By Ichiro Suzuki
This was not an April Fool’s Day joke. On April 2, the shares of Nasdaq-listed Luckin Coffee (LK), dubbed as China’s Starbucks, fell by a breathtaking 75% on an alleged fraud of cooked accounting. It was reported that the bulk of LK’s sales growth since its May 2019 IPO was fabricated. The following week, it was found that iQIYI Inc (IQ), China’s Netflix, had been reporting false revenue and earnings numbers as well, though IQ’s shares suffered a far milder damage than LK’s. These two alleged fraud incidents brought up what has been in the minds of many investors: Can Chinese companies be trusted? On many occasions, China’s economic statistics have not been taken at a face value. It was often said that electricity consumption data tells a greater truth about economic growth than GDP numbers since the former cannot be massaged. Suspicion on China appears to have risen in recent years due to Donald Trump’s trade war. That said, U.S. companies have been far from being unfamiliar with fabricated reporting. Remember Enron? The energy trader was once said to be the most innovative company in the U.S. but perished in late 2001 only a few moths after its equity market capitalization was over $100 billion. There was also WorldCom in those days that reported massively cooked numbers. These companies created a crisis in accounting that made the whole market suspicious of reported numbers. That crisis was a part of the reason behind the market’s 50% correction over two and a half year period beginning early 2000, in addition to valuation adjustments from the hyped levels.
Two decades after that accounting scandal, tightened regulations, notably through the Sarbanes-Oxley Act, appears to be working well. Corporate America was taught a lesson. Since that time, on the other hand, a number of Chinese companies had arrived in the U.S. opting to be listed in the NYSE or the Nasdaq, instead of Shanghai or Shenzhen. There are a few great reasons that make Chinese seek listing in the U.S. rather than in Shanghai, Shenzhen or Hong Kong. First, the U.S. allows dual class shares schemes that give founders disproportionate shares of voting rights, allowing them to concentrate on long-term strategy of their company without being troubled by some shareholders’ short-termism. Second, the U.S. is a better place for companies with global ambitions. Being there gives companies an access to a far greater investor base than the home markets. Finally and and perhaps most important, U.S. listing immediately gives Chinese companies U.S.dollar cash that is hard to get in a country with tight capital control.
So some parts of Corporate China came to the United States, perhaps without fully being aware of what it takes to be there in the post Sarbanes and Oxley environment. Long before LK, some Chinese companies tried to have a presence in the U.S. financial market through an acquisition of struggling small publicly listed American companies, and then using the company as a shell for a presence in the stock exchange. This ‘backdoor IPO’ gave Chinese companies U.S. presence bypassing scrutiny by an auditor and an underwriter. Companies that got a place in the U.S. this way tended to be of questionable quality and their performance in the market was sub-par. Backdoor IPOs since then caught the attention of the authority and acquisition proposals by Chinese companies have been scrutinized.
Then there was a problem of less than impressive performances of Chinese companies in the U.S. Since the wave of their arrival in the U.S. began in the early years of the 21st century, only two companies of meaningful size had posted strong performances on a sustained basis: Baidu (BIDU) and Alibaba (BABA). Of the two, BIDU has not done much over the last 5 years. BABA continues to post solid performances 5 and a half years after its debut in the NYSE. For the lucky few who got hold of BABA ahead of the IPO in September 2014, the company delivered an annualized 22.5% through the first half of April, and this is super. However, for those who were not so lucky to get IPO shares, and bought shares on the company’s first day of trading, the return goes down to 15.5%, which is still very good but not spectacular. In fact, Amazon (AMZN) has delivered twice as high as BABA’s return, since the latter’s IPO. This is why BABA’s market capitalization is ‘only’ $580 billion while that of AMZN is well above a trillion dollars. Having failed to deliver performances, the vast majority of U.S.-listed Chinese companies belong to a small cap category, with market capitalization less than $10 billion, with the majority of them a lot smaller than that. With their trading volume in the market having dried up, some of them are leaving the U.S. to be re-listed in the home market in China. (BABA did its Hong Kong IPO last fall as the HKSE now allows dual class shares.) The NYSE and the Nasdaq are welcoming the listings of foreign companies for the purpose of providing U.S. investors with broader return opportunities. Unfortunately, Chinese companies have not lived up to such expectations.
Investment banks are eager to bring up-and-coming Chinese companies to the Amercan public, since it’s a great business. However, reputation of LK’s lead underwriters, Morgan Stanley and Credit Suisse, got tarnished with this debacle. The LK experience has brought to light the risk of investing in Chinese companies. Banks would definitely become more careful in underwriting Chinese IPOs. While Chinese companies are still coming to the U.S., the LK fraud would put a damper on valuations of future China IPOs.
About the author: Mr. Suzuki is a retired banking executive based in Tokyo, Japan.
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