was not done.”

According to Leon Meng, co-head of China investment banking at JPMorgan: “The Chinese are very cautious. They are aggressive in thinking about going overseas, but they are very cautious about doing it, about actually pulling the trigger. And I don’t think that’s a bad thing, because there are deals that make sense and there are a lot of deals that don’t make sense at all.”

Inward investment

In spite of all the hype and although it is a definite growth area, Chinese outward M&A will continue to be dwarfed by investment into China, and even domestic M&A, Mr Meng predicts.

A look at the overall numbers confirms his view. Since the beginning of 2005, Chinese companies have done about 142 deals overseas, for a total volume of $11bn, according to data from Thomson Financial. That is an increase on the 41 deals, worth just $961m, that were done by Chinese companies in 2001, but it is still substantially less than the $32bn in overseas deals that Singapore, a city-state of just three million people, clocked up in the same period. Strip out one or two of China’s big oil deals and the total would be even lower.

Smaller Chinese companies, below the level of the big state-owned giants, are not tripping over themselves to head abroad. In Shanghai, one government official who is trying to encourage local financial firms to invest abroad says he is facing an uphill battle. “When I talk to them, they tell me it’s too expensive and they don’t have the money,” he says. “Plus they don’t have the management, the people, to do that kind of acquisition. Because for that you need people who know the international financial markets well, who can assess the value of assets, who can negotiate with the sellers. And a lot of the firms here in Shanghai are really very parochial. Their management do not even speak any English. So you cannot really expect them to be able to do a good acquisition abroad.”

Excited last year by rumours that China Construction Bank was considering buying a stake in US broker Bear Stearns – a link up that could have given the Chinese bank access to world class investment banking experience – the government official says he was disappointed to find out that the rumours were untrue.

Part of the reason for the caution is that Chinese companies are already operating in the hottest market in the world, their own, reducing the incentives to take a risk by going overseas. “They’re in a market that’s registering 11% growth per year. Why should they go overseas to markets with which they’re unfamiliar, where they don’t speak the language, and growth rates are only 3% a year?” asks Mr Wang.

Risky business

Going abroad certainly involves taking risks. “It would not be at all surprising if there were some messy situations that developed around Chinese acquisitions overseas,” predicts APCO’s Mr Horgan. “Either because the acquisition wasn’t a commercially astute thing to do, or paying over the odds for certain assets, or once they have become established and are operating in international markets they may not be au fait with environmental requirements, labour requirements and the competitive environment that is quite unlike their home market.”

Mr Horgan has already been proved right to some extent. The CFO of Chinese consumer electronics firm TCL has admitted publicly that when TCL bought television maker RCA from Thomson of France, it thought it was acquiring a premium brand, only to find later “it had deteriorated into pretty much a low-end brand”. The management of TCL is still trying to turn the acquisition around. Similarly in the MG Rover deal, Nanjing Automobile found out post-acquisition that another Chinese automaker had already bought the rights to sell the Rover 25 and 75 models in China, setting the stage for a protracted legal battle.

The jury remains out on Lenovo, which is widely viewed as doing everything right in terms of acquisition strategy, including hiring a CEO from Dell, moving a part of its corporate headquarters to the US and getting its Chinese chairman to present results to analysts in English. Not only is the IBM PC division still operating at a loss, but it also ran into trouble after it won a contract to supply 16,000 computers to the US State Department. Following the cries of outrage that the Chinese might use the computers for spying, the contract was only salvaged after the State Department agreed that the computers would only be used for non-classified work.

Lenovo, which has inherited IBM’s lobbying operation in Washington, was better placed to deal with the onslaught than most Chinese companies, and is probably the exception rather than the rule.

“SOEs face some challenges because their culture, their way of doing business, is quite different,” says Mr Meng. “It’s more of a people/social issue than a deal-execution issue; it’s what happens after a deal, rather than whether they can make a deal happen.”

Where there’s a welcome

As a result, investment bankers predict that the majority of deals will continue to be in the oil and gas sector where, buoyed by sky-rocketing energy prices that make some of their previous deals look very savvy indeed, Chinese companies can congratulate themselves on a job well done.

The UBS’s Mr Barker says: “I think most of the deals will continue to be in the natural resources area, where [the Chinese] feel they have experience and their oil majors have already operated offshore for quite some time. In other sectors, they are going to continue to be relatively cautious, perhaps seek to do things with partners, so they can at least manage their risk and build up acquisition capabilities over time.”

One clear trend that has been seen in a number of deals is Chinese companies that have little M&A experience teaming up with savvy private equity groups when buying up assets. “I think that’s a theme that will be with us for a long time to come,” Mr Barker predicts.

There may also be a tilt towards emerging markets: countries where foreign investment is more welcome than in some developed markets, and where Chinese companies have more experience. The close links being forged between Chinese steelmaker Baosteel and Brazil’s CVRD, and the high number of investments by Chinese companies in countries such as Nigeria, may be a sign of things to come.

THE JAPANESE ARE BACK

With US politicians fixated on the potentially sinister intentions of Chinese state-owned companies, the threat of corporate America being taken over by the Japanese seems to have been entirely forgotten. It was the Japanese corporate invasion after all – epitomised in Mitsubishi’s 1989 purchase of a majority stake in New York’s Rockefeller Center – that triggered off the previous wave of narrow-minded economic nationalism – or Asia-phobia – in the US.

Japan As No. 1, the title of a book by Harvard professor, Ezra Vogel, encapsulated everything that US citizens were worried about: that the Japanese would end up dominating the world economy as the most competitive industrial power.

These days, however, Japanese ambitions overseas raise hardly a comment. According to data from Thomson Financial, since the start of 2005, Japanese companies have done more than double the number of deals overseas that Chinese corporates have, for a total volume of $26.8bn (compared with China’s $11bn), and yet US politicians do not seem to be remotely concerned about it.

True, many of the deals are smaller, but there has been at least one blockbuster, potentially sensitive deal announced that would certainly have caused a furore if the acquiror had been Chinese: Toshiba’s $5.4bn takeover of Westinghouse Electric.

“The US seems to be ready to allow its entire nuclear industry to be bought by the Japanese, without batting an eyelid,” points out one New York-based banker, who specialises in Asian M&A.

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