Newsletter October 2005

Scramble for China’s Bank Market   A fierce battle has been accelerating for a niche in China’s banking industry in the face of China’s preparation to completely open doors of its banking industry.  Foreign banks have been staking out strategic alliances in China, hoping to be well-positioned for the eventual full opening of the industry just one year and three months ahead. Chinese welcome this competition and look at it as an opportunity to bolster their capital and improve management. China wants to raise money to modernize its state-owned banking system by selling minority stakes to foreign investors while retaining control of the institutions. Under current regulations, China limits total foreign investment in any single bank to 25 percent. Individual foreign banks can only hold up to 20 percent shares. The stable economic operation has provided good opportunities for reforming the macro banking regulation system. China lifted the control over the interests on the interbank borrowing and lending market, the bond market, the interbank bond market and the issue of foreign currency loans and step-by-step the floating band of the interest rates on RMB loans. Now, let’s see the current Chinese banking landscape. There are four state-owned commercial banks, 12 joint stock commercial banks, 112 city commercial banks, 681 urban credit cooperatives, seven rural commercial banks, eight rural cooperative banks, and 32,854 rural credit cooperatives. Although joint stock banks have grown considerably, the four state commercial banks still enjoy a dominant position. According to Asia Pulse, they had absorbed 65 percent of the country’s total savings deposits, handled 80 percent of the total payments, settled and provided 56 percent of the total loans, and hold 60 percent of the country’s total financial assets. Differentials in the interest rates between deposits and loan remain the main profit source of Chinese banks. The four state-owned commercial banks realized a combined profit of $50.3billion from 1985 to 2001, according to Asian Pulse.   Their profit in 2002 and 2003 dropped as they used most of the profit to offset the bad assets of the previous years. Although the percentage of bad assets of Chinese banks is high, it has assumed a downward trend for three consecutive years starting from 2002. The proportion of non-performing assets in the four biggest banks has dropped to 10.2 percent so far this year from 29.2 percent in 2000. S&P took note and on September 28th upgraded 25 Asian bank ratings. S&P estimated that governments have spent over $500 billion on banks since the Asian financial crisis and such support would continue given the importance of the sector to the region’s economies.   However there is considerable risk behind this gold-rush.  Banks are facing greater business risk and uncertainty due to fluctuation of interest rates and exchange rates. Uncertainties had arisen due to expanded limits on yuan lending rates and reforms of exchange rate mechanism. China says it will gradually make the yuan more flexible, though it has not specified a timeframe. In July it dropped the yuan’s peg against the U.S. dollar, though since then the exchange rate has moved very little by international standards. Despite the risks, foreign financial institutions are investing billions of dollars in Chinese banks, just as the table above shows. So far China has lured well over $15 billion and is expected to draw much more through IPOs. Core Pacific Yamaici analyst Kent Yau expects, “plenty of demand for the listings, given continued investor interest in China and the scarcity of mainland bank stocks.” And it’s not just the scarcity of stocks. The coming bank IPOs are testing the market at 1.29 to 1.87 times their book value for 2005. And this makes valuation extremely attractive.   Report with Mr. Weidong Yin, CEO of Sinovac (NYSE:SVA)   Mr. Weidong Yin represented Sinovac at the Grand Hyatt New York in New York City on September 26th during the UBS Global Life Science Conference. The conference was followed by a Q&A session and one-on-one meetings. Our senior analyst, Mr. Balazs Fabry, went and reports the following story. Q: How do you see Sinnovac’s revenue growth potential in short– and long-term? A: First of all, we have to realize that each product has a different lifecycle. Sales of Helive, our Hepatitis-A vaccine is expected to grow over 20% in 2005 and surpass 1.000.000 doses. This is our core product at this moment. Bilive, our combined Hepatitis A&B vaccine is expected to generate growth from 2006 and beyond. This vaccine is far superior to any of its competitors and we expect exponential sales growth from it. Anflu, our influenza vaccine is a potential big hit, we a preparing for the 2006 flue season with over 2 million doses. The results of our vaccine will be presented at the WHO November conference, potentially hitting our numbers as well. Our SARS vaccine is a big question mark since no new cases has been reported. Also, don’t forget the advanced stage of our Japanese Encephalitis vaccine, just to name a few drugs from our pipeline. Q: What can you tell us about the employee stock compensation package? This type of compensation is ruining your bottom line and all profitability measures. A: We understand your concern. However investors have to realize that this is our primary tool to keep employees onboard. So we will keep this kind of compensation. But on the same token, we will limit stock option only for a selected few individuals and eventually this type of cost will be marginal. And talking about profitability. We expect the company to turn back to the black in late 2006 or early 2007. Q: What about production capacity? How will you be able to meet production and sales targets? A: First of all, our presence at the UBS conference today is just part of our road-show.  