LIGHT AND SHADOW
Running a business in China's non-state sector is no longer a daunting uphill struggle. But, though the government now allows privately owned enterprises to operate out in the open, their CFOs still have a long way to go before they can sweep the corners clean of dark secrets.
By Enid Tsui

Their happy faces were all over the front page. So was their uniform declaration: "I am so proud to be a 16th congress representative!" More party speak parroted by the faithful? Not this time, for these were a group of real newsmakers celebrating a significant moment in China's history. They were the chosen few - the first ever senior privately-owned enterprise (POE) managers to enter the portals of the Chinese Communist Party Congress. True, the 1997 congress had its own first when the party officially recognized the private sector as "an important part of the socialist market economy". December's congress, however, showed just how important a part the previously excoriated "capitalists" turned policy makers and leadership selectors had played.

Cynics and jaundiced sinophiles might view elevation of the POE representatives as somewhat ironic. After all, few could be unaware of the fate of POE chairman Yang Bin, arrested last November and charged with corruption, tax evasion and other crimes in a case which has yet to come to trial. His listed company, Euroasia Agriculture, is under investigation by the Hong Kong stock exchange for alleged false accounting. Yang is only one of many entrepreneurs now suspected of using illegal means to build their business empires, and Euroasia Agriculture is only one of many POEs to suffer blows to its growth due to those suspicions.

Surviving POEs, however, are doing more than just standing by, hoping to benefit from increasingly favorable government policies. Despite the recent scandals and their slower-than-expected profit growth, POEs still stand at the core of China's efforts to transform its state-controlled industrial sector from a lumbering giant to a sleeker, faster animal. By buying up ailing SOEs, some 150 POEs aim to run their businesses according to strict market rules rather than rushing for sales at the expense of profitability.

One such company, Dongsheng Group, can be found in the Gaoxin Technological Development Area of Xian. Its Beijing-based finance department is staffed by young local office workers and senior managers from Hong Kong, Singapore and Taiwan. Everyone mingles easily and, unlike the air of mind-numbing bureaucracy in most SOEs, there's a democratic feel to the place, set in motion by its charismatic chairman, Guo Jiaxue. A closer look at Dongsheng, however, shows the kind of light and shadows which surround so many POEs. Its management is doing everything it can to lift itself from the middle-ranks of the Chinese pharmaceutical industry and into the global arena. Some of those efforts may seem dubious to outside observers of China's anything-goes economy. Others are the conventional moves any company would make to revamp its finances in order to support its growth ambitions. One of the latter variety was chairman Guo's recent appointment of his third CFO in three years, Kenneth Wong.

Dressed in his well-cut suit, Hong Kong-born Wong has had to give up a lot to join Dongsheng Group: his steady climb up the international investment bank career ladder for one. Wong's CV includes corporate finance appointments at Morgan Stanley and UBS Warburg in Hong Kong and Canada and, before his Dongsheng job, he was a senior manager at AIG Investment Corporation. Then there's his girlfriend's decision to stay in Hong Kong and visit at weekends. And, finally, he's taken a colossal career bet on Guo and Dongsheng's future. But the odds of Wong's success remain long. One of his main jobs is to try and convince domestic and international investors that Dongsheng is one of the good POEs. The trouble is, the very man who hired him is well-known within the investment community for his wheeling and dealing, some of it on the fringes of acceptable business practices.

For example, Guo set up the public trading of Dongsheng's shares by buying the controlling share of a listed SOE. Two weeks earlier, that same SOE used IPO proceeds to buy one of Guo's trading companies. Remarkable coincidence? Possibly, but at least the clever timing sidestepped any accusations of related party transactions. Still, that's small consolation to shareholders who have yet to receive a dividend under the new regime.

