FRANKFURT - ALL ABOARD!
Hubei Pharmaceutical's journey to a euro listing could serve as a model for other China plays.
By Jennifer Lee

That may be so, or is perhaps a little disingenuous. Hubei now has a doorway to raising equity in Europe, where the pharmaceutical industry is a favorite play and investors with strong euros are eager to buy a stake in China's future.

Searching for China Gold?

The company has ambitious founders. Hubei started as the dream of Reid Li, a Chinese investor who was seeking to form a vehicle to invest in local companies. Li settled on the pharmaceutical industry as an ideal entry point into China, confident of the sector's tremendous growth prospects.

He began looking to buy Chinese companies in 2001 through his own US investment vehicle, Red Dot Capital. "[He] realized that there was an excess of 8,000 pharmaceutical companies in China, and that the government wanted to consolidate the sector," says Fletcher. The government had intervened actively to force consolidation. One way to achieve this was through privatization. (As of this January there were more than 3,000 pharmaceutical companies left in China.)

Li went about searching for the right prospect with the methodical savvy of a seasoned venture capitalist. He and his team began by selecting the region. "Xiangfan (in northwest Hubei province) is the hotbed of high-tech in China," says Fletcher. Its other advantages include universities and a ready source of high-skilled labor, an abundance of natural resources, and easy access via road and rail to another nine major cities in China.

The team met with "many tens" of companies and, from these, they narrowed down to just a few. They insisted that the companies be cash positive, but were only able to look back three to four years because of the consistency of the bookkeeping. What could they offer? A Western perspective on management and market penetration, and techniques for maximizing profitability.

Finally, the group selected Hubei Zenith Airbeck Pharmaceutical, a state-owned enterprise with 4,000 employees that had been in business since 1968. Zenith Airbeck was already a supplier to domestic and international markets. Its business focused on contraceptives (a sure market with the country's one- child policy; the company produces one-seventh of China's contraceptive requirements), steroids, antipyretics and analgesics, and tranquilizers. Competition was strong, but then Zenith's contraceptives were listed as part of the central government's national planning initiative, and it had a new product - the morning-after pill, dubbed Luoshuang.

The deal they struck involves several moving parts. Red Dot formed a joint venture with Zenith Airbeck's dosage division, which had been producing about a third, or US$9 million, of Zenith's annual revenue. Dosage was more profitable than the company's bulk division, it's only other unit. The joint venture took the name of Hubei Pharmaceutical Company. Red Dot took majority control, at 57.14 percent, injecting 40 million yuan of the joint venture's 70 million yuan book value. Zenith Airbeck injected 30 million yuan and retained all of the state-owned company's existing debt.

The deal also involved trademark and re-registration of the dosage division's 120 pharmaceutical products and underlying licences; opening a wholly owned subsidiary in Wuhan that would act as sales agent for both the joint venture and the Zenith Airbeck bulk division; and leasing facilities from Zenith Airbeck at "favorable rates".

So how were Li and his team able to convince Zenith Airbeck to give Hubei Pharma control over the cream of its business? "There's no question that these were lengthy and complex negotiations," says Fletcher. It took time to build the trust required for the deal to go through, and it was key that Li was a local. "We were not parachuting people in to do the deal," says Fletcher, noting "That is essential in China. Even if [a company has] a Chinese national who spent most of his life abroad, it won't work."

Still, it took nearly two years to convince Zenith Airbeck that the new management was not going to come in and slash-and-burn. Li and his partners actually sent in a transition team before the joint venture was finalized. The team ended up staying for 18 months. A key point is the length of this transition period. Many of the changes that the group introduced into the company took place before any move to make a public offering. "We had the basic agreements by then, but it was undergoing a number of changes," says Fletcher. "We would have had to report on things that were going to change a month or two later."

A Reverse Takeover

Fletcher looked around for a candidate for a reverse takeover last year, settling on Pan Asia Communications, a telecommunications firm listed on the OTC Bulletin Board. Pan Asia had first listed as Explore Technology in 1998 and had failed in an attempt to buy a communications company that spanned China and Singapore. It was essentially a shell for a business venture that had stalled.

Like all reverse buyouts, it involved some fancy footwork. Under the deal, Pan Asia used shares to buy Red Dot's 57.14 percent interest in the joint venture, but paid so many shares to Red Dot that the private company actually become the owner of the public one. Pan Asia's shareholders became a minority partner in a completely new, and promising business plan. As soon as the transaction was finished, Pan Asia changed its name to Hubei Pharmaceutical Group and set about educating its new group of shareholders.

Next on the bill was the cross-listing in Frankfurt this January. It "was done as a thank you to European investors who have supported [the company]," says Fletcher. What he means is that for European investors who want to sell stock, the Frankfurt bourse is preferable because it is more easily accessed and is cheaper than going through American brokers.

Could a future offering via Frankfurt be in the cards as well? "Europeans seem to understand that China is going to become the dominant world economy," says Fletcher, "and they seem to like the pharmaceuticals business." The listing, says Fletcher, will have "no immediate fundraising impact." He admits that there were costs associated with going to Frankfurt, but that they tried to minimize these by doing a lot of the groundwork themselves.

For now, in China, Fletcher and Li are concentrating on growing the company. The joint venture already recorded an increase in turnover for the first six months of 2003 to US$6.7 million, and Fletcher projects turnover to hit US$15 million in 2004. They are also looking to make more acquisitions, possibly including the bulk division of Zenith Airbeck. And what of the excess employees and debt in that unit? Given the government's interest in consolidating the sector, Fletcher says it is likely they will be able to trim the workforce. And as for the debt, he says that it is quite common for 50 to 60 percent of debt owned by state banks to be written off, and that even 100 percent might be possible. Toward that end, Hubei doesn't want to appear too keen, so it can get the best possible deal.

Obviously, it's early days for Li and Fletcher's China play. The two don't even rule out moving out of the OTC Bulletin Board and seeking a listing on Nasdaq. Why didn't Hubei list on Nasdaq instead of Frankfurt in the first place? Fletcher says: "While we may do this, in the end it was not a good use of the investors' money [today]." By listing in Frankfurt, "we simply set the stage to put us on a more competitive footing in the future, and we think that's good for shareholders."

Jennifer Lee is a contributing editor at CFO Asia