A smallish diversified pump and motor manufacturer located in the Chinese equivalent of Nebraska wouldn’t ordinarily rate a second investigation but Harbin merits a serious exception.
Recall that Harbin is currently pondering a $24 per-share buyout from its founder and chief executive Tianfu Yang and Barings. White shoes abound: Goldman Sachs is advising Barings and has expressed a willingness to sell up to $470-million in loans to get the transaction done. The company, faced with the possibility of being the first Chinese reverse-merger to get LBO’ed, has its own prestige advisors: Morgan Stanley and the Gibson Dunn Crutcher law firm.
This should be easy for them.
It won’t be though. FI.com has reconsidered it’s initial skepticism and is now prepared to argue that something is terribly and horribly wrong here.
A look at their operating margins prior to the Simo Motor purchase in October 2009 is all that need be said: In 2008 they were 28.5%, in 2007 they were 36.3% and in 2006 they were 34.6%; until the recent surprise bad news, they were 26.3%. As we’ll see below, they are not replicated anywhere in the world of low-tech commodity manufacturing. Despite assurances, or at least the liberal use of the word “high-end,” its business is absolutely nothing of the sort.
[According to several investors who have contacted FI.com, the low selling, general and administrative and research and development costs are because its major clients--including the PRC government--simply deal directly with Harbin. Concurrently, there seems to be a uniformity of opinion among arbitrageurs and investors that CEO Tianfu Yang’s political role in the local Communist party allows for contracts to be steered the company’s way.]
To investors, the fact that every other company has to wrestle with issues like S,G& A and R&D is the primary feature to owning the shares of Harbin Electric, not a bug. That, and the prospect of a $24 LBO payday, are fully understandable reasons for enthusiasm and, to FI.com, the best arguments investors and arbs can make.
As a basis for security analysis though, especially if institutional investors entrust you with their hard-earned capital, it is far from rigorous.
Perhaps a visual representation of how much Harbin differs from its peers might clarify a thing or two.
Look at these charts on sales per employee culled from the recent 10-K and 10-Q filings of Harbin and the companies management has said in conference-calls are its competition. Look how much less efficient Harbin is. Harbin is a conundrum worthy of the Oracle at Delphi: It’s margins are a multiple of the competition but is absurdly ineffective as an enterprise.
The only way to resolve this incongruity as a shareholder is to conclude that Harbin’s products are so utterly unique that they have A) an effective monopoly with no real limits placed on what they can charge which makes B) operating efficiency less of a criteria.
FI.com sees it differently.
The only way the 2006-2008 margins were obtainable is via selling to customers that are captive or otherwise beholden to Harbin for some reason. OEMs, China-based or otherwise, simply cannot pay enough to warrant 28%-36% operating margins. Investor relations officer Christy Shue mentioned on the most recent conference call that raw materials make up between 70%-75% of their cost of goods sold, with wages about another 10%. Given that the global metals market is an incredibly efficient market, with little cost differential save for shipping and tariffs, they have only 10% per unit to develop a cost advantage (less actually since they have to pay workers something.) China’s wages are indeed lower than the West’s, but if this is what passes for either the Chinese economic miracle or Harbin’s “killer app,” Harbin is closer to the long walk home than FI.com supposed.
Allow FI.com a brief philosophical interlude: 95% of Harbin’s business is in China and so we can presume a broad uniformity of cost structure between it and its competitors; there just isn’t that much Harbin can save on wages versus another Chinese competitor. So over time, pricing is going to be competed down to just above the cost of production. The way around that is trade barriers (tariffs), originality of product or the absence of competition. FI.com is confident that these circumstances truly do not apply to Harbin.
[FI.com made an effort to try and contact Shue and Harbin's outside PR firm, Christensen Investor Relations--where she worked prior to joining Harbin and which has a nice little franchise advising all sorts of Chinese companies--but to no avail.]
None of this is to say that Harbin doesn’t have a real business. It does. In October 2009, Harbin paid $130-million to acquire Simo Motors, a 50-year old formerly state-owned enterprise whose financials also raise a host of questions, albeit of a more standard variety.
For the charitably disposed, there are two good things that can be said of the Simo deal: That it presented Harbin with a legitimate and deep roster of OEM customers and that at the time of purchase, the company had undergone a miraculous cost-structure transformation.
The first speaks for itself; the second needs some explanation.
In this deal-related filing, we see an epic decline in the cost of revenues as a percentage of sales to 70% for the first-half of 2009 from 88% in 2006. Wow. It is not every day you see a commodity manufacturing business able to wring 1800 basis-points of cost out of the income statement over three short years, yet continue to grow at double-digit rates. Just as eye-catching however was the improvement of profitability from the initial announcement, which showed a net margin of 8.9%, to the first-half of 2009’s 11.3%.
That anyone paid $130-million for this (or just under seven times 2008 net income) is interesting in light of the fact that Simo’s retained earnings account was negative $6.87-million in 2006, although soon to improve to $11.5-million. This begs the question: Was Simo just in a rough spell in 2006 or was it unable, over its previous 47 years, to make much money?