Strange Bedfellows

Like many young, ambitious CFOs in China, Wong has been hired to recreate a company with a past that he played no role in creating. In Dongsheng's case, he's living with the company's successful but distinctly murky back-door privatization. (See “Where's the Money?” below) In fact, there are two types of listed POEs - the ones whose listings stem from their own successful applications and those that acquired listed "shell" companies from the state. The latter group bears a much heavier burden. These companies not only have to churn out good results from their original ventures, but also "fix" the often problematic SOEs that they've acquired. These companies account for around 150 of the 1,187 listed companies in China today. They still form the majority of listed POEs, since only 56 private companies have gained a direct listing.

Here's how Dongsheng did it. Founded by Guo in 1991, Dongsheng Group bought just under 29 percent of Shanghai-listed SOE, Qinghai Tongren Luye in November 1999 for Rmb59 million (US$7 million). Given that the company earned net profits of Rmb28.6 million (US$3.6 million) that year, this price valued the company at seven times earnings, a reasonable valuation for a company in a mature industry. The shares purchased were legal person shares and had belonged to the Tongren County state-owned assets management authority in Qinghai province. The Tongren County local government, which controls the management authority, sold the rest of its shares (23.54 percent of the total) to Shanxi Dongsheng Yaoye (often called Dongsheng Yaoye). Guo is known to own over 70 percent of Dongsheng Group, but his interest in Dongsheng Yaoye, which he also founded, remains unclear. The listed company made a statement through the Shanghai Stock Exchange in September 2000 that the two majority shareholders, Dongsheng Group and Dongsheng Yaoye, were in no way connected. Wong says: "Mr Guo owns none of Shanxi Dongsheng Yaoye. The two companies are entirely separate."

Considering there were 20 companies bidding for Tongren, Dongsheng Group and Shanxi Dongsheng Yaoye must have fought quite a few hard rounds to win control over the company. Guo's previous ventures were in beverages, pharmaceutical products and medical equipment, while Tongren Luye, the listed SOE, made aluminum ingots. Synergy was zero, but neither the seller or buyer seemed to care. Dongsheng's motivation was clear - it had been trying to apply for a listing since 1996. "A public listing can help a company move to a modern corporate structure as well as access the capital market. But back then, it simply wasn't possible for a POE to go public," Guo explains.

But why did the government officials sell to a bidder with no experience in aluminum? According to Wong and his boss, existing shareholders had been unhappy with how dependent Tongren Luye was on the aluminum market, where world prices can fluctuate wildly. Tongren Luye was particularly attractive due to its small debt load and high quality assets. Guo insists that the local government officials favored his group on the basis of its track record. Wong, sensitive to the slightest whiff of cronyism and unfair play in China, added defensively: "This is common practice in privatization sales all over the world. Even in the West, local governments have a say in who they sell assets to."

Wong is the third CFO to work with Guo and probably not the first to be in awe of his boss. Guo, with his height and booming voice, oozes charm and confidence. Describing the day Dongsheng Group took control of the listed company, he says: "It was the same feeling I had when I first touched the hand of my first love. I was so excited I forgot to eat the entire day!" Perhaps, but there was nothing poetic about the way he went about transforming the new company.

It took seven months to close the deal, but shortly after that, the listed company was renamed Topsun Science and Technology (Topsun). The listed company remained profitable, earning Rmb50 million (US$6.2 million) on sales of Rmb310 million (US$38.3 million) from its major operations in 2000 and Rmb 40.8 million (US$5.1 million) on sales of Rmb445.7 million (US$55.7 million) last year. Topsun specializes in the sales of over-the-counter (OTC) flu tablets, health supplements and anaesthetics for hospital use. It's a good market to be in. Sales in the OTC market expanded by an average of 16.3 percent between 1997 and 2000, and are still growing at similar rates.

Guo's next ambition is markets beyond China and this is where Wong comes in. He was hired, he says, for his international experience and is expected to take the company global - this applies to the sales of its products, acquisitions and fund raising. Wong, predictably, says he has a lot of faith in the listed company: "I've worked for international investment banks in Toronto and in Hong Kong at a senior level. All my friends think that to leave my secure job for a POE in China is madness. I may not have been here long but I'm certain I've made the right choice."

