“By making a company successful, you can provide more employment, and, if you treat your staff well, then your business itself becomes a charity.”
Guo Guangchang, Chairman of Fosun International
The official story about Fosun is as follows: The company is a Hong Kong-listed conglomerate, founded by four Fudan University graduates in Shanghai with an initial investment of just US$4,000. One of the four founders, Guo Guangchang, is now the Chairman. He is seen as a master deal maker and often referred to as “The Warren Buffett of China”, due to his investment acumen and use of insurance “float” to fund long-term investments. The four founders are still majority shareholders with 71% of beneficial ownership.
The company started in the pharma business, went into property development by the late 1990s just after the Chinese housing market was deregulated. As the number of acquisitions grew, Guo said that “it became clear that they could no longer operate the businesses themselves” and so they redefined Fosun as an investment company. According to the company’s presentation that they show to investors, the company’s book value has grown at a 42% CAGR since 2004.
The company now has 9 different segments, of which property, investment, health and insurance comprise the majority of operating profit. The below chart show the relative contribution of the currently profitable segments of Fosun (disregarding the loss-making steel and resources segments):
Fosun’s sample of its historical investments have returned IRRs of 22-51%. These acquisitions have been central to building up Fosun to what it is today.
- The health segment includes pharma companies such as Fosun Pharma (600196.CH), hospitals, senior living and health insurance companies
- The “happiness” segment includes Shanghai tourist attraction Yuyuan, Club Med, Thomas Cook, Cirque du Soleil and a number of hotels
- The property segment includes Shanghai-based Forte, acquired in 1998, as well as a number of smaller developers
- The resources segment is involved in iron ore mining as well as oil & gas through subsidiaries Hainan Mining (ticker: 601969.CH) and ROC
- The investment segment includes an insurance operation through in Portugal/China/United States and involvement in the Chinese wealth management product industry
Thanks to acquisition-led growth, it has achieved a revenue CAGR of 12% over the past five years. Some of the portfolio companies appear to be of high quality: Club Med resorts are top notch, Gland Pharma is a successful Indian generics company, Folli follie may be one of the best fashion brands in Greece and Yuyuan is one of the premier tourism and gold trading businesses in China.
The valuation is regarded as modest at a modest forward P/E ratio of 9.5x and a P/B of 1.1x. The adjusted book value per share (adjusted listed-subsidiary book values with their market capitalisations) is much higher, leading to an adjusted P/B of just 0.8x.
The massive complexity of Fosun hides the fact that much of its recent success has been built on an ever-increasing amount of debt. Earlier this year, S&P downgraded Fosun to junk, highlighting concerns about its debt load of 16.8x EBITDA (from 9.1x a year prior).
But despite an enormous amount of debt on its balance sheet, Fosun’s return on equity is barely 10% in renminbi terms. Even more worrying, most of the profits used to calculate return on equity are from capital gains. In 2015, capital gains of CNY 18 billion exceeded Fosun’s profit before tax of CNY 16 billion.
S&P calculates Fosun’s EBITDA at CNY 5 billion in 2015. Whether that estimate is reasonable depends on how recurring capital gains/losses, revenues and expenses are. Let’s assume for now that impairments and gains/losses are one-off while revenues, dividend income and other expenses are recurring. I then get to an EBITDA of CNY 8 billion for 2015. Compared to total capital employed this reflects a return (EBITDA/capital employed) of 2.9%. If you deduct maintenance capex – as you should – it is possible that operating profit actually becomes negative. Total capex ranged from CNY 15-20 billion over the past three years. How much of that represents maintenance capex? Given that EBITDA has barely grown over the past decade, I would guess that most of it does.
The cash flow statement paints an even grimmer picture: cash flow from operations in 2015 was a negative CNY 3.4 billion. Deducting interest paid, which shows up in the financing section of Fosun’s cash flow statement due to its IFRS accounting, cash outflow from operations equalled negative CNY 9.2 billion. Part of the discrepancy between net profit and cash flows is due to the CNY 18 billion in gains & losses, and part of it is due to the CNY 3 billion increase in prepayments, deposits and other receivables. Out of this, CNY 1.2 billion came from land acquisitions prepayments and CNY 1.1 billion from “prepaid expenses”. Whether this represents Fosun’s effort of pushing expenses into the future is unclear. Let’s just say that cash flows aren’t great.
An EBITDA of CNY 8 billion and total interest paid of CNY 5.8 billion leads to an interest coverage ratio of 1.4x – very tight for a capital intensive conglomerate involved with property, steel and mining. With interest-bearing debt of CNY 115 billion and cash of CNY 46 billion – of which I believe roughly CNY 20 billion is unrelated to the insurance business – net debt equals CNY 95 billion or so. My net debt/EBITDA number of 11.8x is lower than S&Ps – but still worryingly high.
Fosun’s currency exposures highlight another aspect of the company’s balance sheet risks. A 5% depreciation in the RMB would entail a CNY 1.1 billion loss in the income statement – despite the fact that Fosun’s financial statements are denominated in RMB. Fosun is essentially a levered bet on the RMB strengthening. It is surprising that Fosun’s medium term notes trade at a mere 3.5% yield to maturity.
The poor profitability and constant need for capex has been resolved by an ever increasing level of debt:
Meanwhile, cash flows and EBITDA haven’t really grown at all:
Rising debt and weaker profits put a question mark around Fosun’s value creation story. How can book value grow 42% per year while cash flows and EBITDA aren’t growing at all?
In my mind, Fosun is either extremely skilled at buying and selling assets that just happen to not throw off any cash flows. Or – they are simply trading assets with related non-consolidated partners to hide the fact that Fosun is not profitable at all. Which of these stories is most the plausible one?
