A Universe Apart: China Galaxy Securities

The Sleeping Giant Panda Awakes: China's Securities Industry

The fact that the world’s second biggest economy is two-fifths the size of the biggest economy but has a securities industry a fifth the size relative to its economy, the easiest conclusion to draw is that brokerage opportunities abound in China. With the US$1.4 billion IPO of China Galaxy Securities, China’s largest securities broker by sales, comes the conclusion that this is the company to invest in. Despite being one of the largest securities broker in mainland China, it has just 5% of the market, which suggests there is lots of potential in the industry. Citic and Haitong Securities are other top ten brokers in China. There are 114 brokers in total in mainland China.

China Galaxy Securities HQ

Headquartered in Beijing and founded in 2000, China Galaxy Securities is a nationwide comprehensive securities company. China Galaxy Securities is majority owned by one of China’s sovereign wealth funds, suggesting an ability to curry favour with the Chinese government – an important determinant in the success of mainland Chinese companies. It founded a Hong Kong subsidiary in 2011, China Galaxy International Financial Holdings, which aims to offer investment banking, asset management, and securities brokerage services overseas. Stock broking, part of its securities brokerage business, is Galaxy’s main business. It plans to develop other parts of the securities brokerage business, such as margin lending, using proceeds from its recent IPO, as these areas’ sales have grown 100% in 2012 due to eased regulation. Other businesses include investment banking, asset management, wealth management and proprietary trading. China Galaxy Securities hold a leading position in the country’s securities industry in terms of debt underwriting, ranking first from 2009 to 2011 and second in 2012. Their business will be helped by becoming one of the ten qualified companies to act as lead underwriters for financial debt instruments of non-financial corporations in 2012. Their other businesses are also quite established with financial advisory clients including major corporations such as China Southern Airlines, China Petroleum & Chemical Corporation, Shanxi Coal Import & Export Group, and Mittal Steel Company. Moreover as at 31^st December 2012, China Galaxy Securities had served roughly 29,000 asset management clients, invested RMB 442 million in 8 private companies with the aim of restructuring the businesses and seeking to exit through an IPO a few years down the line, and counted 190,000 High Net Worth Individuals as clients.

Millions of Yuan

However there are pressures due to the heavy competition. Average commission per trade dropped by 20% from 2010 to 2012. The make-up of the securities brokerage industry has also induced heavy competition resulting in the top 10 brokerages claiming only 40% of the market share. One consequence of this is that there is a big difference between the IPO fees pocketed by investment banks in Europe and the USA (around 7% of deal volume) compared to investment banks in Asia (just 2.5%). This points to the need for fewer players in Asia, not more. Yet there may be a danger of more players entering investment banking once regulation allows the state-owned banks (Bank of China, ICBC, Agricultural Bank of China, etc) into the securities brokerage industry, which may further reduce commission and cut into the market share of the current top 10 brokerages. Furthermore, China Galaxy Securities’ business is closely tied to the performance of China’s capital markets, which have foundered in recent years. This is evident when one compares the S&P 500’s 13% increase in 2012 with the Shanghai-Shenzhen 300 index which only rose 8%. Further difficulties are perceived in the backlog created by China’s markets regulator of over 800 companies waiting to IPO in China.

Prop Trading on the Up in China

Despite the pressures, there are many potential opportunities that China Galaxy Securities are at the forefront of being able to capitalize on. Just as Western investment banks cut back from riskier activities as a result of the financial crisis, top Chinese brokers are filling this gap. These areas such as proprietary trading, private equity, lending money on margin to investors buying securities and other alternative investments accounted for around 21% of the Chinese securities brokerage industry’s profits in 2012. These were all areas where Goldman Sachs was or is the world market leader, for example they run the world’s second largest private equity funds under management and the second largest business servicing hedge funds. Yet as the world’s regulators make these riskier activities more costly for banks such as Goldman Sachs to pursue and outright ban proprietary trading, this is an opportunity for upcoming Chinese brokers to break onto the international stage. For instance China Galaxy Securities got almost 7% of revenues and more than 12.5% of profits (US$38.5 million) from prop trading in 2012. They are also making a concerted effort to expand its prop trading assets, which have grown 30% over the past two years.

