Guangzhou Auto vows to privatise Denway and list in Hong Kong

Guangzhou Automobile, China's largest car maker and a partner of Toyota, yesterday said it is seeking a listing in Hong Kong by the end of July and will simultaneously privatise its 37.9%-owned affiliate Denway Motors, which has been trading in Hong Kong since 1993.

Guangzhou Auto will sell no new shares in connection with the listing, but because it will pay Denway's existing shareholders with shares -- no cash will change hands -- those who now own Denway stock will instead become shareholders of Guangzhou Auto. Based on the mid-point of the estimated valuation range for Guangzhou Auto and the share exchange ratio, Guangzhou Auto will have to fork out about HK$25.7 billion ($3.3 billion) to make Denway a wholly owned subsidiary.

At a press conference yesterday, Guangzhou Auto's chairman, Zhang Fangyou, said the two-pronged transaction will result in a more streamlined corporate structure that will allow the group to manage its resources more efficiently and to make more effective decisions with regard to the management and operations of each of its joint ventures. Guangzhou Auto has joint ventures with Toyota, Japanese truck and bus manufacturer Hino, and Fiat, while Denway operates a 50-50 JV with Honda under the name of Guangqi Honda. Following the privatisation, Guangzhou Auto will take over Denway's stake in the latter which will put all the JVs within the group at the same subsidiary level.

The new structure will also allow the Denway shareholders to participate in the growth of Guangzhou Auto as a whole, Zhang said, adding that the company, as the market leader in the mid- to high-end sedan segment, is well positioned to capture the full potential of China's rapidly growing domestic auto market.

China saw 45% growth in car sales from 2008 to 2009 and overtook the US as the largest auto sales market in the world, but the vehicle ownership rate is still well short of that in more developed countries, he said, noting that China only has 57 cars per 1,000 people, compared with 800 in the US and 600 in Japan.

"This leaves vast room for development...and we believe that there will be sustainable sales growth of more than 10% for years to come," Zhang said in a comment translated from Mandarin.

Secretary to the board, Lu Sa, added that the direct listing of Guangzhou Auto, which has been in the works in various shapes since about 2007, will also improve the corporate governance and management transparency and will allow the group to more easily tap into the international capital markets -- although both Lu and Zhang stressed repeatedly that the company has no need to raise funds in the near-term. The listing should also improve the company's brand image, which will help when it comes to attracting new talent, she said.

This is the first time a scheme like this, involving a listing by introduction (which is the name for a listing where no new shares are sold) and a privatisation has been attempted simultaneously. However, the net effect of the two transactions is the same as if Guangzhou Auto had done a backdoor listing, whereby Denway (the listed company) would have bought Guangzhou Auto and paid the owners in Denway shares, leaving the Guangzhou Auto owners in charge of the enlarged company. Typically following such a transaction, the listed company then assumes the name of the formerly unlisted unit.

The reason why Guangzhou Auto has decided to do it this way seems to stem back to the fact that the company wants to be listed as an H-share company, while Denway is currently listed as a red-chip. Guangzhou Auto is owned 91.9% by state-owned investment holding company Guangzhou Automobile Industry Group (GAIG) and does therefore itself count as a state-owned enterprise, so this does make sense. However, it means that it will be more cumbersome for the company should it wish to issue new equity in the future, as all H-share follow-on sales do need approval from the Chinese regulators. Red-chips, which are China-linked companies that are incorporated outside China and listed in Hong Kong, don't need such approvals.

The transaction in itself could also be a bit more challenging since the privatisation will be done through a scheme of arrangement that will need the approval of 75% of the shares held by Denway's independent shareholders. A backdoor listing, by comparison, only needs 50% of the votes to be cast in favour. And if shareholders aren't pleased with the implied price they will get for their Denway shares, they could decide to block the deal. According to Hong Kong regulations, if 10% of the votes are cast against the privatisation, then the deal won't go through -- even if 75% of the votes were in favour.

Guangzhou Auto is offering 0.37861 of its own shares for each Denway share, which means that the independent shareholders who now own 62.1% of Denway will end up holding 31% of Guangzhou Auto -- which will be a much larger company. In 2009 Guangzhou posted revenues of Rmb50.3 billion ($7.4 billion), which compares with just Rmb638 million for Denway. The parent-to-be also has a significantly larger production capacity and sold 780,000 units last year, versus Denway's 360,000 units.

As a basis for the offering, Anglo Chinese has come up with an estimated value for Guangzhou Auto of between HK$13.62 and HK$14.49 per H-share, which at the mid-point implies a market capitalisation of $10.7 billion. Before the privatisation announcement yesterday morning, Denway had a market cap of $4.3 billion.

Based on Anglo Chinese's estimate and the share exchange ratio, the privatisation offer values each Denway share at HK$5.32, which represents an 18.5% premium to the latest closing price after adjusting for the final dividend for 2009, which has been paid out since the stock was suspended on April 29. The premium versus the weighted average trading price in the 30 days before the suspension is a slightly greater 27.9%.

Some analysts argued that the premium was lower than expected and said this was the reason why Denway's share price tumbled 24% to HK$3.41 when it resumed trading yesterday. However, chairman Zhang noted that Chinese auto stocks have fallen significantly while Denway has been suspended, and argued that it was only natural that Denway's share price should adjust to this new environment.

Among other carmakers, Geely Automobile Holdings is down 19% since April 29, while BYD, an electronic car manufacturer backed by Warren Buffett, has lost 13%.

A banker said the implied offer price values Denway at about 12 to 13 times this year's earnings, which compares with a price-to-earnings multiple of 9.4 following yesterday's drop, according to analyst estimates compiled by Bloomberg.

Not surprisingly, Guangzhou Auto's management argued that the offer price is fair and the chairman said he is confident that the Denway shareholders will approve of the privatisation. However, it is worth noting that this is not a merger that will lead to a lot of synergies and while the Denway shareholders will get a chance to continue to benefit from the performance of Denway and the joint venture with Honda, a key reason for them to swap their shares would be that they feel they are making a gain in the process. If they don't think the price is sufficient they may well vote no to try and force a better offer -- perhaps one involving at least some cash.

Yesterday's drop in the share price does of course mean that the implied offer price looks more attractive - the premium versus the market price widened to 56% in one go -- but this holds true only if investors agree with Anglo Chinese's valuation of Guangzhou Auto (and the assumptions it is based on) to begin with. It is probably a fair assumption that its valuation report will be one of the most read portions of the privatisation documents.

A shareholders meeting to vote on the issue will be held in late June and so far, only one of Denway's existing shareholders have said that it will support the transaction. According to an announcement issued yesterday, Platinum Investment Management, which holds 5.2% of Denway's shares has made an irrevocable undertaking to vote in favour. However, this undertaking is only valid until July 31, which gives the company a deadline of sorts for completing the transaction.

Templeton Asset Management, which is Denway's largest independent shareholder with a 15.5% stake, has made no indication so far of whether it intends to support the proposals.

China International Capital Corp, J.P. Morgan and Morgan Stanley are acting as financial advisers with regard to the Denway privatisation. BNP Paribas is advising Denway's independent board committee.