Moreover, its statement of cash flows shows that it–like its new parent, Harbin, was funded primarily via short-term debt–and that it’s free cash flow over the previous 3.5-years was a negative $45.7-million. As baffling as some of the above is, there is an earnestness to Simo’s filings. A company in a competitive low-tech industry that had long been state-run is supposed to have a hard-time generating cash and likely is in need of short-term debt to make the business run. No one should suppose that in nine months Siemens is going to have to deal with a fearsome new competitor.
As a brutal flip-side however, there is the issue of capital-expenditures.
Simo’s infrastructure dated back to the 1960s, according to the most recent conference call and has to be entirely replaced. This has forced Harbin to spend $57.5-million through three quarters (versus $40-million last year) and there are dozens of millions more needing to be spent. This is ugly and it will get uglier when they start running depreciation through the income statement on all of that cap-ex that the company currently has tied up in construction-in-progress. Clearly, prodigious cash-flow generation is going to be needed.
They aren’t going to get it.
According to the 10-Q, for the nine-months Harbin generated $79.1-million in cash-flow from operations. We can back into a figure of $30-million generated in the third quarter since at six-months it was $49.1-million. But if you dig into what Harbin is seeking to do, it’s obvious the company is on something of a knife’s edge. To start, much of the $30-million differential is due to changes in accruals–pen strokes–rather than actual generation of cash.
Then, given Harbin’s short-term funding model, they are going to have to come up with at least $20-million in the next four months, and given the vagaries in the disclosure, perhaps as much as $5-million more. [After FI.com’s initial look at this company, any number of equity investors protested that while no company would seek to fund themselves this way--with loads of short-term debt--much of the reason for this had to do with complying with the PRC’s practice of very strongly encouraging banks to meet lending targets by shoveling out loans to companies, regardless of need or structure.]
FI.com is nothing if not reasonable so we’ll agree to this explanation, with the stipulation that only a centrally planned government could mandate something so stupid. There is no chance, however, that borrowing five-month money from a hedge fund at 10% is anything other than the silent scream in a cash squeeze.
Harbin’s recent quarter show it is evolving out of a full-bore financial miracle into a highly-economically sensitive manufacturer of commodity small-motors and oil pumps. In one quarter. Oddly, none of this appears to have been communicated. Business prospects went from ripping along to a slugging match in the course of three-months. It seems pointless to note that most companies that are not Salomon Brothers circa 1994 do not have their markets shift so drastically.
On a quarterly increase of $3.91-million in sales there was an increase of $4.47-million in expenses with operating margins declining 630 basis points in one quarter. The fourth quarter is expected to be “flat” to the third so little relief is on the way.
That investors love chief executive Tianfu Yang is understandable. He has acted boldly, if bafflingly, to transform the company from a small company with dubious accounting into a cash-strapped mid-cap with deteriorating prospects. As such, like many an American CEO he is avoiding a day of reckoning via the miracle of private-equity.
To his credit, there is no denying that he has boosted the share price many levels above where it would be without a prospective deal on the table. The question is why on earth Barings would go anywhere near this man.
Which brings us back to the LBO.
To start, it is flat out difficult to get around the combination of trying to raise $470-million in loan debt to get a deal done in an environment in which its operations are slowing down. Assuming interest rates of between 10% and 12.5%, this implies between $47-million and $59-million in annual interest expense.
Though private-equity shops have done some terrible deals over the past decade, this would step to the front of the line. The only way the deal works is if the lender assumes revenue, income and cash-flow growth of about 15% annually, which is to say that the lender completely disregards the last nine-months of Harbin’s results.
From the perspective of CEO Yang the entire concept of an LBO is philosophically astounding. Looking at this chart, if Harbin has the capability of earning a 40% return on [lightly-levered] invested capital, why would they borrow hundreds of millions of dollars at 10% or more to take it private and be assured of losing the ability to grow capital at 40%?
Is Yang implying with this offer that he can earn some presumably greater return on invested capital as a private enterprise? This would require us to believe that a manufacturer of low-tech commodity goods–as opposed to, say, Google–is even capable of meeting these targets. If so, he owes Barings and his investors some very, very specific answers. Yang, under such a scenario, would need to at the very minimum immediately triple net income and operating cash-flow growth and then continue growth at a double-digit level for the foreseeable future.
But nothing of the sort is occurring.
Which again begs the question: Why is he doing this? If he wants to increase his ownership stake then it is much easier for him to begin a stock buy-back program. Moreover, this would allow Harbin to maintain access to the much deeper U.S. capital markets and, it need hardly be said, keep Harbin’s balance sheet clean if they come across some accretive acquisitions, become a target of a larger suitor or run into some economic difficulties.
On a risk-adjusted basis, it would appear that this LBO proposal is being done for some reason other than economic reasons.
