Description

HONG KONG: 0350

This is more of a trade than long term investment, but I think the risk/reward is attractive.

Jingwei Textile Machinery (The Company) has shares listed on both Hong Kong and ShenZhen stock exchanges. ShenZhen is one of the two main stock exchanges in China, the other one is ShangHai. The ShenZhen shares are trading at $9.92RMB, while Hong Kong shares $6.88HKD, which is about $5.50RMB, a 40% discount. Hong Kong and ShenZhen shares are equals and have same rights.

On 03/21, the controlling shareholder of the Company, Chinese state owned enterprise HengTian Group announced that it is considering (no formal offer yet) to acquire all Hong Kong listed shares for $7.89HKD per share, a 30% premium compare to what the stock was trading before the announcement. HengTian group would own 60% of the Company after the transaction.

HengTian Group was founded in 1988 and is owned directly by the Chinese government. Currently the group controls five public companies with a wide range of different businesses including textile machinery, import/export, car manufacturing and more.

One of the main themes of the current economic reform proposed by the Chinese government is to encourage state owned enterprises to become more efficient and to “mix” with private enterprises when appropriate. Since bosses of the state owned enterprises are appointed by the Party, they will no double follow the directions. Plus I bet they will find plenty of ways to enrich themselves along the way. So we are already seeing a lot of capital market activities in this space and will definitely see more.

Besides the legacy textile machinery business, which is losing money, Jingwei owns 37% of ZhongRong Trust, the forth largest trust company in China. ZhongRong trust has been growing very fast, profits doubling every year for the last five years. Admittedly, this is due to the credit and shadow banking bubble China has been experiencing. On the other hand, ZhongRong has been a very valuable asset to the Company, generating most of its profits. It makes sense for HengTian to consolidate its control over Jingwei before taking further actions with ZhongRong trust, spin it off for example.

Even without the motivations mentioned above, it is still a good deal for HengTian to retire Hong Kong shares at such a discount.

Regulatory approval shouldn’t be an issue. SOEs normally have good connections with regulators and the stock was halted for about three months before the announcement so I think the main issues have already been worked out with regulators. Financing shouldn’t be a problem either. As SOE, HengTian will have ample access to state owned banks.

Insiders seem to agree that the deal will happen. Between June and October of last year, they bought almost 1.5 million shares. Assuming average purchase price of $5HKD per share, that is $7.5 million. In retrospect, clearly they knew what was coming.

What if the deal never happens? How much downside protection do we have?

The stock was trading around $6.10HKD before the announcement, compare to current price of $6.90, about 10% downside.

In April, the Chinese regulator announced a pilot program which will allow Chinese domestic investors to buy certain Hong Kong listed shares via ShangHai exchange and vice versa. Before, it was possible but difficult to do this. One consequence of the pilot program is that the price gaps between dual listed shares of the same company narrowed significantly, in some cases 40%, as investors arbitrage the price differences. It is expected that the regulator will announce a similar program for shares listed on ShenZhen exchange as well. So even if the deal does not happen, this pilot program or the expectation of the pilot program should provide some additional downside protection.

In terms of valuation, the company is very cheap. I don’t take much comfort from that since ZhongRong trust will probably blow up if the credit bubble bursts. That being said, I believe we will know whether the deal happens or not within a couple of months and I don’t think the credit bubble will burst that soon, since the government still has capacity to intervene.

Here are some 2013 numbers (in RMB): revenue $10.5 billion, growth of 21.4%. Profit $600 million, growth of 37%. PE is below 7 while the average PE of last five years was about 14 times.

To recap, I see 15% upside vs 5% downside for a holding period of several months. There is also a small chance that HengTian will raise the offer since Hong Kong shareholders now have the alternative option of waiting for the pilot program.

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