Brian Gaynor: Shanghaied in Shanghai?

China was the main topic of conversation at the Ellerslie Convention Centre on Tuesday afternoon. There were large maps of the country and Shanghai on overhead projections and talk of exciting prospects, cheap labour and complex property ownership laws.

The occasion was Richina Pacific's annual meeting, the NZX company with the longest and greatest exposure to the emerging economic giant.

Richina's Chinese involvement began in March 1995 when a group of investors, called the Richina consortium, acquired a 51 per cent shareholding from NZI and Peter Menzies at 28c a share (Richina has had a one-for-five share consolidation and three rights issues since then).

The company was called Mainzeal at the time and owned 51 per cent of Mair Ashley, another NZX-listed company. The consortium head was Richard Yan, who was born in Tianjin, China, in 1963 and was brought up in Beijing.

Yan came to New Zealand in 1981 under Auckland Rotary Club sponsorship for his final secondary school year at Auckland Grammar. He went on to obtain two degrees at the University of Auckland between 1982 and 1984.

The Richina consortium was a 50:50 joint venture between Richina Equity Trust 1, a US$52.5 million US-based fund that was put together by Yan to invest in China, and several wealthy American investors.

In May 1996, Mainzeal acquired 100 per cent of Mair Ashley and, four months later, changed its name to Richina Pacific.

Its first Chinese investment was the development of a huge tannery in Shanghai in partnership with Shanghai Leather, a Government-owned organisation. Shanghai Leather supplied the land and buildings and Richina contributed $17 million for a 55 per cent stake in the joint venture.

The tannery began operation at the end of 1996 and was expected to achieve its first profit in 1998.

In 1998, Richina bought another 40 per cent from Shanghai Leather to give it 95 per cent. But the tannery reported a loss of $9.6 million for that year before allocation of corporate overheads and interest charges.

The Shanghai operation reported its first profit in 2000 and since then its performance has been unspectacular. Richina stopped reporting it as a separate entity after the June 2004 half year but for that six-month period it reported ebit (earnings before interest and tax) of $5.3 million on revenue of $106.2 million.

Chief executive Yan wrote in the latest Richina Pacific annual report that the tannery's ovine garment and bovine upholstery divisions turned in unexpectedly large losses in the July to December 2004 period.

Yan went on to say that the company had been overly optimistic about these two businesses and it might have to reduce its capital exposure to the operation.

Richina's second Chinese investment was the construction of a new aquarium in central Beijing with the Beijing Workers Stadium. The Workers Stadium received an initial 20 per cent interest in the aquarium's profits in return for supplying stadium land for the project. The profit interest rose to 25 per cent in November 2003.

Then Prime Minister Jim Bolger opened the new aquarium, called Blue Zoo Beijing, on November 29, 1997. It cost significantly more than the expected $26 million.

The performance of Blue Zoo has been disappointing, mainly because Richina believed it had been granted exclusive rights in Beijing but now faced intense competition from similar facilities. Thoughts of building or acquiring other aquariums in China had been abandoned.

Richina's profit performance in China has been poor. As the accompanying table shows Blue Zoo has recorded operating (ebit) losses of $3.5 million and the Shanghai tannery has had total operating profits of just $10.5 million.

These figures flatter to deceive because prior to 2001 interest and head office costs were not allocated to individual subsidiaries. If these costs are assigned to the two Chinese operations in proportion to their assets, then Blue Zoo and Shanghai tannery have had total operating losses of more than $10 million.

Richina's other main operation is the New Zealand-based Mainzeal group. The property development and construction company has annual turnover of more than $300 million but operates an ebit margin of less than 3 per cent. Richina made its third Chinese investment in December 2004 when it bought 90 per cent of Shanghai Leather for US$20.6 million. The new acquisition, which was purchased from the Government, is Richina's former joint venture partner in the Shanghai tannery.

Shanghai Leather is an old fashioned former Chinese state-owned enterprise with interests in industrial water supply, chemicals, shoe manufacturing and distribution, leather products, parking services, taxis, plant leasing, real estate and a hotel and department store. At the time of purchase, it had 4650 employees on long-term contracts and 1000 temporary employees.

This week's Richina Pacific annual meeting was disappointing because Blue Zoo and the Shanghai tannery were hardly mentioned and all the emphasis was on the new acquisition. The problem with this is that Shanghai Leather is now perceived as a property development company, instead of an operating entity, and the Richina directors gave little indication that they know much about property development in China.

Shanghai Leather has land use rights over 43 plots of occupied land in China's largest city (there is no freehold or leasehold land in China). This is about 56ha and the potential for more commercial office space than Auckland and Wellington combined.

According to former Prime Minister Jenny Shipley, who is a Richina director, the biggest holding is about the same size as the Viaduct Basin from Princes Wharf to the Team New Zealand base. Shipley also told the meeting that Mainzeal was applying for a Chinese development licence. Richina will need to develop big projects because of the relatively large size of many of the central Shanghai sites.

But the decision to go down the property development route has raised more questions than answers. These include:

* Where will Richina find the development expertise? (Shareholders were later told that although Mainzeal was applying for a Chinese construction licence it wouldn't operate in that country.)

* Where will Richina obtain the capital to fund these huge projects?

* What will happen to the existing buildings and their employees? Has Richina made any commitment to the Chinese Government?

* Does Richina have the ability to do whatever it wants given China's complex land ownership rules?

* How long will it be before these developments contribute to the bottom line and will Blue Zoo and the Shanghai tannery fill the gap in the meantime?

Shareholders were particularly concerned about the continuing poor performance of Richina's existing Chinese operations and the prospect of their holdings being diluted by capital raisings to fund the huge Shanghai property developments.

But nothing could dampen the enthusiasm of Yan and his fellow directors. They believe they have a tiger by the tail and their journey through Shanghai will be paved with gold. New Zealand investors, particularly professional fund managers, are far less optimistic. They are not convinced that Yan and Richina have the strategic or operational expertise to create shareholder wealth from China's spectacular boom.

* Disclosure of interests: Brian Gaynor is a Richina Pacific shareholder and an executive director of Milford Asset Management.