There have been a number of examples recently of Chinese companies whose valuations seem to have lost touch with reality. One of these is Mascotte Holdings (ticker: 136.HK); its share price had already nearly tripled between the start of April this year and early June when trading in its shares was halted. Mascotte subsequently announced that Evergrande and Tencent would acquire a 75% shareholding in the company through a subscription of new shares. When trading resumed on 3 August, the share price immediately jumped by as much as 150%. It has since fallen back somewhat, closing at HK$0.48 on 5 August. Though this is still nearly 70% higher than the pre-announcement price and gives Mascotte a pro forma valuation of HK$78bn.
Mascotte has a chequered history and a propensity to issue scrip that would make a Zimbabwean finance minister blush. It currently has 36bn shares in issue (despite a 1-for-16 share consolidation). The company is frequently described as a “solar” manufacturer, although it sold its polysilicon manufacturing business over a year ago, without it ever generating any revenue. Its main business now is a loss-making manufacturer of photographic accessories. At 31 March 2015, the company had assets of just HK$125m and negative shareholders’ equity; it has not made a profit in any of the last five years. However, despite this, immediately before the trading halt, it had a market cap of HK$10bn.
In June, the company announced that Evergrande and Tencent would invest HK$750m in the company by subscribing for 123bn new shares, giving them a combined shareholding of 75%—55% for Evergrande and 20% for Tencent. The subscription price of HK$0.0061 per share is a staggering 98% discount to the share price immediately before trading was halted; at this price, the implied value of the existing shares is just HK$0.2bn. After issuing the new shares, the company will have a massive 164bn shares outstanding (assuming all the company’s outstanding bonus warrants are exercised), while at the current share price, Evergrande’s shareholding alone would be worth HK$43bn.
So what are the acquirers’ plans for the company? To be honest, it’s not entirely clear, although it seems to be some form of “O2O” venture. The new shareholders intend to develop an “internet community service online platform”, establishing “an open and collaborative platform with both online and offline community services focusing on the Hengda Community… as its first batch of users, so that various consumer-related needs of the community service users can be fulfilled and integrated in one-stop, ranging from ordering, logistical arrangement and delivery of products or services”. The subscription proceeds will be used to fund the new business. Around a third will be spent on R&D including the purchase of a “carpark intelligence navigation system” (is it just a coincidence that Evergrande has lots of surplus car parking spaces?); around a quarter will be spent on hardware including a cloud computing centre, while the remainder will be spent on marketing, other investment and working capital.
This transaction raises a whole host of issues. It is clearly an attempt to obtain a backdoor listing for what at the moment is, in effect, just a business plan. Ironically the absence of any sizeable acquisition means the transaction may not be caught by the Hong Kong stock exchange’s reverse takeover rules (Evergrande has performed this trick before with Evergrande Health). Nonetheless, I would argue that since the exchange takes a principle-based approach to these rules, they should apply in this situation. This would mean the new venture needed to comply with the requirements for new listings, including the existence of a three-year track record.
The transaction will also enable the existing shareholders to sell at an inflated price. One of Mascotte’s largest shareholders has already sold half its holding, although it is as yet unclear who bought the shares and why they were sold at a large discount to the market price.
Perhaps the biggest question is: what are Evergrande and Tencent hoping to achieve? If this is such a valuable business opportunity, it seems strange to give away a quarter of the value to the shareholders’ of a worthless shell company. (Or perhaps more accurately: worthless apart from its ability to facilitate a backdoor listing.) It is not clear why they would not form a private joint venture; the current investment is not substantial and, at the moment, there is no need to raise outside financing. Evergrande is clearly the dominant partner; Tencent’s role appears to be to provide some internet star quality. It is hard to avoid the conclusion that the whole point is the inflated market value, particularly when press releases are issued talking up the share price.
The credibility of the Hong Kong stock market has already been damaged this year by the Hanergy fiasco. Except that did not involve two of the largest Hong Kong-listed companies engineering a further increase in an already inflated share price. This appears to be an egregious abuse of unsophisticated investors, who are anchoring on the earlier share price. The Hong Kong authorities need to clamp down on transactions like this before Hong Kong’s reputation is further damaged.