We aim to raise $25 million to secure funds for an additional 20 million dose facility. We have potential investors to meet and we believe investors will realize the potential that Sinovac and our line of products represent. Q: Lastly, we see the low institutional ownership as a burden on the share price performance. What do you plan to do about it? A: We agree, the share ownership structure is far from ideal at this time. But, you have to realize that we have gone on a long way since we became public.  We have 18,281,850 free trading stocks plus 19,830,361 restricted stocks as we speak. In other words, insiders own 52 of total shares outstanding. Now, concerning the float of 18 million shares, Non Objecting Beneficial Owners own 75 percent of that.  And this is a significant change from last year when 17 percent of the stock were owned by non-interested investors (e.g. converted shares of the company Sinovac purchased to help go public). And don’t forget that 82% of our floating shares are owned by U.S. based beneficiaries up from 65% in 2004.   Where does my Chinese investment barometer point? NORTH!   We have some serious questions to answer. Why would any rational investor consider nesting his or her eggs in China and if so then how to do it right? First of all, it’s getting harder and harder to miss China from the economic landscape. It’s not that China is the most populous country on earth and as such it is doomed to grow.  But if we take a closer look at micro and macro economic levels, the story is the same. Growth all across the border. Many of us don’t pay closer attention to IMF and central bank numbers, not to mention rating agencies like S&P when they upgrade or downgrade stocks or markets. However if these three tell the same at the same time, we better listen. First, it was September 15th when China’s official Xinhua reported that trade volume between China and the 10-member Association of Southeast Asian Nations (ASEAN) grew 25 percent in the first half of  this year to reach $59.76 billion.  Less then a week after the news, a Morgan Stanley report showed that Chinese internet industry will surpass Japan’s in 10 years. The report highlighted the fact that the Chinese market is more dynamic while the Japanese market is dominated by one company. “The  $15.1 billion equity value of China’s commercialized internet, which includes 13 portals, online game services and auction houses, lags the approximately $40 billion equity value of the same market in Japan. However the balance is about to change because China’s growing online population is the second biggest in the world and the biggest for users under age 30.” according to the report. And while Yahoo! Japan controls much of the internet  in Japan, China is seeing no dominant player. Then came the IMF on September 21st by raising the 2005 growth forecast for China to 9 percent. In its twice-yearly snapshot of the world’s economies, the IMF said Chinese growth was now poised to hit 9 percent this year, up from 8.5 percent in April. In 2006, the fund expects China’s economy to grow 8.2 percent, again up from the IMF’s April outlook of 8 percent.   China’s Central Bank followed suit on September 26th, raising GDP forecast to 9.2 percent  this year, up from an initial estimate of 9 percent. The report did not elaborate on the reason for the revision in the GDP growth estimate. But economists have pointed to strong demand for exports and a rebound in spending on construction as key reasons for the continued strong growth. However, growth in China’s GDP is expected to slow slightly to 8.7 percent in the first half of 2006, the research bureau of China’s Central Bank said. China’s economy grew a blistering  9.5 percent in 2003 and 2004. The icing on the cake came from  a global ratings agency, when S&P upgraded 25 Asian bank ratings on government support on September 28th. The agency estimated governments had spent over $500 billion on the banks since the Asian financial crisis and such support would continue given the importance of the sector to the region’s economies. “The banking sector’s critical role in financing the economy and as a repository deposits, particularly retail deposits, includes Asian governments to support the banking system more they perhaps might do in systems where developed capital market exists”, it said in a statement. In addition to the banking sector, Asian mergers and acquisitions activity is up 20 percent in the first nine months of 2005, according to Dealogic. The data provider said on September 29th that in addition to more M&A activity, investment bankers are also selling more stock offerings as the region’s economies outpace those in Europe and the U.S. Asian Pacific M&A, excluding Japan, was $188.3 billion through September, compared with $156.7 billion a year ago, according to preliminary data from Dealogic. Hong Kong’s bourse chief’s remarks perfectly line up with these findings. Chief Executive Paul Chow said on September 28th that he expects funds raised by IPOs to exceed HK$100 billion ($12.8 billion) this year, topping last year’s $12.5 billion haul, as more mainland Chinese firms look to raise capital. Hong Kong’s market, favored venue for Chinese firms listing abroad, has helped 32 companies raise $8.86 billion through initial public offering so far this year. The healthy IPO pipeline will get  boost next from China Construction Bank in October as she plans to raise $7.7 billion, Hong Kong’s larges ever. Now, one can ask: how do I transform these numbers into growth in my own pocket? We believe U.S. listed Chinese companies are the way to go. They offer greater transparency combined with growth potential. And as our growth and conservative portfolios have outperformed all major indices, we can not highlight the importance of  reliable investment advice. 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