What You See Isn't Necessarily What You Will Drink

Sarbanes … Huxley?

One of my self-assigned tasks, on this trip, has been to look at what is being done in China about the environment (I mean, to improve it) -- in particular water quality. As part of this investigation, I visited Shanghai Municipal Raw Water Co., which is listed on the Shanghai Stock Exchange but controlled by an entity of the local government.

Essentially, “Shanghai Muni” pumps water out of the Yangtze and Huangpu rivers and delivers it to various plants that, in turn, treat it so that it can be distributed as tap water to several Shanghai districts.

Or, maybe, I should have said “pumped” and “delivered”. For, it turns out, an asset swap between “Shanghai Muni” and its major shareholder is planned for the end of 2006, which is about to give the company the most extreme of extreme makeovers.

By then, all of the present assets of Shanghai Muni will be returned to that major shareholder (which, by the way, issues water licenses in Shanghai and determines the price at which water is bought and sold by local utilities). In exchange, this shareholder will inject into Shanghai Muni the assets of two water treatment and distribution companies that it currently owns. All the current assets will be gone and all the future assets will be new.

What about the employees who go with these assets? They will be gone too and Shanghai Muni will inherit the employees of the “injected” companies.

“What about you?” I asked the Corporate Secretary. “I was supposed to have retired last year, so I will be gone, too. The only person remaining of the old Shanghai Muni will be the CEO… And, by the way, the name will be changed to Shanghai Water Works.”

OK. Fair enough. Injections and restitutions of assets between government-controlled entities and their publicly-listed affiliates are hardly a new thing in China and none of what I relate necessarily indicates any intent to take advantage of shareholders. In fact, the Corporate Secretary who received us actually was as helpful and straightforward with answers as she could be under the circumstances. It’s just that a lot of information about the injected companies hasn’t been released yet – even to Shanghai Muni.

Paging Messrs. Sarbanes and Oxley!..

By the way, as things stand today in China, tap water does not mean drinkable water – just water clean enough to boil before consumption. Based on the information available, or lack thereof, Shanghai Muni’s story is not yet quite potable either.

First of all, it is clear that the reason for the swap is that the distribution companies will require a fair amount of new capital, which will be easier to raise with a publicly-listed vehicle. On the positive side this implies that some growth is expected, since the acquired assets are fairly new and would not, by themselves, require a lot of capital expenditures. Conversely, the (old) raw water assets will not require much investment or show much growth: they better fit into a privately-held company, indeed.

But one worry is that, whereas the old company had very little debt (net asset value of about 6 billion RMB out of total assets of 6.8 billion RMB), “The tap water company will have more debt than this”.

Why would this be necessary? Let us speculate:

For one thing, the major shareholder may decide to inject other assets into the company, this time for cash. While this must not necessarily hurt the newly-renamed Water-Works, there is a risk that it could be used as an ATM machine by its major shareholder.

Then, there seems to be a number of small local water companies in the suburban areas of the district that the shareholder may want to acquire and subsequently “inject” in the new company. But it was not clear, for example, why Water Works itself would not simply be allowed to acquire these companies directly, without intermediation by its Big-Brother shareholder…

Finally, there is the ongoing reform of the A shares market in China, which tends to result in the dilution of many majority shareholders. Until recently, majority holders of A shares were restricted from trading their shares on the open market. To offset the lifting of that restriction, some trade-off was required in favor of minority holders. In Water Works’ case, the majority shareholder will “give” each minority holder 2.3 additional shares plus some warrants for each 10 shares previously held -- from its pocket. Could Big Brother then be tempted to use assets injections to restore its percentage of ownership?

On top of all this, the volume of water handled by the new Shanghai Water Works will be significantly lower that of the old Shanghai Muni, because it will serve two districts instead of three. Other things (like margins) being equal, profitability would also decline. Our only comfort is that Water Works has a “gentlemen’s agreement” with its large shareholder that its acquisition price for raw water will be lowered and that it will receive some rate relief on the distribution side, so that “future profits should be equivalent to past profits”. But these measures, subject to public hearings, apply to all and would equally benefit utilities in other districts, which are not necessarily seeing their water volumes reduced by asset swaps.

Again, in an environment where margins are set by diktat, there is no indication that shareholders will not be protected or that any of this will turn to their disadvantage. But there certainly is no guarantee to the contrary.

François Sicart (in Shanghai)

June 7, 2006