One quick glance at the cash flow statement shows that Fosun’s acquisitions are actually primarily of further stakes in subsidiaries, associates, joint ventures or equity method investments. As an example, in 2013 Fosun increased its stake in Shanghai Yuyuan from 20% to 25%. This alone does not prove anything, although it’s somewhat suspect that tens of billions needs to be invested in portfolio companies on a regular basis. Or is Fosun simply great at negotiating good prices for investments that it already has stakes in?
First of all, the 42% CAGR in book value is on a total-company basis and rather than on a per-share basis. Somewhat misleading. It also includes a lot of goodwill. Tangible book value per share has gone from CNY 3.0 in 2007 to 6.4 in 2015, a CAGR of 9.9% – lower than China’s nominal income growth. But even this exaggerates Fosun’s ability to create value.
If you count back to the IPO in 2007, roughly CNY 28 billion of the increase in book value came from revaluation gains of stakes in subsidiaries, associates, JVs and equity interest investments. Another CNY 24 billion can be attributed to rights issues and bonds converted into equity. Yet another CNY 22 billion can be attributed to an increase in minority interests. These add up to CNY 74 billion. In contrast, Fosun’s book value only rose by CNY 68 billion. So other than the revaluation gains – Fosun actually destroyed book value over time. This is particularly alarming given that one of Fosun’s main businesses is property development and that Fosun has benefited from one of the greatest property market booms in history.
Regarding Fosun’s claims about 22-51% IRR on historical projects, the first thing to note is that they excluded some of their major investments. The 2010 acquisition of Nanjing Iron & Steel is excluded – as is Club Med, Folli Foolie and a host of other investments. Nanjing Iron & Steel’s profit fell from CNY 1.0 billion profit at the year of acquisition to a CNY 2.3 billion loss a 2015. Club Med is still loss-making. Cherry-picking projects when showing the range of IRRs is not lying per se, but misleading at best.
Even for the IRRs that were disclosed, the numbers are incredible. 21-51% unleveraged IRR is a hell of a return, especially over a 10-20 year period. In the following table I have estimated annual profits for subsidiary companies vs the investment cost per share multiplied by the number of shares. For the years of no data, I have assumed net profit growth of 25% per year and extrapolated backwards. For terminal multiples I have assumed 10x the average of the past three years’ profits. Some of the subsidiaries are valued at higher multiples – but let’s use these assumptions for now.
For some of the investments, Fosun’s IRR numbers aren’t that far off. Fosun made some great deals – including Zhaojin Mining at 3.9x PE, Hainan Mining at 4.5x and Yuyuan at what I believe was a highly valuable asset. And if current market capitalisations are used as a guide, then some of the IRRs look even better.
But a problem with the above IRR calculations is that they measure profits rather than cash flows. I have not seen full disclosures of where the last few years’ of almost CNY 50 billion in subsidiary investments went, but it is possible that Fosun has repeatedly supported them through additional capital. In Fosun’s IRR table for example, they only included their direct investment in Zhaojin Mining and not Yuyuan’s own investment. Additional investments were not included and I have not been able to track them completely. Zhaojin Mining itself recently made a bid to acquire Polyus Gold. As Yuyuan is not consolidated, taking on debt and increasing the dividend or selling a small stake could be one of the ways that Fosun is able to create those gains year after year.
The book 中国奇迹 sheds some light on Guo Guangchang’s success story. Guo and his friends did not just scramble together US$4,000 to build a multinational business. His old boss Wang Ronghua who later became the Vice Chairman of the Shanghai Political Consultative Conference helped him a great with land acquisitions, for example. His contacts also helped Guo Guangchang getting access to Li Yuanchao – now the Vice President of the People’s Republic and a member of the Politburo Standing Committee. Fosun’s investment into Nanjing was said to be brokered by Li Yuanchao. A JV was set up, using Nanjing Steel’s own operational assets as well as debt to buy shares in itself. I have no doubt that any property development or rent-seeking business in China at least to some extent has benefited from government connections. In Guo Guangchang’s case, it just more obvious.
Given his early success in Shanghai and elsewhere in the region, one might assume that Guo Guangchang indeed knows how to pull strings. But as the company expands internationally, it is unclear in my mind whether Guo really has a master plan. Some of Fosun’s recent investments are highly priced and financed via debt. The Gland Pharma transaction was 60% debt-financed and said to represent a PE ratio of 35-40x. Club Mediterranee might be a great investment but is not making any profits at the moment. BCP at 0.35x book looks cheap on the surface, but the bank has a 5% equity/assets ratio in an economy weighed down by the strong Euro. The jury is still out on whether Fosun can replicate its success internationally.
What next for Fosun
Fosun’s traditional businesses of real estate, iron ore, gold trading and pharma distribution have served them well over China’s property and construction boom over the past decade. The company is now facing a number of obstacles however: leveraged exposure to a property bubble, a steel business that is still in heavy oversupply, as well as a sprawling portfolio of investments that I think might be too much for Fosun to manage. S&P’s concerns about debt are justified, particularly given the long-RMB bias of the balance sheet, negative cash flow and hardly any EBITDA to speak of. And Fosun’s ability to pull strings to get access to great investments may diminish. In the turf war between Xi Jinping’s second generation reds and Jiang Zemin’s Shanghai faction, trusted allies of Fosun in Shanghai may not be of much help anymore. Guo’s connections may even work against him, given that he has repeatedly been withheld for questioning in recent years – presumably as part of Xi Jinping’s anti-corruption campaign. Either way, the reliance on asset sales to boost profits is not going to work much longer. Once the mirage of profits is dispelled, Fosun’s shares are in my view unlikely to trade at the level they are today. If so, Fosun will ultimately prove to have been a charity – just as Guo Guangchang envisioned – transferring capital from minority shareholders to insiders such as himself.