Legalized Queue-jumping

Indeed, a CFO of Wong's caliber would never have abandoned his home in Hong Kong if Dongsheng Group didn't have a listing. As for Dongsheng, it's not hard to understand its impatience to have publicly traded shares. In 2000, the old quota system for IPO applications, which favored SOEs, was abandoned. Any firm can now apply to the CSRC for a listing. But in practice, private firms are still excluded. Many hundreds of SOEs applied to list in the late 1990s, before the process was opened up to non-state firms, and have not yet had the opportunity to go forward. The recent bear market has further stacked the cards against private firms. Low demand for shares is restricting the China Securities Regulatory Committee's (CSRC) ability to allow IPOs to proceed. In the first seven months of 2002, Chinese companies raised Rmb46 billion (US$5.8 billion) through share issues, 51 percent less than the same period in 2001. According to the CSRC, as of August 2002, about 300 firms had already received permission to list, but could not do so because of the lack of demand. The vast majority of these firms were SOEs. As a result, the issuance waiting list is full.

Regulatory barriers are stacked against private firms too. The Company Law requires a company applying for public issuance to have been in existence for at least three years - with a return on equity of 10 percent or more for the three most recent years. Many large private companies only became shareholding companies in the late 1990s, meaning they joined the line of IPO applicants late.

Many more private companies, as a result, are expected to buy state-owned listed "shells," in effect, achieving a back-door privatization. Dongsheng Group and Dongsheng Yaoye had only one way of taking control - through buying farengu, or legal person shares. Indeed, only 26.5 percent of total shares were, and still are, publicly traded on the Shanghai stock exchange. The farengu, it turns out, were much cheaper than the publicly traded shares because they were priced according to the company's net asset value. Dongsheng Group formally took over its 28.9 percent stake on November 26, 1999. The share price on the secondary market during the seven-month period prior to that day averaged Rmb15.32 (US$1.92 cents) per share. But the two Dongsheng companies paid Rmb2.18 (US$0.27 cents) per share for the farengu. It was, says Guo, based on Tongren Luye's net asset value (NAV). This kind of deal, however, may not have much of a future. The CSRC's new rule on the acquisition of listed companies came into effect on December 1 last year, after three years of preparation. The section on pricing non-tradable shares stipulates that these should be sold at either the NAV, or the highest price paid for those same shares within the previous six months, whichever one is higher.

Sweet Medicine

Once the deal was done, Guo and his team quickly got to work. Between 2000 and 2001, the listed company (now renamed Topsun) used the cash it picked up through its back-door privatization and acquired two unlisted pharmaceutical SOEs. It paid Rmb12 million (US$1.5 million) in November 2000 for 80 percent of Gaitianli, a company owned by the Jiangsu Province Qidong Country government, which was both loss-making and heavily in debt. Topsun then bought 52 percent of Qinghai Zhiyao, a company which holds a monopoly over the production of anaesthetics and psychiatric drugs in China, for a total of Rmb70 million (US$8.8 million). The effect on the listed company's results was immediate - it recorded revenue of Rmb130 million (US$16.3 million) and Rmb11 million (US$1.4 million) of net profits in 1998. Two years after Guo's forces arrived, sales reached Rmb446 million (US$55.8 million) and profits tripled in 2001.

Of the two acquisitions, Gaitianli was by far the more important and highlights well just how sound business practices can transform sick state-owned companies into real winners. This rather shabby company had huge receivables, was heavily in debt and had guaranteed various third party bank loans. The local government honey-coated its sales pitch with assurances, telling the buyers not to worry about the receivables, the debt and the guarantees. They'd take care of them. The share transfer agreement included the promise that the Qidong county government would pay Rmb8 million (US$1 million) which Gaitianli owed its staff for retirement benefits, plus Rmb14.8 million (US$1.9 million) it owed in land tax. The Qidong County government also agreed to take over as guarantor all bank loans that Gaitianli guaranteed for other parties.

