GOODBYE, GUANXI
China’s politically connected companies are under pressure to overhaul financial
management. The initial success of China Gas may indicate cause for some optimism.
By Cesar Bacani

The Hong Kong-born Leung, 45, is mindful of the misgivings, but he’s a man with a plan. “Last year was very much a corporate finance activity year,” he says. “This year, I have two objectives. One is investor and media relations work, and the other is financial management.” He promises to be transparent with fund managers, retail investors, analysts, and journalists. He will also spend up to US$3m on an ERP platform that will unify diverse systems at the company’s 50 subsidiaries. Leung will focus on internal control and risk management in 2007. “I can do these things only if I have reliable and real-time financial systems,” he explains.

Limits of guanxi

These days, even politically well-connected Chinese enterprises are discovering that they must put in professional management, and fast. Relying on guanxi – personal connections – while making do with unskilled managers is no longer enough in a market that is opening up to foreign competition, reforming business rules, and raising capital in domestic and foreign bourses. The trend is evident in the finance sector, where geographic and customer restrictions on foreign banks will be removed this year, distribution and retail, insurance, telecommunications, and infrastructure.

Tianjin Port Development Holdings, for example, hired Hong Kong-born Daniel Lai as CFO last November. The 38-year-old former external auditor had held key finance posts in Danish multinational Akzo Nobel and conglomerate China Resources. In February this year, Shanghai Prime Machinery appointed as its CFO Wang Pin, 32, previously deputy manager of the internal control department of Shanghai Gong Xin Zhongnan Accounting Firm. In March last year, Bank of China hired New Yorker Lonnie Dounn as its first-ever chief credit officer. But the the former HSBC executive recently tendered his resignation “for personal reasons” effective in September, a reminder that transforming financial management at Chinese companies can be tougher than expected.

The winds of change are also blowing in the piped gas distribution sector. Among other changes, China has issued new regulations to reform the bidding process for city gas distribution, replacing private treaty negotiations between city mayors and gas companies with public tenders (see box, page 21). As Leung’s success at raising capital shows, a professional CFO can bring business transformation to a guanxi-laden company. However, it’s too early to say how he and other newly hired CFOs will fare when it comes to internal control, risk management, and other operational areas.

So far, Leung and China Gas are reading from the same page. The company knows it has to bend with the shifting winds. China Gas competes not only with older local players like industry leader XinAo Gas and Panva Gas for monopoly contracts to distribute gas to individual Chinese cities. It also goes head-to-head with Towngas, a Hong Kong utility established in 1862. Towngas is cash-rich, has a deep management bench, and boasts more than a century of experience in gas distribution, which are key considerations for a local government that must make sure its chosen utility can safely supply households and businesses with gas for 30 years.

Before the reforms, China Gas had seemed a shoo-in for industry leadership, with or without professional management. Founder and chairman Liu Ming Hui had built up guanxi with many local governments as a result of a city garbage incineration business he set up in the 1990s. He also enjoyed good relations with Strait Finance, a unit of the Taiwan desk of the State Council, China’s cabinet. The central government was open to the private sector getting into the natural gas distribution business, part of its drive to replace usage of pollution-causing coal with cleaner burning gas. And Chinese oil companies were discovering abundant gas deposits and building pipelines to transport the gas to the cities.

In 2001, Strait Finance had taken over a listed shell company in Hong Kong for the purpose of turning it into a Taiwan travel business. But the plan was scuttled as relations between Beijing and Taipei soured. Liu persuaded his friends at Strait Finance to make the shell company a city gas distributor instead. Beijing approved the proposal in 2002.

Liu and his managers were given stock options to run what is now China Gas, with Strait Finance as key shareholder. In just four years, China Gas signed agreements with 49 cities, nearly as many as XinAo Gas, founded by private entrepreneur Wang Yusuo in 1993, did in a decade. To raise working capital, Liu periodically issued new shares to the public and made private placements. By the time Leung was hired in 2005, the majority of the shares were in public hands, with Strait Finance, Liu and his managers, and state-owned oil company Sinopec as substantial shareholders. But there was potential dilution – in 2004, outstanding options exercisable by the managers equaled some 14% of the issued stock.

