Warburg Pincus invests in Gome

One of Asia''s smartest private equity investors hopes to revive the fortunes of China''s largest electronics retailer.
Private equity investor Warburg Pincus announced yesterday (February 2) that it will pay $128 million to purchase up to 9.7% of China's leading electrical goods supplier, Gome Electrical Appliances.

The deal was structured via a five-year convertible bond and warrants issue under the lead of Gome's house bank ABN AMRO Rothschild. It includes a strategic partnership between the two firms that will allow Warburg Pincus to nominate one non-executive director to Gome's board. It also contains several undertakings by Gome chairman and majority shareholder Wong Kwong-yu, which seem designed to address long-standing investor concerns about a lack of transparency within the group.

According to a statement, Wong will provide Gome with audited financial information on his privately-owned retail chain (which also sells electronic consumer products) starting from 2007. He has also given the listed company, in which he currently owns 66%, an option to buy all his privately held retail assets and has committed to inject them into Gome by 2011.

The listed company will also have exclusive rights to operate in, "all new formats of consumer electronic retailing," according to the statement. Investors have shunned the Gome stock since news of the privately-owned vehicle emerged in June last year on concerns the two units could end up competing directly with one another. Indeed, Gome's smaller rival China Paradise, which listed in Hong Kong in mid-October, has consistently traded at a premium to its larger competitor.

Analysts say the Warburg Pincus investment could help alleviate some of these concerns. The private equity fund has built a reputation as one of Asia's smartest investors and is also known for playing an active role in strengthening corporate governance in the companies it invests in.

Says one analyst, "Some of the overhang will be lifted and it may give the share price a chance to catch up with the other home appliance counters." Some uncertainty will still remain, however, since it is not yet known what valuation the private assets will command when they are injected into the listed vehicle.

Investors may also want to see how successful Wong, who was named China's richest man by Forbes for the second straight year in 2004, and Warburg Pincus will be in executing their joint aim to create, "a best-in-class Chinese company with high corporate governance standards." They also vow to make Gome, "a listed company that is highly respected in the capital markets through transparent and timely communication with investors and analysts" - attributes which can hardly be said to have defined the corporate culture at the firm so far.

According to Thursday's agreement, Warburg Pincus will buy five-year convertible bonds with a face value of $125 million, as well as five-year warrants that can be exercised into $25 million worth of Gome shares. The subscription price for the warrants is $3 million.

The deal represents Warburg Pincus' single largest investment into a Chinese company, although it has invested over $650 million in China since it entered the country more than a decade ago. The bonds will carry a 1.5% coupon and are convertible into new company shares at a price of HK$6.40, which equates to a 16.79% premium to the average closing price over the last 30 trading days.

The share price gained 7.08% to HK$6.05 last Thursday before being suspended from trading last Friday. Over the past 12 months, however, it has fallen 18.8%.

China Paradise, by contrast, is up 25.2% since listing and is currently trading on a 2005 P/E multiple of 23.8 times, compared with Gome's 20.1 times.

The fact that the conversion premium was not based on the latest closing price was indicative of the buyer regarding this as a strategic, rather than a financial investment, one observer said. It also reflects the fact that negotiations between the two parties have been going on for at least one month, he added.

The bonds are redeemable at 109.48%, giving a yield to maturity of 3.26%. There is an issuer call after three years, subject to a 130% hurdle, although only 50% of the bonds can be redeemed. The warrants are exchangeable into shares at a price of HK$7.70 each, which represents a premium of 40.51% to the same 30-day average close. The bonds and the shares received upon conversion or exercise of the warrants will be subject to a one-year lock-up.

Gome said it will use the proceeds to expand its business in China, while the cash received upon the full exercise of the warrants will go towards general working capital. In order to fend off fierce competition from rivals such as China Paradise, Gome plans to increase its total number of outlets on the mainland to 1,000 by the end of 2008 from about 260 at the end of 2005.

While the new stores are adding revenues, analysts have expressed concern that the increased costs are eating into profit margins. In the first nine months of 2005, Gome's operating margin narrowed to 5.1% from 6.6% a year earlier.

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