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Archive for August, 2011

In this post I’m back onto the subject of VIEs, or more specifically VIE disclosures. Previously I’ve focused on US-listed companies using VIEs, this is not only because many of the bigger companies using VIEs are listed there, it’s also because of the sometimes lacking disclosure we find on other exchanges.

Professor Gillis had a good post on this earlier where he discussed the disclosures we find in Hong Kong, with many companies reporting VIEs as wholly-owned subsidiaries without any added information to guide investors. The standard statement for this reads:

The consolidated financial statements incorporate the financial statements of the Company and entities controlled by the Company (its subsidiaries). Control is achieved where the Company has the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.

This is something of a weakness that’s available for companies under IFRS, and it is severely inhibiting investors from gaining a proper understanding of the risks involved in their investments. The lack of information can easily lead to investors not properly examining the company’s VIE structure, it’s also entirely possible for even professional investors to completely miss the fact that a VIE structure is in use.

I would like to add to Professor Gillis’ statement regarding the dangers present in Hong Kong and draw attention to the fact that this also goes for other exchanges operating under IFRS. Most notably, perhaps, Singapore and London.

Needless to say, investors on these exchanges looking at Chinese stocks will have to be extra careful when researching new investments, and looking over the old ones might not be a bad idea. The potential economic downside to missing a VIE structure, or even not seeing the entire picture could be massive, as we’ve seen in recent times.

I personally believe that anyone investing in a VIE structure needs to do extra due diligence to map out the possible effects it might have, and what the company has done to mitigate risks and plan for worst-case scenarios. This need is only amplified by the current lack of information normally provided under IFRS.

As there is sometimes no disclosure, investors have few options other than even more extensive DD for finding out how well planned these structures are, and it would certainly be much easier to hide an ill-made VIE structure under these circumstances.

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With Tudou evermore anxious to press ahead with its IPO, come what may, the circumstances are ripe for speculation and rumours. Some will likely be far fetched, some probably even ludicrous, but there’s one that I find quite intriguing; that Tudou won’t ever make it to an IPO, but will instead be snatched up by Baidu.

As with any rumour caution is adviced, it could be wild speculation, someone might want to sell papers, or the information might have been planted by one of the players with ulterior motives. But I find the idea of this M&A move quite intriguing so I’ll take a few minutes to discuss whether or not I think it would make sense.

As I spent my previous post stating that the Tudou IPO is most likely due to circumstances forcing the hand of management, it might seem strange to entertain the idea of a Baidu bid taking it off the market. But there are some pretty interesting synergies and circumstances that could push developments in this direction.

Let’s start by looking at this from Baidu’s perspective. Could Tudou offer value to the company?

There’s little doubt that the online Video market in China has huge potential, Baidu have in fact got their own venture in the market, Qiyi, which has been seeing quite good growth numbers in the past. So the opportunity is there and Baidu definitely want to be a part of it. Thus, getting hold of the second largest player in the market would, of course, be worthwhile.

The existence on Qiyi would also allow Baidu to swiftly integrate the two services to create one larger platform to rival market-leader Youku. Adding a strong brand name to the current Baidu strategy of pushing Qiyi through it’s search results should add credibility to the offering as well.

Further, If the rumours about Youku being a default app in CMMC iPhone are true the company is setting up to take advantage of Tudou’s fall to shore up its position as number 1. If Baidu wants to make a move now could be the time.

Looking at Tudou, I believe the company is desperate to make something happen quickly, and their latest SEC filing would suggest that they need a serious cash-infusion, preferably yesterday. Add to this the fact that even though the word last week was that the company would IPO “any day now”, or even “within 2 days”, the earliest likely IPO date right now is 20/8.

The markets are crashing everywhere, Chinese companies have been particularly undervalued due to dodgy accounting, more and more people are realising VIE-structures carry real risks (especially when ex-wives still hold claims to them)… This is not looking good, and the way the company is haemorrhaging money it’s losing value at a rapid rate. Day by day a Baidu buyout will look more and more appealing.

I think Baidu could add good leadership and management practices to Tudou, as well as some political and business clout to make things happen for the company. However, I maintain that Tudou is not worth what the company is currently asking, so Baidu would likely play the waiting game and look to snatch up market share on the cheap as Tudou get more and more desperate.

I now cede the floor to further speculation by others.

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As Tudou looks set to finally IPO any day now a lot of questions are being asked. Some people are scratching their heads to understand why the company is pushing forward with its plan to go public, even though the conditions seem anything but good.

The company has had what might be called an on-again-off-again relationship with its US listing, mainly due to issues related to the divorce of the CEO and owner, Gary Wang. In this proceeding the ex-wife of Mr. Wang sued to get 76% of the company’s operational VIE. This was then settled but the company has still struggled to get its IPO underway.

There are some serious issues to be raised here, and investors should take them into account when deciding on the stock.

1. Tudou operates in the highly saturated and competitive online video market in China, it’s the second largest player by market share after Youku. However, it is trailed by many other players, including Xunlei, and Baidu’s Qiyi offering, and some of these are rapidly gaining ground. So the company is second in the market and trailed by many fast-growing alternatives, its competitive position should hardly be described as strong.

2. The business itself is stretched. The company is in a similar situation to where market leader Youku was a year ago: it’s not making money, and needs some way to secure financing for its continued operations. The big difference here is that Tudou actually filed for an IPO before Youku, but due to a constant inability to see it through they have lost the confidence of many potential investors

3. The current market conditions for Chinese companies might be described as hostile at best. Too many frauds have surfaced, and there is widespread skepticism about almost every Chinese company listed overseas.

4. The company has probably the most insecure VIE structure I have ever witnessed. There has been no attempt to align the interests of VIE owner and new investors, the VIE can operate entirely on its own, and to top it off the actual ownership is still in question.

Even though Mr. Wang has settled his divorce the settlement is dependent on his former wife receiving cash payments before and after an IPO. As far as we know there are no other conditions but I have yet to see any full disclosure on this point. If Mr. Wang fails to meet his obligations his ex-wife may still be entitled to 76% ownership of the VIE, in which case it would be up to her whether the VIE will continue to operate as a part of Tudou or not. As the divorce appears to have been nothing but messy I’d bet on the second option.

So why is Tudou pushing through its IPO in these conditions?

Best guess at this stage is because they had to do it, the current conditions have left management with no other option readily available. The company needs the money, and perhaps more importantly Mr. Wang needs to pay off his ex-wife. So with the backs against the wall they have no option but to bravely press on.

As for the question of who would be brave enough to purchase stock in a company operating in a saturated, highly competitive business with little history of profits, and has repeatedly failed to conclude its IPO, and also risks losing its entire operations depending entirely on actions not associated with the business, in a hostile market… We’ll just have to wait and see.

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