Enter the banker

Leung says his focus on corporate finance should be seen against this background. In the current industry climate, where public tender rather than private treaty is the way to win contracts, “no matter how good a relationship you have with the government, if you don’t have the capital, there is a limit to your expansion.” The greater transparency means local governments will be looking more closely at the company’s financial resources, expertise, and track record in constructing and maintaining gas pipelines, as well as its ability to source natural gas over the life of the concession.

Leung’s first task was to determine China Gas’s capital needs for fiscal years 2005, 2006, and 2007. The figure came up to US$300m, reflecting its goal of increasing revenues to 1.8 bn renminbi (US$224m) in fiscal 2007, nearly five times sales in fiscal 2004, and eventually becoming China’s dominant city gas player. The problem was that the company’s inexpert handling of stock issuances had come home to roost. “I went to see almost 90 fund managers in North America and Europe,” the CFO recounts. “Essentially, they said we had too high levels of outstanding options and warrants. They were worried about equity dilution.”

So Leung turned to the debt capital market. He wrapped up a US$60m loan from a syndicate led by Société Générale in April last year. Two months later, he issued US$40m worth of convertible bonds. The proceeds took care of capex for fiscal 2005, but both deals have to be repaid in only five years, which does not jibe with the typical natural gas project’s cash flow. Construction of a city gas network lasts between 12 to 18 months, and achieving 60% penetration of all households, considered saturation, takes another six years. By the time the loans mature, the projects they funded would still be incapable of fully servicing the debt.

Leung’s solution was to tap longer term loans by development banks. These are typically granted on non-commercial terms, with the main objective to aid a country’s social and economic development. China Gas, Leung reasoned, should be a good match for development funds because it is in an environment-friendly industry. He approached FMO, the development finance company of the Netherlands, which has a reputation for backing environmentally friendly projects. Last October, FMO and French development bank PROPARCO granted China Gas a nine-year US$50m loan facility.

Leveraging Liu’s guanxi and that of Strait Finance, Leung also got a meeting with China Development Bank (CDB), which makes policy loans to further national programs. “We laid out our business plan for what we wanted to do in the next five years,” says Leung, “how we can contribute to the community, and what we can do to become a downstream player in natural gas.” Upstream operators like PetroChina and Sinopec, he told CDB, do not have the expertise for the last-mile task of connecting homes and factories to their natural gas fields. China needs a downstream player like China Gas to help meet the country’s goal of making natural gas account for 8% of total energy usage by 2010.

It took nine months, but CDB finally approved a loan facility for an unprecedented 20 bn renminbi to be repaid in 15 years. “We don’t need to repay the principal for the first five years, so we can conserve cash as we work toward household saturation,” says Leung. Up to 4 bn renminbi can be used as equity contribution, further conserving funds. A city gas project requires equity contribution from the concessionaire equal to one-third of the total investment, with the balance to come from borrowings. CDB will match China Gas’s equity contribution dollar for dollar, up to 4 bn renminbi, thus halving the internally generated funds the company needs to stump up.

The interest rate matches the central bank rate, with the possibility of a 10% best customer discount. Leung had also achieved a favorable pricing for the nine-year FMO-PROPARCO credit line, at LIBOR plus 235 basis points (equivalent to around 7.75% currently). The five-year Société Générale loan is priced at LIBOR plus 150 basis points, which comes to 6.9%.

Anticipating today’s interest-rate rises, Leung swapped both floating-rate loans to fixed rate, good for 30 months. China Gas is now paying only 5.05% per annum on the Société Générale loan and 5.73% on FMO-PROPARCO. “I expect the US Federal Reserve to have another hike (in June),” says Leung, “but interest rates will then stabilize for some time before they start coming down, probably in the second quarter of 2007.” If interest rates do fall, he would let the commercial loans lapse back to floating rate.

Making new friends

Despite worries about dilution, Leung also completed three equity stake sales, raising an additional HK$644m (US$83m). “It’s not just the money,” he says. “It’s the synergies China Gas can get from partnering with new shareholders.” China Gas issued 210m new shares to the Gas Authority of India Limited (GAIL) in February last year, 133m to fund management firm Templeton in October, and another 210m to Oman Oil the following month. GAIL, Oman Oil, and Sinopec now each own 7.4% of China Gas. Templeton, a key institutional investor, has 4.7%. Strait Finance is the single-largest shareholder with 12.1%, followed by management with 9.3%. The public holds 51.6%.

