Far from shipshape

For a company at the centre of an insider trading investigation, Well Advantage seems an apt name.

The Hong Kong firm has caused some embarrassment for its owner, tycoon Zhang Zhirong. It is accused by the US Securities and Exchange Commission (SEC) of being part of a group of traders that used privileged information to buy stock in Canadian oil and gas company Nexen. The SEC notes that company insiders seem to have bought shares just days before Chinese oil major CNOOC announced a $15.1 billion takeover bid. There was an immediate $13 million gain in value from the spike triggered by CNOOC’s bid.

The SEC likewise noted that Zhang is also the controlling shareholder at Rongsheng Heavy Industries, a company that has “significant business activities” with CNOOC.

The SEC’s announcement proved costly for the Jiangsu businessman. The day after the news emerged, shares in Zhang’s listed companies nosedived in Hong Kong. Rongsheng Heavy Industries, China’s largest private sector shipbuilder, slumped 16.4%. His property developer Glorious Property Holdings shed 10.6%.

The scandal comes at a terrible time for Rongsheng, a company already suffering from a global slowdown in demand for new ships. Making a bad PR week worse, Rongsheng subsequently delivered a dismal set of first half results and spooked investor confidence further by backing out of a planned acquisition.

Zhang now faces a series of questions. Is heavily indebted Rongsheng heading for the rocks? Can he bounce back from the SEC allegations or will they hurt his firm’s business dealings with CNOOC? Could the scandal even derail CNOOC’s attempt to buy Nexen?

Rongsheng’s problems seem to extend over a wide area, but our starting point is the calamitous state of China’s shipyards.

An industry all at sea?

The shipping slowdown won’t be news to regular readers of WiC: we last mentioned the “perfect storm” facing the industry in February (see WiC137). The Financial Times has since called it the “worst shipping downturn in 25 years”.

Rongsheng’s first half results showed that it is feeling the pain too. The shipbuilder announced that profits fell 82% in the first six months of 2012, versus the same period in the previous year. That meant it barely stayed in the black, with net income registering just Rmb215 million ($33.8 million). Moreover, Rongsheng would have fallen into the red were it not for a government subsidy.

Demand has collapsed. The Shanghai Daily points out that in the first half of 2012 Rongsheng received orders to build just two ships (versus 24 a year earlier) “as global overcapacity deters shipowners from adding ships”. Those two orders were worth just $55.6 million versus $1.08 billion of business in the prior period, reports Reuters.

The reduction in demand is leading to cutthroat competition too, as local shipbuilders fight to win the limited order book on offer. South Weekend spoke to one industry player who cited a recent bidding war for a container ship contract in which the price dropped to $25 million – a level where the yard will make a paltry profit.

Zhang’s voyage into troubled waters…

Zhang Zhirong is a native of Jiangsu, one of China’s more entrepreneurial provinces. His rise has been nothing if not rapid: still in his early forties, Zhang was ranked by Forbes as China’s 22nd richest person in 2011, with a net worth of $3 billion.

He made his original fortune in real estate, primarily in Shanghai. But in 2003 he was made aware that China’s leadership wanted to see local firms take on a more dominant role in shipbuilding. Keen to diversify, Zhang posited that ships were like ‘offshore real estate’, says South Weekend. He decided to enter the industry, despite lacking any prior experience.

Zhang rectified some of this shortfall by recruiting one of China’s most experienced shipping executives, Chen Qiang. He also had the advantage of a close relationship with the local government in his hometown of Rugao, part of Nantong City. He struck up a close rapport with Rugao’s Party secretary Chen Huijuan, persuading her that shipbuilding was a great development opportunity.

Locally they became known as the ‘Three Musketeers’ as the trio sought to build China’s biggest shipmaker from scratch. Crucially, the local government official was able to secure a prime spot for the yard on Changqingsha Island, near the Yangtze River (such an important location that it required State Council approval). The Rugao government also gave the fledgling firm subsidies and lobbied banks to provide competitive loans (since 2008 Rongsheng has been offered credit lines worth Rmb200 billion, or roughly $31.5 billion). A Hong Kong IPO in 2010 also helped to boost growth.

Key clients such as Brazil’s Vale were landed, and by 2011 Zhang was boasting that Rongsheng was China’s top-ranked shipyard by new orders.

Even as the Baltic Dry Index plunged, Zhang’s manner was confident, telling Nantong’s deputy mayor last October that “Rongsheng is leaping towards becoming one of the global shipbuilding leaders”.

Not waving, but drowning?

Rongsheng’s CEO Chen Qiang was notably less ebullient. He’d earlier admitted that hardly any orders had been obtained in the most recent fiscal quarter and that profit warnings were likely.