Harbin bulls (at least the many in touch with FI.com) have their own favorite reason for looking at this LBO as a no-brainer: Yang’s desire for a listings arbitrage. In this scenario, he does an LBO with the stock trading at seven times earnings and eventually re-lists on a China exchange at PE multiple of 16-times this year’s earnings.
To which FI.com replies: Really? It’s that simple? You can saddle the company with about $50-million in interest expense and a half-billion dollars of secured loan debt, be forced to build out cap-ex in a declining operating environment and the new Chinese investor base is going to say, “I’ll pay double what the Americans are paying!” As it stands now, with tax holidays set to expire over the next calendar year and revenues flat over the past four quarters, it is difficult to model a scenario where Harbin is more than barely profitable.
That supposes, naturally, that an automatic and near-eternal PE multiple expansion opportunity is available. But if it was, wouldn’t a whole lot of U.S. companies seek to do so as well? Or, if the opportunities exists only for Chinese-domiciled companies–Harbin is a U.S. company–then it’s not clear, given that so many reverse-mergers are scams, how many of these company CEOs are going to risk their necks to pull their shuck-and-jive on their countrymen.
Goldman Sachs, it should be clear, exists to sell that which is difficult to sell and Morgan Stanley is there to facilitate transactions. FI.com has complete confidence in their ability to get comfortable with this LBO, to tell Barings to pull the trigger and then to raise money for it.
Always and evermore are the people who play a role in making Harbin the very special thing that it is.
Someone should run a probability analysis on the likelihood of a company entering the U.S. market and accidentally encountering the cast of characters Harbin did. To save the reader some time, the word “zero” will feature prominently in the answer. It is hard to believe that someone in a position of control didn’t know they were dealing with a rogues gallery of corner-cutters, cheats, promoters and all-around scammers.
The first article looked at their accountants: Kabani and then Frazer Frost, as well as mentioning the omnipresent conflict-of-interest colossus that is Benjamin Wey. There can’t really be anymore said about these accountancies that hasn’t been said before. Actually, given this report on a company that Frazer Frost audits, there are indeed new things to be said.
As far as Wey goes, everything he does seems, at some point, to collapse. One suspects that much of this is because he tends to structure transactions for companies audited by accountancies like the above.
But the character angle runs deeper.
There is Conrad Lysiak, the lawyer with a history of busted penny-stock deals and regulatory sanctions to his credit who handled the sale of the Torch Executive Services shell that Harbin merged with. Here is an example of Lysiak’s craft–note that the company went to over $1-billion in market cap before regulators had the good sense to shut this organic fraud down. Actually, a search of Lysiak’s name on this site is illuminating, since he played a key role in Gatelinx/GTX Global/Vision Technology, an inelegant yet long-lived scam.
In a nation of lawyers, the ability to find a Conrad Lysiak, with his unique skill-set, is no accident. Someone spent time and energy finding him so he could a very specific sort of legal work.
A red thread between Lysiak and the launching of what became Harbin is a truly electric outfit out of Plano, Tx. called Signature Stock Transfer, the original stock transfer agent for the company (It is has since shifted to Stock Trans.) Signature has been the transfer agent in a simply overwhelming volume of pump and dump deals, many of which have been the fodder for various regulatory actions. A stock transfer agent that isn’t meticulous or diligent can allow ownership to transfer improperly and private stock to trade when it shouldn’t. They also can turn a blind eye to unregistered or undisclosed ownership groups controlling the float. Often enough, a crummy stock transfer agent can work in conjunction with a crummier attorney to secure bogus letters approving the transfer of stock to off-shore entities.
Interestingly, the SEC charged Robert Bogutski, the brother of Signature’s CEO, Jason Bogutski, with fraud for running his own improper stock transfer operation.
A man named William Astman has played a role in Harbin’s foray into the capital markets. The owner of Los Angeles’ First Wilshire Securities, he has handled Harbin’s 144a stock sales. Fair enough, save for for the fact that Astman was at one point a key booster of a financial crime against nature called ACLN, one of the most point-blank frauds in recent memory. It gets worse. According to the linked interview, he traveled to Europe to meet with the company’s management and came away impressed with their operation. It warrants noting that ACLN had no operation, it was a root-and-branch fraud, almost more redolent of a movie than a standard stock promotion or a scam. It’s not a crime for a portfolio manager to fall for a swindle–his investors may have thought otherwise since the stock went rapidly to zero–but to boast of rigorous, bottom-up research and then get so completely blind-sided is apropos, especially in the context of the cast of characters Harbin has around it.
Another way of looking at Astman’s role in Harbin is that out of thousands of people and firms to execute a stock transaction, Harbin somehow found a trader with a direct link to a scam and investor loss.
FI.com departs from cynics, skeptics and short-sellers, as well as those offended by rank financial absurdities, in arguing that this deal probably gets done. There is too much money to be made to not get Yang and Barings to the alter.
Yang’s motivation is immaterial at this point; what really matters is what Barings thinks.
On that front FI.com’s only guess is that whatever it’s thinking, what’s best for their investors isn’t very high on the list.