A long-term Chinese investor

Additionally, since April 2012, the Chinese Securities Regulatory Commission have liberalised rules allowing Chinese brokerages to invest in a wider variety of markets, to lower their capital requirements against these activities and to start issuing their own bonds. In the year following the liberalisation, just over US$13 billion of bonds were issued by Chinese brokers. The aim is to introduce more liquidity into China’s stock and bond markets. Yet the real problem is the lack of a long-term investing culture and the dearth of established institutional investors such as pension schemes, insurers and mutual funds. The moves are part of efforts to broaden and deepen China’s capital markets, and brokerages are already taking the opportunity to boost borrowings and juice up returns. The added advantage is that this is all happening with Chinese brokers having quite low leverage, with the industry’s total net assets just 1.4 times net capital currently.

China Galaxy Securities IPO’d on the Hong Kong stock exchange in May 2013, with its shares rising 11% to settle at HKD 5.62 at the end of its first day. They are currently trading at HKD 5.26 per share. So invest in a company a financial universe apart, invest in China Galaxy Securities. You may be investing in the Chinese Goldman Sachs, which will boost your profits to a universe apart too. 

The Last Frontier: Myanmar Telecoms

The new Telecoms dawn coming over Yangon

Myanmar has opened up one of the last territories in the world not to have extensive telecommunications service. This is one of a string of modernizations that the country is undergoing having decided to abandon its isolationist policy. The auction of telecoms licenses to international companies is the first major public contract tender outside the natural resources sector. The auction liberalises the telecommunications network which was previously controlled by the state.

Norway’s Telenor and Qatar’s Ooredoo won the fiercely contested auction and will launch their telecoms services in the next few years. Telenor will provide nationwide coverage within five years, but the first mobile services start in 2014. The two operators will install modern telecoms networks across the country. Each company could spend US$1-1.5 billion to create a network from scratch in a country with poor infrastructure and limited skills. The state-run telecoms operator, Myanmar Telecoms, will continue to operate, although it has notoriously poor network coverage that supports mobile penetration of only 5%.

Expanding to villages all over Myanmar

The sheer magnitude of the task facing Myanmar shows what they have been missing out on for the past 60 years of isolation. Just 10% of the population has a mobile phone compared to 80% in Cambodia and Laos and over 100% in Thailand. With mobile phone ownership so low, many ordinary citizens communicate using makeshift phone kiosks. Actually it is the lack of mobile phones in this country of 60 million people that has attracted interest from the world’s major telecoms companies.

Myanmar are hoping that Telenor and Ooredoo will be able to boost Myanmar’s telecoms coverage to 80%, in line with Cambodia and Laos by 2016. Yet for the companies themselves this venture is not without significant political and economic risk. At least for Telenor they have considerable experience creating new networks in frontier markets with involvement in Pakistan. It will be interesting to see how improved mobile penetration in Myanmar feeds a nascent mobile app development industry among young entrepreneurs in the country.

The Spin-Off Effect

The financial crisis of the past several years has highlighted an old phenomenon, “the Spin-Off Effect”. A company breaking up with part of itself can allow each individually to outperform the market. There is evidence of diseconomies of scale if we ever needed it. In fact, evidence reveals that companies that have spun off from their parent companies in the past five years have increased their share price over 300%, on average, compared with an 85% increase in the S&P 500. This could be called the “Spin-Off Effect”.

Looking on the Up after Split

One recent example has been Rupert Murdoch’s News Corp’s split in two in June between itself and the film and television business of 21^st Century Fox. Both’s shares have since risen by 25%, easily beating the S&P 500 in the same period. Another example is Siemens’ spin-off of German lighting company Osram, which has allowed both of their shares to rise by roughly 35% since July. Last December, the UK’s Cookson also split itself into a technology specialist Alent and ceramics supplier Vesuvius – both are doing far better apart.

Familiar Names?

Yet, companies have been spinning-off for over 100 years. The most famous were court-mandated destructions of monopolies such as the breakup of Standard Oil into 34 companies in 1911 and the splitting of AT&T into 8 companies in 1984. Other famous spin-offs have been due to changes in strategic direction, such as American Express’ spin off of Lehman Brothers in 1994 as they stopped trying to become a financial conglomerate and the UK chemical company Imperial Chemical Industries’ spin-off of its pharmaceuticals business Zeneca in 1993 as the link between chemical and pharmaceutical businesses grew more tenuous.

Part of the reason for the “spin-off effect” is that companies are able to focus their capital on their core operating areas. Additionally, investors often overlook weaker businesses within a company until they are spun-off. A case in point is Thailand’s Major Cineplex plc where investors could be charged with overlooking its bowling alley and ticket booking businesses. Therefore it seems that just as mergers and acquisitions are oft said to destroy value, their undoing can also create value. Another case in point is AOL and Timewarner, the promulgated “deal of the century”, who split from each other in 2010 after ten years together. At the time of splitting up, the combined entity was worth a mere 10% of its value at the firm’s zenith, US$2.5 billion. Both companies have since managed to find their feet in their respective business areas and excel.    

