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Chinese IPO Prospectuses = Buyer Beware


Understand the risks of Chinese IPOs before buying into the China Internet bubble brewing on US exchanges.

Slap a Chinese name on a familiar US-based Internet business model and call it a successful IPO.

The Amazons (AMZN) and YouTubes (GOOG) of China are stories that seemingly sell themselves given China's Internet population of over 450 million users and their rapidly increasing Internet usage.

The idea is alluring. The reality is that in an ironic turn of events, China is outsourcing to the US. They are outsourcing an Internet bubble.

Why? Because gullible US investors will frantically buy into just about any story that contains the word China.

E Commerce China Dangdang (DANG) and (YOKU) surged 87% and 161% respectively on IPO debut day back in December. Four Chinese dotcom companies that IPO'd earlier in 2010 averaged a 57% gain on the first day of trading. A similar story will likely soon be told for, the Facebook of China now rumored to go public sometime in 2011.

Have investors even opened the prospectuses to these companies? Have they considered the fact that the Chinese government maintains total control over China's Internet? Do they even understand the general inherent risk of Chinese companies?

My guess is no.

So allow me to paint a clearer picture of a Chinese IPO. One of my best friends here in Shanghai works for an investment bank that focuses solely on companies seeking to list in the US. While completing the pre-IPO process, a client operating gyms across the city informed her that in their prospectus, they will only include the four profitable locations in their portfolio. The other eleven unprofitable businesses will be "divested" to another holding company and re-acquired post-IPO.

The actual resulting structure of these transactions is unknown, even to her, the banker. The point is that there is a lot that goes on behind the scenes (and behind the stated numbers) of a Chinese company. From my understanding and discussion with Chinese friends in the business, the Chinese aren't strangers to misrepresentation when it comes to filing for an IPO.

Taking a look through Dangdang's financials, the company posted an operating loss of RMB 77.8 million and RMB 87.8 million in 2007 and 2008 respectively. For 2009, the latest year reported in the prospectus, operating income was a positive 10.9 million. In 2009, the gross profit increased a whopping 600 basis points from 16.6% to 22.5%; right "on par" with Amazon

How in the world was this miraculous performance achieved? Management claims it was due to lower product procurement costs as a percentage of revenue and better pricing. Commanding just 8.9% market share and sales of less than $220 million, it's difficult to accept the explanation and believe that the company was able to achieve such scalability in such a short period.

The recent shareholder lawsuit filed against Mecox (MCOX) proves there is good reason to question the results. The company, which just IPO'd in October, revealed that its 2010 gross margins will decline 400 basis points and post long lists of significant increases in cost, including a 40.2% rise in compensation and benefit expenses.

Mercox is joined by an increasing list of Chinese companies being sued in the US for supplying prospectuses that contain false or misleading information, creating a barrier to truly understanding the business models and determining the sustainability or probability of profitability.

Yet, Dangdang is selling at 6.64 times sales compared to Amazon, with historically proven strong cash flow generation, persistent growth and a net margin nearly triple that of Dangdang, selling at 2.38 times sales.

Youku is selling at 81.2 times sales. It has yet to post a positive gross profit. Even after Mecox's steep decline following the lawsuit, it still sells for 52 times earnings.

Significant opportunity lies in China's underdeveloped Internet space. While the government recently announced plans to step up Internet censorship in response to Middle East protests, it also protects domestic players, blocking or making it difficult for international players to exist in the market.

Like the US tech bubble, there will be robust winners that emerge from this Chinese Internet phenomenon. But given the nature of reporting, particularly in IPO prospectuses, investors will have to rely mostly on their gambling luck and hope for a momentum gain for future IPOs like renren. Because at the end of the day, what you see isn't always going to be what you get when it comes to Chinese investments.
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