Will China rescue water tech as it falls?
Published February 23rd, 2017
I was in Shanghai last week to join Poten Environment in ringing the bell to open trading on the day of the Chinese industrial water treatment specialist’s initial public offering. It was a very Chinese event, but at the same time one which is a symptom of a global trend which is affecting the value of water businesses.
Within three seconds of the market opening, Poten’s share price had risen by 44% from RMB6.74 to RMB9.71, but there was none of the frenzy that would surround such an opening premium on NYSE. Just 200 shares changed hands during that time. Since then, the shares have risen by 10% each day, so that they now stand at RMB14.22. It is a pretty sure bet they will rise by 10% tomorrow as well, because Chinese stock market rules suspend trading when the share price rises by that amount. The way things seem to work in these Chinese IPOs is that companies do not expect to raise much money, so it does not matter if they are heavily under-priced on their debut. What matters is developing upward momentum in the shares so they can be used for raising more money later.
Poten’s IPO raised just RMB270 million ($39 million) – but its market cap is now RMB5.7 billion ($827 million) and rising. This gives the company (which has expected 2016 revenues of RMB2.3 billion ($337 million) a nice currency with which to make acquisitions. That is where the fun starts. Private companies like Poten are increasingly struggling to maintain their growth rates in the domestic Chinese market, and they are looking overseas for opportunities. When they look, they find that there is a big difference in the way foreign water businesses are valued and the way that Chinese businesses are valued. If you can buy a foreign business for an EBITDA (earnings before interest, tax, depreciation and amortisation) multiple of 12.5x (which is roughly what is expected for GE Water) and get those earnings re-rated to the 25x multiple that your shares trade on, then you can double your money with every acquisition that you make. Poten’s share price currently implies a 22x 2016 EBITDA multiple. Tomorrow I expect the multiple to reach 24x, and next week it will climb further.
This game of rolling up acquisitions and re-rating them as you go along used to be a popular play on Western stock markets: it was what built USFilter from nothing to a $5 billion-a-year company during the 1990s. It has fallen from favour because all too often these roll-ups fail to deliver the organic growth rate needed to justify a high valuation. The difference in China is that there is a genuine value arbitrage taking place. This is in part because China’s investors save more than foreigners, but have fewer options for saving. It is also because there is a genuine discrepancy between the way water technology companies are valued in the rest of the world compared to China.
At the moment, there is a distinct trend away from investing in water technologies that are tied to capital investment in North America and Europe. There are four main reasons for this. First, capital sales are slow to roll out because customers are risk-averse, and by definition capital projects are not a day-to-day need. Second, the cleantech investment boom (2006-2014) pushed up valuations in the water sector for a period, and many of the recipients of this largesse are now worth less than what was achieved at their last investment round. This overhang has dampened the enthusiasm of new investors entering the sector. Third, the exit of both Siemens and GE Water from the sector has raised concerns that water technology does not deliver the kind of returns that are acceptable for major industrial groups. And fourth, the smart money in the sector is moving into new areas.
Specifically, digital investments and other service-type offerings are in great demand. Digital is important because there is a sense that it could revolutionise the way the water sector works. Service is important because it avoids the slow adoption cycle that goes with the sale of capital goods.
These attitudes contrast strongly with the outlook in China. Here, foreign technology acquisitions have a double value. The first element is the competitive advantage they buy at home, where undifferentiated technologies are the norm; the second is the platform they provide for overseas growth. Risk aversion is less of an issue for Chinese customers: it brings prestige to them if they adopt the latest foreign technology brought in by a local company.
So what is stopping Chinese companies buying up the cream of the international water technology sector tomorrow? The biggest barrier is risk aversion on the part of Chinese companies as they look abroad. The language barrier, different management approaches, and unfamiliar legal systems complicate the underlying financial logic of international investment. The very same concerns also restrict the willingness of foreign technology companies to access the opportunities in the Chinese market.
With a view to reducing the perceived risks and barriers between China and the rest of the world, we have set up a joint venture in China with Envi Union to bridge the gap between Chinese water companies and water technology companies in the rest of the world. We are launching it with a workshop at the Global Water Summit in April. If you are a technology company with something interesting to offer China, or a Chinese company looking to invest in or partner with a foreign technology company, attending the event could be the best investment you make this year. Do e-mail our China Editor Yujia Shen at email@example.com if you would like to be part of it, and unlock the potential value arbitrage.