However, spin-offs can also initiate new M&A opportunities for the newly separated companies. Dutch telecoms giant KPN agreed to divest its German business to Spanish giant Telefonica, engendering a bid for the whole of KPN from Mexican Carlos Slim, who as KPN’s biggest shareholder was against the German sale. Even here the “spin-off effect” was palpable with KPN’s shares escalating by 16% shortly afterwards.

Divestitures are admittance that jigsaw doesn't fit?

Yet, most CEOs won’t happily shrink their business – there is an element of self-interest and moral hazard inherent in their bias. CEOs fear that suggesting divestitures to shareholders may be viewed as admitting their strategy and vision of the company has failed, that employees’ morale may be damaged, or that the company may lose some of their economies of scale. Moreover, spin-offs do not generate the cash for reinvestment that sales do. It is about finding the courage to shrink as spinning off businesses can genuinely create value. There are many examples of companies that should be considering this. For example, the UK’s Whitbread has been a perennial candidate for breaking up its Costa Coffee chain from its hotels and restaurants business. Meanwhile Microsoft has mooted spinning off its Xbox business as they see few synergies going forward.

The annual Shareholder letter

The “Spin-Off Effect” comes down to a simple principle of corporate finance. Business creates the most value for shareholders and the economy as a whole when it is owned by the best owner. Adhering to this principle would suggest that companies should continually reallocate their resources as circumstances change. Too bad there are a few too many self-interested CEOs without the courage to admit a change of strategy is sometimes necessary.

Key Benefit of Spin-Offs: Long-term Strategic Vision

Ultimately though the “Spin-Off Effect” is more than just providing a favourable boost to both companies’ share prices. In fact, it provides the most benefit from a realignment of the companies’ strategic visions, the corporate restructuring opportunity, and the tax advantages relating to the transaction. The misperception is that the “Spin-Off Effect” is about a quick fix to low market capitalizations. It’s much more than that – the real factor in the value of spin-offs is that they are tied to expected performance. In other words, increased valuations of the split off businesses reflect the market’s expectation that performance will improve at both companies once each company has the freedom of self-determination with regards to strategy, people and organization. This is why spin-off businesses, on average, increase their profit margins by 2% and double their growth rates.

There are also the tax advantages – sometimes spinning-off a business is better than selling it. UK and US tax laws treat spin-offs as tax-free transactions. Furthermore, many continental European countries also treat spin-offs favourably for tax purposes in order to facilitate them. For example in the USA, a company has to pay 35% income tax on any gain arising from the sale of a business. A company decides to divest one of its business units which, if spun off would have a market capitalization of US$500 million. There is an offer of US$650 million for the business unit from another company, which is at a premium to the market capitalization. Yet, the company’s book value for the business unit is US$150 million, so a sale would carry a tax liability of US$175 million on a US$500 million gain on the sale, which reduces after-tax proceeds from the sale to US$475 million. This would be less than the business unit’s expected market capitalization from spin-off. Therefore, from the perspective of creating shareholder value, taxes alone should make the company consider a spin-off rather than a sale. The tax dynamics will lead to companies being more likely to spin off highly profitable businesses and sell less profitable businesses.

And how does the “Spin-Off Effect” help the wider economy? Changes in strategy within spun-off businesses suggests an improved allocation of capital with higher-profit businesses more likely to increase their investment spending while lower-profit businesses are more likely to cut their investment. Therefore, watch out for the benefits of the “Spin-Off Effect” when making investment decisions; there may be a temporary boost but it may also herald a longer period of long-term growth. 

The “Sudden Death” Bank Bond

Danger in the Eurozone

Like from some avant garde video game, “sudden death” or “wipeout” bonds have surged. These are a type of contingent convertible bond (cocos) which either convert into equity when a bank’s capital ratio fallows below a pre-agreed trigger and bonds which are written off entirely after a trigger event.

These “Sudden Death” bonds are turning bank investors’ money into nothing, prompting criticism that they discriminate against investors. Nonetheless European banks, struggling with mounting regulation, are increasingly issuing them. In particular, Basel III regulation is forcing banks to hold more Tier One Capital, the safest portion of a bank’s capital comprising of common equity and retained earnings. Yet, in another demonstration of the perennial conflict between bankers and regulators, the bankers have innovated a loophole to bolster their Tier One Capital by using cocos. This way banks can push losses onto investors and at the same time provide fresh capital.