Most importantly, it agreed to collect Gaitianli's Rmb90 million (US$11.3 million) of receivables and to pay Topsun the outstanding sum in cash if it failed to do so by May 2002. It promised to collect another Rmb27 million (US$3.4 million) of receivables without setting a deadline. In return, Topsun promised the county government that Gaitianli, under new management, would generate a yearly revenue of at least Rmb300 million (US$37.5 million) in 2001. It would pay that much in value-added tax even if sales didn't hit target.

Topsun injected a total of Rmb70 million (US$8.8 million) to upgrade production facilities and in 2001, launched a re-marketing campaign for Gaitianli's main product, a flu tablet called Baijiahei ("White Plus Black"). In 2000, national sales were only Rmb23 million (US$2.9 million) for this product. In 2001, the re-launched Baijiahei, now color-fast (the ones made by the SOE faded easily), easier-to-swallow tablets in smart packaging, raked in Rmb239 million (US$30 million). In the first six months of this year, Baijiahei made Rmb43.7 million (US$5.5 million) of operational profits on sales of Rmb54.5 million (US$6.8 million), a remarkable 80 percent profit margin.

This one product accounted for 26 percent of Topsun's total revenue in the first half of 2002. In 2001, it made up 53.6 percent of total sales. The value of Baijiahei, according to Wong, is that it's the first nationally known, mainstream product in the Topsun stable. Marketing and advertising was by far the largest expenditure during Baijiahei's Rmb10 million (US$1.2 million) re-launch. A new product actually called Gaitianli was launched in 2001. In the first half of 2002, it sold as well as Baijiahei, had a similarly high profit margin, and together, the two made up more then half of Topsun's revenue.

The Sickness is Showing

Wong explains that it's not just a marketing success story. He blames the failure of many SOEs on their enormous, aged receivables and high costs. He says: "We are constantly trying to improve our collection processes." For example, he explains, the company introduced a strict credit management system for its distributors. It also worked on product pricing. "The re-launched Baijiahei is now in the same price range as Tylenol [around Rmb12 (US$1.5) per box]," he says proudly. And, unlike past practice, it is sold at the same price to distributors all over the country. "Each agent earns 3 percent commission on completion of sales. We've also cut down on production costs since we started an online, open, bidding system with our suppliers," he says. This encourages competition among suppliers and also makes bribery, which Guo admits was a serious problem in the past, very difficult. Today, the cost of making one multi-color Baijiahei box is Rmb0.115 (US$0.014 cents). The old black and white box cost the company Rmb0.185 (US$0.023 cents) each before the new bidding system. The new box alone has saved the company over Rmb3 million (US$375,000) so far. With the acquisition of Gaitianli, more importantly, Topsun took the first step to become a major player in the pharmaceutical industry. Baijahei became the top selling OTC flu medicine in the country a year after the re-launch. The original aluminum business was removed from the listed company in 1999. Today's Topsun makes over 95 percent of its income from pharmaceutical products.

All well and good, but nirvana is nowhere in sight. Despite Wong's best efforts, total receivables have now reached Rmb24 million (US$3 million), up from Rmb20 million (US$2.5 million) the previous year. The main reason is the Qidong County government. It has not kept its promise. The deadline for recovering Gaitianli's previous receivables, or in case of failure, compensation, has long gone. The same amount of receivables are still sitting on Topsun's accounts. No explanation has been released.

