Yue Fung's Paper Trail
23 November 2000

Hong Kong-listed calculator maker Yue Fung International Group Holding Limited (Yue Fung) yesterday announced the acquisition of a stake in an "online trading business" called Slough Technology Limited (Slough), incorporated in the British Virgin Islands.

According to the announcement, 

"[Slough] targets to facilitate trading of electronic products between China companies and overseas companies by provision of online trading platform for buyers and sellers. In addition, the platform also aims to provide value-added trading services such as search engine, request for quotation and so on, latest technical and market information in electronics industry to facilitate transactions between buyers and sellers."

In other words, a B2B wannabe. As far as we can tell from web searches, the unnamed site is not yet online. Slough was incorporated only on 18-Feb-00, and has recorded a loss of HK$51,744 up to 31-Oct-00, when net assets were $103,256. Put them together and assume no other capital changes, and you have a start-up capital of exactly HK$155,000 (US$20,000). There are 20,000 shares in Slough.

Now Yue Fung proposes to buy 3,500 shares (17.5%) for HK$28m, valuing Slough at $160m, or more than 1,000 times its start-up capital. And you thought dot-mania was over! Yue Fung will also subscribe HK$2m for 300 new shares in Slough, taking their stake to 18.72% in the enlarged company.

The entire cost is HK$30m in shares valued at HK$0.10 each, so Yue Fung will issue 300m shares equal to 45.2% of its current capital and 31.1% of the enlarged capital. There are no selling restrictions on any of the vendors or on Slough itself, and because they receive less than 35% of Yue Fung, they do not trigger a takeover offer. 

The vendors of the shares in Slough and the resultant holdings in Slough are:

The company states that the vendors are all independent third parties, but since it fails to disclose who owns the corporate vendors, we have no way to verify this. Of the 280m shares to be issued to the vendors, 265m (or 27.5% of Yue Fung) will be issued to four companies with anonymous owners. The largest holding of any vendor will be 8.3% of Yue Fung, which is less than the antiquated 10% disclosure threshold in Hong Kong. That means we'll probably never know who owns the vendors and whether they have sold.

Valuation

Yue Fung states that the price:

"was negotiated... with reference to the value of the entire interest in [Slough] of HK$160m as at 30-Oct-00 which was estimated by Chesterton Petty Limited with reference to the projected financial data and business  plan of [Slough]."

If the name seems familiar, regular readers will recall that Chesterton Petty was responsible for the valuation of Cents.com Ltd in the controversial proposed acquisition by Pacific Challenge Holdings, which was eventually aborted. They seem to be establishing something of a track record in attaching massive valuations to internet start-ups. Historians may note that by pure coincidence, Yue Fung's IPO was sponsored by Pacific Challenge Capital.

We spoke to Andrew Slevin, Director of Industrial Services at Chesterton Petty, who was unaware that the valuation had been used by Yue Fung. He told us that Chesterton had been instructed by Slough "to provide a valuation to [Slough] to assist them in determining the potential value of the business for discussion with investors", but he was not aware of the identity of the investors. He also told us that the written report to Slough contained a requirement for Chesterton's consent before it could be used by third parties. Mr Slevin added that the valuation was based on discounted cashflow as projected by Slough, that he had never heard of Mandy Lau (who is the only human shareholder of Slough), and that his instructions had come from a Mr Ivan Wong.

We have not seen the Chesterton Petty report, and we probably never will, because "Discloseable Transactions" (where the consideration is less than 50% of the issued shares of the company) require only minimal disclosure in shareholders' circulars, even though approval of the share issue is being sought. In this deal, the new shares are equal to "only" 45.2% of the issued shares. A simple reference to the valuation will satisfy the listing rules. No accountants' report on the acquisition is required either - just a bottom-line disclosure of profits before and after tax, and net assets.

We do know that in the Cents.com case, which was a "Major Transaction" under the listing rules, Mr Slevin wrote for Chesterton Petty:

"the financial information, especially that relating to projected revenues... was provided by [E1 Media, the vendor]. We have relied to a considerable degree on this financial data and we give no opinion of the reasonableness or attainability of the underlying assumptions of the financial forecasts"

In other words, we based the valuation on the projections but we don't know whether they are reasonable, or if we do know, we're not saying.