Despite the criticism, investors on the hunt for yield are buying up cocos and wealthy emerging market institutionals, able to leverage their investments, are using these products to boost their returns. From their perspective, cocos are at least yielding higher than other assets.

However in the USA, the prevalent restrictive definition of Tier one Capital has limited US banks from utilizing cocos to bolster their Tier One Capital. In the USA, only instruments considered debt for accounting purposes can be included in Tier One Capital, which effectively places cocos outside the realms of the definition. US regulators are worried about what they have coined the “slippery slope of increasingly diluted capital standards” if they let the definition widen.

Financial innovation seems to be galvanizing again. Let’s hope the American prudence continues to prevail for the longer-term rather than succumb to the desperation bred by desperation in Europe. 

Asian Blockbuster: Major Cineplex Group

In developing countries, cinema is a Veblen good. The added advantage that developing countries have is that a burgeoning middle-class are and will begin to regard the cinema as just another entertainment good in their growing portfolio of weekly leisure activities. With that context in mind, Major Cineplex Group looks to be an excellent value investment for the future.

Major Cineplex currently operates 435 cinema screens in 62 locations throughout Thailand. Included in this number is Thailand's largest cinemaplex, Siam Paragon, which boasts the country's only IMAX theatre as well as the world's most expensive cinema experiences, such as Nokia VIP cinema (THB2,000 per person) and members-only Enigma (THB4,000 per person). They expect to reach 500 screens by the end of 2013. They have also invested in upgrading their screens to become digital-based, reflecting a focus on quality and an exceptional customer experience. In Thailand, Major’s ticket sales have risen 25% this year as a result of the growing middle-class and an increase in the number of cinema screens providing easier access to cinemas to more people. Furthermore, an alliance with PTT Group to launch 100% biodegradable popcorn buckets highlights the important connections that Major have cultivated which will aid them in their local and regional expansion efforts. By the end of 2014, Major hopes to introduce 150 new screens within Thailand and surrounding countries.

Enigma Cinema, Siam Paragon

In fact, their strategy is focused on exploiting their relative expertise internationally, marking a significant transition for Major by moving from a local cinema operator into a regional and global business. They are focusing initially on Cambodia, Laos, Myanmar, Vietnam and India, with a view to taking advantage of the increased business flexibility being introduced by the ASEAN economic community in 2015. In particular, they are investing THB220 million in opening its first multiplex theatre in Cambodia with 8 cinema screens – this will be a major development for a country without a modern cinema to date. The company has also put THB200 million into developing a 100-lane bowling alley in India, a manifestation of their diversification into several entertainment activities. Major’s overseas investments should output an expected 10% of total revenue by 2015.

Bowling Alleys Asia

Major have invested heavily in bowling alleys, which is a very popular entertainment activity within Asia as it is associated with Western middle-class aspirations. Currently they own 360 lanes with 222 karaoke rooms, another popular activity derived from China, Korea and Japan. Furthermore, Major possesses a property development division that leases retail space as well as owns a 25% stake in shopping mall developer, Siam Future Development plc. The company also has a stake in California WOW Xperience plc, the largest fitness center operator in Thailand with ten outlets across the country. Its ticket subsidiary, Thaiticketmajor, sells advanced cinema tickets as well as tickets for a host of events such as concerts and has extensive growth potential as it seeks to digitise its operations to meet expectations of the youthful Asian population.

Higher levels of service - Asian customisation

On a macroeconomic level, the cinema business has a lot of room to grow just within Thailand alone. There are currently 800 cinema screens in Thailand with Major operating roughly 55% of these. Thailand sells just under 50 million movie tickets annually. Juxtaposed to the 2,000 cinema screens and 200 million tickets sold annually in South Korea – a country with 17 million less people than Thailand and you can perceive the great domestic potential in Thailand, particularly as ticket prices in Thailand are about 50% less than average prices in South Korea. Major, as the largest cinema operator with monopolistic market share and international expansion ambitions, will surely be a great value investment. Its currently trading at THB 19.40 on Bangkok's SET exchange within a 52 week range of THB 14.70-24.90 and with a market capitalization of THB 17.2 billion. The added bonus of investing in Major shares is their annual 5.05% dividend yield. So invest and watch this Asian blockbuster explode onto the ASEAN scene.