Aside from the general deterioration in industry conditions, Chen was soon having to deal with operational concerns too. In March Rongsheng was forced to dismiss safety concerns over the huge Valemax vessels – a new breed of dry bulk carrier – that it has been building for iron ore giant Vale. This came after Chinese transport officials referred to the “hidden dangers” of these colossal 360-metre ships. To the chagrin of their Brazilian owners, the Valemax ships have been barred from docking in Chinese ports.

The row has left Rongsheng with a headache too. It won orders from Vale to build 16 Valemaxes worth a total of $2.1 billion. But the Brazilian firm is now reluctant to take delivery of ships that it cannot unload in China – the destination for which they have been designed. For instance, Rongsheng completed the 380,000- tonne carrier ‘Vale Hebei’ in February but Vale has yet to accept it into its fleet, offering various reasons for the delay. Needless to say, until a buyer takes delivery, a large chunk of the contracted price goes unpaid, which weighs increasingly heavily on Rongsheng’s balance sheet.

Finances already looks stretched: as of March, the shipbuilder had run up Rmb35 billion in liabilities and is paying an estimated Rmb2 billion per year in interest. In the past it has always been able to count on a supportive local government to ensure access to bank finance. But the media now wonders if that tried-and-tested route is still open. In June Chen Huijuan resigned as Rugao’s Party secretary. South Weekend muses: “Whether Zhang Zhirong and Rongsheng will still obtain the powerful support of the government remains unknown.”

Any more bad news?

The failed acquisition of Anhui Quanchai Engine could prove another setback for Zhang. Last year Rongsheng agreed to acquire the Quanjiao local government’s 44.5% stake in the diesel engine maker and said it would make a formal tender offer to other shareholders in the listed firm at Rmb16.62 per share.

News of the bid saw the target company’s shares rise in price. But as the business environment worsened, the deal was repeatedly deferred. As deadlines passed and Rongsheng requested more delay, Quanchai Engine’s stock began to slide. Finally, on August 17 Rongsheng announced that it had withdrawn its offer. Investors seem to have expected it. Since March, Quanchai’s stock has almost halved to Rmb8.02 per share.

The deal’s collapse is being taken as further evidence of Rongsheng’s constrained cashflow. But minority investors in the target company are furious. According to the Economic Observer, they have applied to the CSRC, China’s stock market regulator, to take legal action over the debacle.

Indeed, after the Nexen insider trading case and the botched bid for Quanchai Engine, the 21CN Business Herald has concluded that the shipbuilder “is facing an unprecedented crisis of credibility”.

Zhang’s top priority is…

According to the South China Morning Post (SCMP), the tycoon has hired a specialist lawyer to help him deal with the SEC allegations. The newspaper claimed that sources familiar with Zhang say he is keen to avoid a fine and is looking to cut a deal with the SEC. This could involve forfeiting the multi-million dollar profit that Well Advantage made trading Nexen stock.

The SCMP adds that the businessman is “facing growing pressure from CNOOC, with which he used to have a good business relationship, to settle the SEC case quickly.”

CNOOC is one of Rongsheng’s key clients. Earlier this year, Zhang told Hong Kong media that a pipe-laying vessel made for CNOOC brought in Rmb1 billion in gross profit. Over the past four years Rongsheng has also supplied the oil firm with floating cranes and CNOOC has been the chief customer for its ocean engineering division. Significantly, local media says that this is Rongsheng’s highest-margin unit. The loss of future CNOOC orders would further damage the group’s profitability – especially at a time when its core shipbuilding business faces such bleak prospects.

The danger for Zhang is that the insider trading scandal risks his relationship with CNOOC’s senior managers, who will be very aware of the need to present themselves in a good light in order to secure the regulatory approvals for the Nexen deal.

CNOOC will be wanting to avoid a humiliating rerun of its efforts to buy the US oil firm Unocal in 2005, with the bid eventually withdrawn after strong opposition from regulators and US politicians.

That might explain why CNOOC has begun talks – according to the 21CN Business Herald – with Sany to replace Rongsheng as an equipment supplier. And likewise why CNOOC is publicly downplaying its relationship with Rongsheng. Yes, it was an anchor investor in Rongsheng’s IPO, the oil firm admits. But an official from CNOOC told South Weekend that “it cannot be deduced there is intimacy between us”. After all, the executive pointed out, CNOOC has seen its investment in Rongsheng fall by 80%, like others who bought shares in the IPO. That’s hardly grounds for a backslapping friendship and draws attention to why many fund managers have also lost faith in Zhang.

Zhang himself professes to be unbowed, promising he’ll turn Rongsheng into China’s equivalent of Hyundai Heavy Industries, the world’s top shipbuilder. He’s even forecasting annual sales will hit $10 billion within five years, about four times last year’s revenues.

But to achieve this feat he will have to survive a ‘perfect storm’ of business and regulatory troubles.

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