Supercam

This is not the first deal Yue Fung has done with its shares. On 5-May-00 it announced the acquisition of 35% of Supercam Data, Inc (Supercam), which "is principally engaged in the development of digital image processing technology including image processing software and multifunctional digital camera". In fact, one of its products, the Wondereye, is made by HK-listed Welback Holdings, as shown on its web site.

Supercam was incorporated less than a year earlier, on 2-Jun-99. As all of its operating expenses had been capitalised with no turnover, Supercam had unaudited net assets at 31-Dec-99 of just US$1m (HK$7.75m), the same as its start-up equity.

For 35% of this, Yue Fung paid US$9.8m (HK$75.95m), equal to 35% of the valuation of US$28m (HK$217m) by American Business Appraisal Inc at 28-Feb-00. That's 28 times start-up capital. Apart from references to this deal, we could find no trace of this "independent professional valuer" on the web, and the shareholders' circular did not contain a copy of their report.

The consideration was payable with HK$13.55m in cash and the issue of 120m shares at $0.52 each, half to Tong Wai Keung and half to Lee Cheung Woo (Mr Lee). As a result, each person had 9.95% of the enlarged Yue Fung, just below the 10% disclosure threshold. There was no lock-up on the shares, so they were free to sell without disclosure.

The share price has been plunging ever since. The rest of Supercam is owned by Ma Luen Chi (22%), Ha Tung Lak (5.5%), Hui Tung Sing (5%) and Mr Lee (32.5%). On 7-Aug-00 Yue Fung announced plans to buy another 16% of Supercam based on the same valuation, this time for 232.96m shares at $0.15 each.  This deal would have been treated as a "Major Transaction" under the listing rules. The deal was scrapped on 29-Sep-00, citing unspecified "commercial reasons" but stating an intention to continue to negotiate for new terms.

On 23-Aug-00 the controlling shareholders agreed to subscribe HK$20m for a zero-coupon 3-year convertible note which converts at just $0.16 per share. The next day, a placing and subscription of 60m new shares at $0.15 was made through Kingsway SW Securities Ltd, raising $8.3m net. The share issue completed on 7-Sep-00 and the convertible bond was approved on 3-Oct-00. Both issues are intended to finance the manufacture and development (presumably in reverse order) of a new series of personal digital assistants called "Smart Doctor".

Performance

The shares are now trading at $0.108, down 70% year-to-date. Yue Fung listed on 8-Oct-97 with an IPO of 65m shares at $1.00 per share. It just beat its $40m prospectus profit forecast, recording $40.6m in the year to 31-May-98. As is so often the case with IPOs, the flotation year was their best year ever, and it has been downhill since, recording profits of $30.8m to 31-May-99 and $20.2m to 31-May-00. The company has only once paid a dividend, being the 3.5 cents promised in the prospectus for the year to 31-May-98.

Accounting for Investments

Yue Fung's acquisition behaviour wasn't always so erratic. Last financial year, it made two acquisitions, both of which, to be fair, seemed quite sensible and compatible with the core business.

Rubber key maker

On 28-Jan-00, it agreed to buy 25% of Richlink International Holdings Ltd (Richlink) for HK$34.875m, paid for with 60m new shares at $0.45 each plus the transfer of machinery and moulds worth $7.875m. That deal followed an aborted attempt by Richlink to reverse itself into a NASDAQ OTC shell called Nova Natural Resources Corp.

Richlink makes melamine products, silicone rubber key products and other electronic components. Calculator components supplied by Richlink accounted for HK$7.3m, or 7.3% of Yue Fung's purchases in the year to 31-May-99. The remaining 75% of Richlink was held by Mr Fu Chu-kan (67.5%) and Ms Fu Yu-ling (7.5%), each having sold 12.5%. The deal was completed on 15-Mar-00. 

Richlink made an unaudited profit in 1999 of HK$23.25m, and based on a reasonable 6 times earnings, Yue Fung valued it at $139.5m, so 25% was priced at $34.875m. By coincidence, the head office is just 1 floor below Yue Fung in Cable TV Tower.