Further, the decision to let go of Tongren's aluminum business is now in dispute. In 2000, the business, worth Rmb61 million (US$7.6 million) in assets, was transferred to Number 2 shareholder Dongsheng Yaoye. In return, Rmb171 million (US$21.4 million) worth of the same shareholder's assets were put under the listed company. This was the Weiaoxin business, which makes a medicine for heart problems sold under the company name. The listed company paid around Rmb10 million (US$1.25 million) in cash to compensate Dongsheng Yaoye for the discrepancy in the assets' value. The local state assets management company, which sold the Tongren shares in the first place, objected to the swap. It wanted the listed company to keep the aluminum business but did not reveal its reasons. One can make a good guess, however. The business had always been profitable and just a month prior to the swap, Rmb30 million (US$3.75 million) of the IPO proceedings was spent on upgrading facilities.

Guo had to ask the higher level provincial government to fight for his case, which it did. While the deal's merits may never be entirely clear, the Weiaoxin business has become a significant part of Topsun's product portfolio, bringing in Rmb24 million (US$3 million) of revenue in the first half of this year. According to Guo, the aluminum business under Dongsheng Yaoye is still profitable.

Mixed Parentage

The question of the relationship between the two largest shareholders is still unanswered. When we spoke, Guo often referred to the two as if they were one. At one point, for example, he said: "We injected roughly Rmb17 million (US$2.1 million) of pharmaceutical assets into the listed company." Guo is only the chairman of Dongsheng Group and according to all disclosed material, holds no position at Dongsheng Yaoye, a company he founded. The two companies seem to act with one mind, however. Earlier this year, Guo went on a crusade to win the controlling share of another state-owned, listed pharmaceutical company called the Lizhu Group. The Lizhu Group is a huge player in the flu medicine market. Dongsheng Group bought, with its own money, the largest chunk of Lizhu Group farengu available.

Competition arose from the secondary market, however, where there were enough free floating shares around for one buyer to take control of the company. That buyer was TaiTai Group, another POE. It launched its own IPO in June 2001 and was loaded with cash, which it used to snap up tradable ordinary shares. Guo did not drag Topsun into the fracas directly but at that point, both the Dongsheng Group and Dongsheng Yaoye mortgaged most of their Topsun shares in exchange for large sums of bank loans. The timing suggested their intention to join in TaiTai's buying frenzy. If that's the case, they weren't quick enough. TaiTai eventually took majority control of Lizhu Group. This episode not only put the rest of Topsun's shareholders at risk (since they could have found themselves investing in a company run by banks), it also strikes home the fact that the majority owners' lack of transparency is at a very high level, even for China.

Meanwhile, Wong is struggling with more prosaic matters, namely restoring the company's overall profitability. While sales may have shot up, profits have fallen under pressure. Total revenue, largely driven by the two Gaitianli products, rose by 43 percent between 2000 and 2001. Yet net profit fell from Rmb53 million (US$6.6 million) to Rmb41 million (US$5.1 million), or 23 percent, in the same period. One culprit is probably interest payments as long term debt has gone up from Rmb19 million (US$2.4 million) to Rmb54 million (US$6.8 million) from 2000 to 2001. The acquisitions were funded partly by the Tongren Luye share proceeds, but mostly by bank loans. While buying Gaitianli appears to have been a wise move, the other acquisition, Qinghai Zhiyao, only contributed around Rmb0.9 million (US$112.500) of revenue in 2001. Unfortunately, the stock market has proved useless as a source of cash. The company's application to issue new shares has been postponed for over a year because of poor market conditions.

Another pressure on profits, Wong explains, is that the company started selling three new products in 2001 which increased costs in many areas. Also, the company still needs to invest a lot on marketing and advertising. "We are building a good, solid, platform to launch a more diverse range of products under the Topsun name in the future," he says, again. As for the matter of improving the company's transparency, Wong is looking forward. He's working on a business plan, using discounted cash flow models, which he hopes will pull in a strategic foreign investor. No doubt his travels will take him to Hong Kong, Singapore and perhaps as far as the US. His job, in sum, will be to shed some light on all those shadows.

Enid Tsui is the editor of CFO China, sister magazine of CFO Asia. Stephen Green, director of Asia research at London's Royal Institute of International Affairs, contributed background research.