GAIL is central to China Gas’s plan to enter the CNG (compressed natural gas) business, a far more lucrative franchise than household distribution. Cleaner and cheaper than petrol, CNG is used as fuel by modified taxis and buses. “In China, one family burns only 0.5 cubic meter of natural gas a day for cooking, heating, and other activities,” says Leung. “A taxi on an eight-hour shift burns up to 40 cubic meters; a bus uses 65 to 70 cubic meters.”

GAIL already sells CNG to more than 200,000 taxis and buses in Mumbai and Delhi. A joint-venture agreement is currently awaiting approval by GAIL’s board. China Gas is interested in GAIL’s engine conversion technology, which Leung says is 30% cheaper than the current Chinese method, and also hopes to learn from GAIL’s experience with CNG problems like engine knocking and corrosion.

Oman Oil brings another sort of strategic value to the table. “We’re looking to them for resources input,” says Leung. “PetroChina wants to have as much oil as possible, so we can arrange for our shareholder, Oman Oil, to sell them, say, 10m barrels of oil. In exchange, we’ll ask PetroChina to increase its allocation of natural gas to us.” Gas supply is becoming a pressing issue. PetroChina’s 4,200-kilometer West-East Natural Gas Transmission Pipeline saw demand in 2005 exceed forecasts by 28%, but was able to increase transmission by only 16%. PetroChina now expects to reach the pipeline’s maximum transmission capacity of 12 bn cubic meters in 2006, a year ahead of schedule. “By 2007 to 2008,” Leung worries, “demand may be so staggering that supply may not be sufficient.”

Industry players are responding in various ways. XinAo Gas is slowing acquisition of new projects, focusing instead on maximizing gas connections in the cities it already serves. The company’s 59 concessions give it access to a connectable population of 32m people (versus 17m at China Gas, with 49 concessions), but only 10% are users of piped natural gas (China Gas: 13.6%).

China Gas is going the other way, aiming to increase the number of cities under coverage to 56 by 2007. To ensure gas supply, it plans to build LNG (liquefied natural gas) processing plants near gas fields owned by minority shareholder Sinopec. It is also looking at building its own LNG terminals that will store imported gas, a hugely expensive undertaking currently being done by the upstream players.

Now the hard part

Can a four-year-old company that has just hired its first-ever CFO execute on its big plans? Analysts are keeping an open mind, but some are worried. “We are concerned about current cost control,” says Aochao Wang, an analyst at UOB Kay Hian (Hong Kong) Research. Distribution, administration, and financing expenses jumped 175%, 194%, and 255% respectively in the first half of fiscal 2005 ending September. Blaming rapid expansion, China Gas says most of the spending was for one-off items such as new branch offices.

JPMorgan, an investment bank, notes that new connections dropped 6% year-on-year in the first half. One-off connection fees, which city gas utilities are allowed to charge even before supplying gas to customers, are an important source of revenues while construction is still going on. New connections at XinAo Gas have also slowed, resulting in the ratio of EBITDA to cash interest expense falling to 4.2 times, and prompting credit-rating agency Moody’s to downgrade its outlook for XinAo to negative. Leung cannot say what China Gas’s EBITDA/interest ratio is in advance of a results announcement in July, but it is likely to have deteriorated as well.

Fears over equity dilution, at least, may subside. The size of the concessional CBD loan is five times market capitalization, notes CLSA, another investment bank, implying a lower risk of China Gas issuing new shares. Leung has just announced a decision not to go ahead with a stake sale to Korea Gas, in part to avoid dilution. But JPMorgan estimates that outstanding management and employee stock options now equal 18% of issued capital. “We do not have any plans to issue new options of any material magnitude at this time,” says Leung, who defends the options as making up for low salaries at China Gas.

Going forward, can Leung continue to make a difference? Talking about Chinese companies in general, Martin Fahy, director of development at the Chartered Institute of Management Accountants, Asia Pacific, is optimistic. “The success of firms such as Lenovo, China Merchants, and Cosco illustrates that finance professionals in Chinese companies are capable of competing at the highest levels,” he says. Fahy estimates that China already has 12m accountants, of whom around 120,000 have qualified with the national accounting body. The next challenge, he adds, is to ensure “conformance with the highest ethical standards and international level of enterprise governance.” That would be saying goodbye to guanxi, indeed.