PCB maker

On 18-Feb-00 Yue Fung bought 30% of Advanced Technology International Holdings Ltd (ATIH) for HK$57.33m, paid for with 80m new shares at $0.60 each plus $3m cash and the transfer of machinery and moulds worth $6.33m.

ATIH, incorporated in the BVI on 18-Nov-98, is a printed circuit board maker founded and run by Mr Roy Ho Wing-cheong (Roy Ho), who was formerly with HK-listed PCB maker Elec & Eltek. The business in practice goes back to 1991 and ATIH was created as part of a restructuring. ATIH is a supplier to Yue Fung, accounting for HK$7.1m, or 7.1% of Yue Fung's purchases in the year to 31-May-99. 

Yue Fung cited an unaudited profit of ATIH for the year to 31-Dec-99 of HK$27.3m, multiplied by 7 to get a valuation of $191.1m, hence 30% was priced at $57.33m. Of that, 17% was purchased from Roy Ho and 13% from Ms Chan Yuet-hing. After the deal, Roy Ho held 58% and Mr Dennis Ho Wing-hung (probably his brother) held 12% of ATIH.

On 24-Mar-00 a restructuring took place. ATIH was transferred to a BVI company called I.World Ltd (I.World) which swapped all of ATIH for 16.3m new shares in a Nasdaq OTC company called Score One Inc. As a result, Yue Fung owns 30% of I.World, which owns 81.8% of Score One Inc. US filings tell us that the head office of Score One is now 2 floors above Yue Fung and 3 floors above Richlink in Cable TV Tower.

Accounting treatment

Normally, since the company owns over 20% of Richlink and I.World, they would treat them as "associates" which would be "equity accounted". That means you record the share of profits or losses of such companies in your own accounts, and your balance sheet includes associates based on your share of their net asset value. Indeed, in both acquisition announcements, Yue Fung wrote that Richlink/ATIH "will become an associated company of [Yue Fung]".

However, in its annual report for 31-May-00, Yue Fung says it is "not in a position to exercise significant influence" over the operations of Richlink and I.World. Therefore it has treated both holdings as "long term investments" rather than associates. This allows Yue Fung to carry the holdings at cost rather than write them down to net asset value, and on the income side, no losses are recorded, and only dividend income is shown (none so far).

At the same time, Yue Fung recorded the deposit on Supercam (the acquisition of which was pending at the year end) as a "deposit against long term investment", implying that the 35% stake would be treated as an investment, not an associate.

Yue Fung will own less than 20% of Slough, so it will count as an investment, not an associate. This lumps it in with Supercam, I.World and Richlink, creating a substantial degree of opacity to the accounts, since we will see a large part of the assets only as long term investments, with no disclosure of their results. Yue Fung should go beyond the minimum diclosure and at least include summaries of the accounts of these investments if it chooses not to equity-account them.

Recommendation

The proposed acquisition of Slough is scant on detail, but appears to be another serious dilution to minority shareholders in Yue Fung.

This case highlights a pressing need for the Stock Exchange to require full disclosure of counterparties in such transactions, not just a string of anonymous BVI companies. If we are told who owns a counterparty, then although we can never be sure that a human being is not acting as a nominee for someone else, at least we have someone who will put their name to the deal, who faces the risk of prosecution if they lie, and who is not a post office box on a Caribbean island.

The Stock Exchange should also require circulars on Discloseable Transactions to contain an accountant's report on full financial statements of the target, so that we can see consider the target's accounts before approving the relevant share issue. It is simply unacceptable for a wannabe world-class market to allow issues of up to 50% of a company's shares on the basis of such poor disclosure.

Where a company cites an independent valuation in relation to a transaction, then that valuation report should be published in the shareholders' circular, and the valuer should state that the financial projections on which they rely are, in their opinion, reasonable and made by the target after due and careful enquiry, rather than disclaiming any opinion on them. That would result in professional firms thinking a lot more carefully before signing off on sky-high figures.

In the meantime, unless Yue Fung and Chesterton Petty are willing to meet these standards, we urge public Yue Fung shareholders to vote against the transaction.

© Webb-site.com, 2000

Organisations in this story

• Knight Frank Petty Limited
• YUE FUNG INTERNATIONAL GROUP HOLDING LIMITED

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