China steel merger a ‘rip-off’

The mega-merger of two Chinese steelmakers has a lot of benefits for the country. But it is a terrible deal for shareholders.

The long-awaited merger of Baoshan Steel (Baosteel) and Wuhan Iron and Steel is almost at the finish line. Baosteel announced the details of its acquisition this week, offering 0.56 shares of Baosteel for each unit of Wuhan Steel stock.

The deal makes a lot of sense from a public policy point of view. By merging two steel giants, China’s powerful State-owned Assets Supervision and Administration Commission (SASAC) will begin tackling the thorny problem of overcapacity in the sector.

But although it might be good news for government officials in Beijing, the merger is leaving shareholders out in the cold.

Acquiring companies usually pay a premium to shareholders of the target, making sure the deal goes through with minimum complaints, said a portfolio manager in Hong Kong. But Baosteel’s offer — and the equivalent cash settlement for those who do not want Baosteel stock — comes at a discount to Wuhan’s last trading price.

But investors in Wuhan are not the only ones with cause for complaint. The acquisition means Baosteel investors will see their earnings per share fall as the company swallows its loss-making rival.

“The Baosteel-[Wuhan] deal is 28% earnings dilutive,” one shareholder in Baosteel said. “It does look like to me that the government is trying to achieve its goal of improving national asset quality by ripping off private individual shareholders.”

Minority report

Baosteel plans to issue 5.65 billion new shares — 34% of its total shares outstanding — to replace Wuhan’s existing shares.

Investors in Baosteel are being forced to accept the absorption of a markedly less profitable company. This is despite the fact Baosteel itself is hardly generating dizzying margins.

Baosteel’s net profit in the first half of 2016 was Rmb3.5 billion ($524 million), giving it a return on equity of 3%. Wuhan, meanwhile, reported a net loss of Rmb130 million in the first half, giving it a slightly negative ROE. That is better than last year, when its ROE was minus 23%. But that’s little consolation to investors.

The earnings dilution following the merger would push down Baosteel’s earnings-per-share for 2016 from Rmb0.21 to Rmb0.15, according to a research analyst at Bank of America Merrill Lynch.

After the merger, Baosteel will be renamed China Bao-Wu Iron & Steel Group. It will surpass Hebei lron and Steel Group to become the largest steel producer in China and the second largest in the world, behind India’s ArcelorMittal.

The merger creates obvious synergies. It gives the combined entity a higher market-share, potentially lower costs, and more efficiency when it comes to logistics and procurement, according a research report by Deutsche Bank. But the report also came with a warning.

“[The] transaction might create market concerns about China SASAC’s ignorance towards minority shareholders’ interests because this merger is dilutive to such a good quality asset as Baosteel,” Deutsche analysts wrote.

An official at Baosteel rebuffed the criticism of the valuation, claiming those investors who did not want the share swap could instead take a cash settlement. But that does not appear a good option for investors.

If they choose not to participate to the stock swap, Baosteel shareholders will have an advanced cash option of 4.6 yuan per share while Wuhan holders can have 2.58 yuan per share

Baosteel last close was 4.9 yuan and Wuhan was 2.76 yuan. That means the 0.56 shares that Baosteel is offering Wuhan shareholders equates to around Rmb2.744, a slight discount. The cash offer comes at a discount of more than 6%.

Wuhan could not be reached for comment despite repeated phone calls.

Wider plan

China plans to cut its steel production capacity by 45 million tonnes this year and by 150 million tonnes by 2020, according to government plan.

“I’m very confident that we can achieve the targets,” Xu Shaoshi, chairman of the National Development and Reform Commission, said at the World Economic Forum in the northern city of Tianjin in June this year. “The most urgent task is reducing excess capacity.”

This deal is a palpable example of the Chinese government’s attempt to pull-off reform of state-owned enterprises. Some recent SOE mergers and acquisitions include the merger of railway giants China CNR and CSR in mid 2015, China Minmetals’ acquisition of China Metallurgical in late 2015, and the merger of China Ocean Shipping and China Shipping in early 2016.

Bankers and analysts think there are plenty more to come.

The merger of Baosteel and Wuhan Steel was well flagged back in June, when trading in both companies was halted.

Baosteel will only acquire the production arm of Wuhan and will let the parent to retain all its non-steel businesses.

The boards of Baosteel and Wuhan Steel already approved the transaction. But it is still pending approval at shareholder meetings, as well as from the SASAC, the China Security Regulatory Commission and the Ministry of Commerce.

Citic Securities is the financial advisor for Wuhan Iron & Steel.

The legal adviser is King & Wood Mallesons.

China International Capital Corporation (CICC) is the financial advisor for Baoshan Iron & Steel. The legal adviser is Fangda Partners.

¬ Haymarket Media Limited. All rights reserved.

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