A lot of positive spin in IPO sponsors' reports

I arrived in the office on Wednesday to find a bulky brown envelope on my desk. An anonymous reader had posted me 1.5 inches worth of photocopied research reports on Rongsheng Heavy Industries and its glossy brochure. The privately owned shipbuilder is to raise HK$17.6 billion in an initial public offering. That will make it the third-largest IPO this year - right behind AIA and Agricultural Bank of China. It certainly needs a push. Apparently, someone finds this column a nice place to do the honours. Well, he or she may regret bringing the company to my attention. The reports issued by its sponsors have tonnes of positive spin on Rongsheng. It is the largest privately owned shipbuilder in the mainland. It has impressive profit growth and strategic co-operation with a major offshore oil producer. It is the only private shipbuilder approved by the government to build dry docks. It has a knowledgeable team and its order book is full right up to 2012. Well, shipbuilding is too difficult an industry for me to understand. I don't know how soon any overcapacity in the industry will be corrected. Nor do I know when steel prices will start heading downwards. However, I do know an easy way to assess the future of a company, in particular a privately owned one in the mainland: make sure you know its controlling shareholder. Who is the boss? How did he or she make the first bucket of gold? Is the boss strapped for cash? How well has he or she treated its minority shareholders? These are all relevant questions to ask. (Unfortunately, in most cases, you are not going to find answers in any research report.) Rongsheng was founded by entrepreneur and property developer Zhang Zhirong in 2006. The 41-year-old ranks 38 on the country's rich list thanks to the listing of his property firm, Glorious Property Holdings, in Hong Kong. As always, little is known about how he made his fortune - apart from his humble beginnings as a construction worker. But a look at Glorious Property is telling enough. Zhang is clearly well connected. In November last year, the Shanghai government put out two pieces of land on tender. But only a shipbuilder or repairer was allowed to bid. Guess what? A shipbuilder owned by Zhang submitted the only bid - and got it at the asking price of two billion yuan (HK$2.32 billion) - about 20 per cent below what the government had asked for in a 2008 failed tender. Zhang subsequently sold the two pieces of land to Glorious. The connection, however, did not translate into a stellar performance. Glorious boasted a doubling in its profit last year - its IPO year. But by June this year, its profit had dropped by 56.7 per cent. The management blamed it on the lack of fair value gains in investment property as in 2009. In October, management admitted that it had achieved only 46 per cent of its sales target for the year. Nor is the stock doing well. Even though Zhang has spent more than HK$125 million raising his stake, Glorious has never managed to regain its HK$4.40 IPO price. It traded at HK$2.91 yesterday. That's 33 per cent below the offering price, underperforming not just the market but also its peers, which have seen no more than a single-digit correction in the past 14 months. After all, investors aren't dumb. Zhang has largely built his empire by aggressive expansion with money borrowed from banks and private equity funds that have been willing to lend, expecting to reap juicy returns from an IPO. In the case of Glorious, its gearing stood at 669 per cent in 2008, 10 months before the IPO. Only a month before its IPO, Glorious had to borrow 2 billion yuan from Shanghai Industrial. (Rongsheng had 85 per cent gearing until Zhang injected 2.5 billion yuan into it after raising billions from the Glorious listing.) Thanks to the public offering that brought in HK$6.9 billion, Glorious' gearing was reduced to 7 per cent by the end of December. Yet, it did not take long for Glorious to return to its heavy borrowing ways. By June, its borrowing had increased from 6.8 billion yuan in December to 10.7 billion yuan. That brought the gearing to 50 per cent. That's not including 4.1 billion yuan in new loans that it took up a week ago. It is not just the size of the new borrowing that is worth noting but also the sources. Instead of banks, Glorious resorted to a trust corporation, which means it is paying a higher rate of interest. It borrowed 1.67 billion yuan from Jiangsu Trust at 8.5 per cent. It also issued US$300 million two-year senior notes at 13 per cent interest. From these moves, it is not hard to sense that pressure on Glorious and other developers in the country is growing. The problem is that the tightening has just begun, with Beijing announcing the first interest rate increase in three years only two weeks ago. How well Zhang and Glorious can survive is anybody's guess. It is therefore not difficult to understand why the Rongsheng management has given a full page in its prospectus to emphasise their independence from Zhang. It said that except for Zhang, no other director of the controlling shareholders sits on Rongsheng's board. Each director is aware of his fiduciary duty, and three of its 11-strong board are independent members. It also said Rongsheng has its own accounting and treasury departments but makes financial decisions according to its own business need. How reassuring is that? The fact is Zhang is its non-executive chairman and controls 75 per cent of the company. He is hoping to pocket HK$3.5 billion from the listing of Rongsheng and is free to sell more after 12 months. Besides, mainland directors are not renowned for protecting minority interests.